Question #49
Reading: Reading 25 The Term Structure and Interest Rate Dynamics
PDF File: Reading 25 The Term Structure and Interest Rate Dynamics.pdf
Page: 20
Status: Unattempted
Correct Answer: B
Part of Context Group: Q49-51
First in Group
Shared Context
Question
The comment made by Ross is most likely:
Answer Choices:
A. inaccurate with respect to the statement about spot rates, forward rates, and yields
B. inaccurate with respect to the statement about rolling down the yield curve
C. inaccurate in both respects
Explanation
100 =
+
3.14
1.023
103.14
(1+S2)2
96.93 =
103.14
(1+S2)2
(1 + S2)2 =
= 1.06406
103.14
96.93
100 =
+
+
4.35
1.023
4.35
(1.0315)2
104.35
(1+S3)3
91.66 =
104.35
(1+S3)3
(1 + S3)3 =
= 1.13845
104.35
91.66
P0 =
+
+
= 104.58
6
1.023
6
(1.0315)2
106
(1.0442)3
Ross's comments about the relative values of spots, forwards, and yields-to-maturity is
inaccurate; when the yield curve is upward-sloping, forward curve will be higher than spot
curve and spot curve will be higher than yield curve. If the yield curve is downward-
sloping, the yield curve will be higher than the spot curve which will be higher than the
forward curve.
Riding the yield curve describes a strategy whereby an investor will buy a bond with a
maturity greater than his investment horizon and sell it before maturity. This strategy will
provide higher returns than buying a bond and holding it to maturity over the same period
only if the yield curve is upward sloping and its shape remains stable over the investment
period. If the yield curve steepens sufficiently the strategy may produce losses.