Swap Spread
The swap spread is obtained by taking the difference between a swap’s fixed leg rate and the yield on a recently issued government bond (“on the run issue”) with the same maturity. Swap spreads can be used to value bonds….
Swap Rate Curve
An interest rate swap is a contract to exchange interest rate payments in the future between two parties over a specified period. Vanilla interest rate swaps (most commonly traded and most liquid) are contracts to exchange a fixed interest rate…
Riding the Yield Curve
Riding the yield curve (rolling down the yield curve) is an active trading strategy where a bond trader buys bonds with a maturity longer than their investment horizon. In an upward sloping curve, bonds with longer maturities earn higher yields…
Assumptions Relating to the Evolution of Spot Rates
Recall from the first learning objective of this reading that the forward rate lies above the spot rate for an upward sloping spot curve. On the other hand, the forward rate in a downward sloping spot curve lies below the…
Bootstrapping Spot Rates
Bootstrapping spot rates is a forward substitution method that allows investors to determine zero-coupon rates using the par yield curve. The par curve shows the yields to maturity on government bonds with coupon payments, priced at par, over a range…
Spot Rates and Forward Rates
This reading will establish how interest rates and prices of bonds for different maturities are related. Spot Rates The zero-coupon bond (discount bond) is the basic debt security that pays one unit of currency, e.g., $1, at maturity. The price…
The Capital Asset Pricing Model (CAPM), the Fama-French Model, and the Pastor-Stambaugh Model
The Capital Asset Pricing Model (CAPM) According to CAPM, investors evaluate the risk of assets based on the systematic risk they contribute to their total portfolio. The expected return on an asset is calculated as: $$\text{Required return on share }i=\text{Current…
The Equity Risk Premium
The equity risk premium (ERP) is the additional return (premium) required by investors for holding equities rather than risk-free assets. It is the difference between the required return on equities and the expected risk-free rate of return. $$\text{Required return on…
Return Concepts
Holding Period Return (HPR) The HPR is the return earned from investing in an asset for a specified period, and is given by: $$\text{r}=\frac{\text{D}_{\text{H}}}{\text{P}_{0}}+\frac{\text{P}_{\text{H}}-\text{P}_{0}}{\text{P}_{0}}=\frac{\text{D}_{\text{H}}+\text{P}_{\text{H}}}{\text{P}_{0}}-1$$ Where: \(\text{D}_{\text{H}}=\) Investment income, e.g., dividends. \(\text{P}_{\text{t}}=\) Share price at time \(t\). \(\text{P}_{0}=\) Share price at…
