Can anyone explain to me why Fixed Income Self-Test #3 (schweser) is not C? I don’t want to publish the whole Q since I know ppl like to take these as a diagnostic at the end of a section. Anyways, I just bombed the self-test after cranking on fixed income all weekend. Boo.
pure expectations theory - long term interest rates are the mean of expected short term rates. does not consider the price risk - that a bond may be sold prior to maturity and does not consider reinvestment risk - that rate at which bond cash flows can be reinvested might change. liquidity theory: liquidity premium associated with expected future spot rates and investors demand that premium to be compensated for the position of holding the exposure to the reinvestment rate risk. this liquidity premium is positively correlated with the time to maturity. Forward rates may rise a) because the rates themselves rise (upward sloping yield curve). or b) because the investor demands a liquidity premium to be compensated. Preference habitat theory: The premium here is not due to maturity - but due to the imbalance between supply and demand. premium is to induce investors to move out of their “preferred” zones (maturity range) and go to another zone. You cannot use this to predict that a rate would be 32 basis points … hence this is wrong.
Yeah, but all the question said was that the premium of 20 yr over 2 yr would be 32 bps. The preferred habitat explains that supply and demand for a given maturity dictates the premium. For example, if more investors wanted to be in the 2 yr than the 20 yr, there would be an interest rate premium on the 20 yr to induce investors to move to that maturity. The question just says that the relative premium is 32, which is exactly what it is. I don’t understand how that statement is inaccurate. I was actually going to select the liquidity theory, since the yield did go up with increasing maturity, but it just seemed like such a minor effect. I think the difference in yield between the 10 and 2 yr was only like 10 bps, which didn’t seem like a huge liquidity premium.
where did the question talk anything about supply vs. demand at each level, whether there are more borrowers (who need a reduction in premium) vs. supplier (who needs a increase in the premium) to be induced to shift their maturity range? It only gives you the time period range and the yield. So you cannot say anything about whose preferred habitat which period range is, and other stuff required to go with the preferred habitat theory.
So you can’t infer that lower yield means this is the preferred habitat for more lenders (investors), and higher yield means that it is less preferred for most lenders (investors)?
if you want to still continue to answer it that way, be my guest. but you are reading meaning into the table over and beyond what’s presented.
Yeah, I guess you’re right… it just bothers me cause I think both answers could be supported. I guess the take away for me is that if the yield curve is upward sloping, this supports liquidity theory, regardless of how tiny that slope might be (>0). Thanks!