When constructing a yield curve, what is the role of zero-coupon bonds? What is a yield...

When constructing a yield curve, what is the role of zero-coupon bonds? What is a yield curve? What is the difference between a spot rate, a short rate, and a forward rate? How is a one-year forward rate five years out easily calculated?

Expert Solution

A coupon is a periodic interest received by a bondholder from the time of issuance of the bond till maturity. Zero coupon bonds, also known as discount bonds, do not pay any interest to the bondholders. Instead, you get a large discount on the face value of the bond.On maturity, the bondholder receives the face value of his investment. In simple words, the investor purchasing a zero coupon bond profits from the difference between the buying price and the face value, contrary to the usual interest income. Zero coupon bonds can work wonders, if used meticulously and in sync with your investment goals.

A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. There are three main types of yield curve shapes: normal (upward sloping curve), inverted (downward sloping curve) and flat.

Difference between spot rate, short rate forward rate are :

A spot rate is a contracted price for a transaction that is taking place immediately (it is the price on the spot). A forward rate, is the settlement price of a transaction that will not take place until a predetermined date in the future; it is a forward-looking price. Short rates are future short term interst rates that might happen in the future. Spot rate are most frequently referenced in relation to the price of commodity futures contracts, such as contracts for oil, wheat, or gold. This is because stocks always trade at spot. The forward rate is what you can lock in today by buying and selling today's spot rates. Short rates are rates that might occur. This implies some sort of generator is needed.

jeff jeffy answered 2 years ago

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