Deck 18: The Risk and Return of Interest Rate Securities

Question 1

How do we go from Monte Carlo Simulations to security prices?

Answer 1

We use the Feynman-Kac theorem that states that the solution to the fundamental pricing equation is given by an expectation. Then, thanks to the Central Limit Theorem, we know that the expectation can be ap- proximated by an average of simulated payoffs.

Question 2

On what does λ depend?

Answer 2

The market price of risk depends on the coefficent of risk aversion, the amount of risk and the convexity term.

Question 3

Explain the intuition behind the link between high long term yields and higher amount of risk.

Answer 3

A higher amount of risk pushes the market price of risk up, as market
participants expect to be compensated more.

Question 4

What is the "delta" approximation?

Question 5

You are planning to use Monte Carlo Simulations in order to simulate an interest rate one quarter from now. Which probability do you use?

Question 6

Explain the intuition behind the link between high long term yields and higher risk aversion of market participants.

Question 7

What problem does the "delta" approximation have?

Question 8

What factors explain long term yields?

Question 9

How do we define the market price of risk?

Question 10

You are planning to use Monte Carlo Simulations in order to compute the value of the range ?oater for di?erent scenarios. Which type of probability do you use?

Question 11

Explain the intuition behind the link between high long term yields and higher expected long term inflation.