Lecture 05: Yield Curve Arbitrage

This lecture concerns one of the most important topics in Finance, the yield
curve. We said the yield was an attempt to look at an investment, and without
paying any attention to the market or anything outside the investment, to try to
assess how attractive the investment was. This applyies that to a bond, since it
has cash ows. You could also apply it to a hedge fund that is taking in money
and paying out money, and the formula we came up with said:
C(0) +

C(T )
C(2)
C(1)
+ ::: +
=0
+
1 + y (1 + y)2
(1 + y)T

(1)

Some of the cash ows (CFs) above might be negative and some of them might
be positive. The formula solves for y, such that discounting all these CFs at
rate y gives you 0. We dened this y as the yield of the investment.
We also saw that that had some advantages. For example, in a hedge fund,
if you just look at the rate of return it makes on its money every year, that
doesnt take into account that in some years, its got a lot more money. So
if those were the years that lost money, and the years when it hardly had any
money were the years it made money, just taking the average, the multiplicative
average, the geometric average of all those yearly rates of returns, would give a
misleading gure.
However, the yield also may give a somewhat misleading gure. Lets give
an example. Suppose that the cash ows happen to be 1, -4, and 3. Now whats
the yield to maturity? Well, there are two of them. You could have y = 0,
because:
1

4
3
+
=0
(1 + 0)1
(1 + 0)2

(2)

That equals 0, so the yield to maturity of 0 percent, makes this have present
value 0. But also I could try Y = 200%, and then Id have:
1

4
3
+
=0
(1 + 2)1
(1 + 2)2

(3)

which also equals 0. So is the yield to maturity, the internal rate of return 0
percent or 200 percent? Its ambiguous. So the yield to maturity cant be the
right way of doing things.
To go back to the hedge fund example, suppose that there was some period,
at which point everyone had taken all their money out, so the hedge fund wasnt
actually doing anything for a bunch of years, maybe for a long time, and then
it started up and took money in and paid money. Well, because the gap in
time was very long with nothing happening, if you take a positive y, the stu
that happens in the second incarnation of the fund is hardly going to be making
any dierence, because by that time, it will all be discounted a lot. The yield
will depend too sensitively on stu early rather than stu late. Therefore, even
though the term is somewhat inappropriate, the word lives on, and part of the
common vocabular.
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Now what would Irving Fisher say you should do, if you had to summarize
how good an investment was? He would say: "Just look at the present value of
all these cash ows." However, to do that, youd have to know, the market rate
of interest with which to compute the present value? So Fisher would say, "Its
ridiculous to evaluate how good an investment opportunity is just by looking at
the cash ows. Youre throwing away too much information."
You know what the market is doing, you know what the interest rates are.
Use the market interest rates and gure out what the present value of all the
cash ows is. Lets use an example. Suppose the U.S. Treasury issues a 1-year
bond, a 2-year bond, a 3-year bond, a 4-year bond and a 5-year bond, all in the
same day. Also suppose that the coupon it sets is 1 dollar for the 1-year bond,
2 dollars for the 2-year bond, 3 dollars for 3 three-year bond, 4 for the 4-year
bond, 5 for the 5-year bond. and the face value is always 100. Further lets say,
when they actually market these, and supply equals demand in equilibrium, the
prices turn out to be (1) = 100.1, (2) =100.2, (3) =100.3, (4) =100.4,
and (5) =100.5. So 100.5 is the price the market is paying for the 5 year bond.
Finding the yields for each bond is then straightforward. For instance, for the
4-year bond:
100:4 =

4
4
104
4
+
+
+
1 + y(4) [1 + y(4)]2
[1 + y(4)]3
[1 + y(4)]4

(4)

and y(4) can be found using something like the solver in Excel. However,
the information that you want to deal with is the price, and what did the
coupon actually pay. But now, what does Fisher say you should do? The most
important thing to do is nd the zeros interest rates. If you modernize Fisher a
little bit, the most important thing to do is nd the prices of the zeros:
(i)

todays money price for 1 dollar at time i.

Okay, now why do you want to nd these things? Because once you know
these things, youd be able to value any investment. For instance, the price or
fair value of an investment is a sum of the product of the cash owsand the s.
:
P = C(1) (1) + C(1) (1) + ::: + C(T ) (T )

(5)

Now why is this the right price? Because if you can go in the market and
buy 1 dollar at time 1 for (1), and 1 dollar at time 2 for (2), etc., you can buy
all the cash ows from this investment project by spending P . So if somebody is
oering you the investment opportunity at a higher price, it would be crazy to
do it. You could have bought those cash ows yourself by paying P . If he oers
it to you at a lower price than that, then denitely you should do it, because
its a bargain, because if you had to buy it yourself, it would be more expensive.
In fact, if hes oering it to you at a lower price, you can make an arbitrage
prot. How could one realize this arbitrage prot? You buy his project for
the lower price P and then sell these very promises, C(1), C(2), C(T) on the
market. So you sell it in fact for a higher price. You make the dierence, and
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when it comes time to keep your promises, the project is giving you the cash to
keep your promises, so you lock in a prot for sure. So if you knew the 0 s,
you would know for sure how to value any project where you knew for sure the
cash ows.
So far we said literally that (1) is the price you would pay today to buy 1
dollar tomorrow. Now how could you go about buying 1 dollar tomorrow, given
that the only things you can trade on the market are these Treasury bonds for
which you know the price and coupons? You can trade, buy or sell any of these
Treasury bonds. The arguments involve the ideas of Replication, Pricing, and
Arbitrage.

(1)

(2)

(3)

1
1
(1) =
100:1 = 0:991
101
101
1
2 1
(1) +
(2) = 0:963
102 101
102
3
3 1
1
(1)
(2) +
(3) = 0:917
103
103 102
103

(6)
(7)
(8)

(1) is 1/101 of the price of the 1 year bond: to buy one 1-year bond it
costs 100.1 so (1) will cost 1/101 of the price of the bond. To get (2) you buy
1/102 (since the 2-year bond pays 102 dollars) of the price of the 2-year bond
and sell 1/102 of the present value of the $2 coupon that you dont need but
receive in year 1.
In words, what weve done is weve said, there are things you can actually
trade on the market. Those are the Treasuries. Those are our benchmark
securities. Now what were interested in is some other maybe ctitious securities
or new securities. The price of the zeros, those are the basic building blocks
that will help us evaluate the present value of any investment. So the reason
why we know these prices is because we can replicate them by trading only the
benchmarks, only the Treasuries.
To get the 1-year zero, we just buy the correct fraction of 1 year Treasuries.
To get the 2-year zero, we have to buy the correct fraction of 2 year Treasuries
and sell the correct fraction of 1 year Treasuries. So weve replicated the 2-year
zero by a portfolio consisting of being long the 2 year Treasury and short the
1-year Treasury.
To get the 3-year zero coupon, we have to buy the 3-year Treasury, sell the
2-year Treasury and do something complicated with the 1-year Treasury. And
then well just add up the cost of that portfolio that replicates this. The 0 s are
the prices of zero coupon bonds of various maturities, and those arent really
traded directly in the market. Whats traded directly in the market, where
pieces of paper change hands, are the Treasury bonds. But everybody, every
day is calculating these zero coupon prices, because thats what they need to do
to evaluate every single project that they might conceivably do that day, and
decide whether its a good project or a bad project. Is it worth the price or not
worth the price?

However, instead of the more complicated approach above there is a very fast
algorithm that you can do almost instantly, and thats why its such a triviality
to calculate these numbers ever day. So its called the principle of duality.
For instance, suppose someone is willing to pay me 93 cents to recieve $1
three years from now (i.e., pay 93 cets for a 3 year zero).
Well, Id say, "Thats wonderful." Ill sell them this promise in year 3, of 1
dollar for 93 cents. Then with that 93 cents, Ill only use 91.7 of those cents
and Ill go out and buy the 3-year Treasury. Ill sell some of the 2 year Treasury
and Ill sell a little bit more of the 1 year Treasury. And that portfolio which
Ive done by doing that will pay me exactly 1 dollar in year 3, enabling me to
keep my promise to him, but it will only have cost me 91.7 cents.
So Ill have made a 1.3-cent prot for sure, with no chanceits a pure arbitrage. I made a prot of 1.3 cents with no chance of losing any money, because
Ive done all the transactions today, and the governments going to keep its
promises. I dont have to worry about the government giving me the money,
and so Ill be able to turn the money over to that guy in year 3. Meanwhile,
hes given me his 93 cents.
If you want to do an arbitrage and make your prot, you have to gure out
what the replicating portfolio is, and the replicating portfolio also tells you the
price. But it takes a long time to gure out what all these arbitrage-replicating
portfolios are.
The principle of duality is required to replicate and gure out what the (1),
(2), (3), (4), and (5) are. I can nd those numbers now just by clicking a
button in Excel, trivially, without bothering to nd the replicating portfolios.
Then if some bad trader comes to me and oers me 93 cents for the 3 year zero
coupon, then Ill gure out the replicating portfolio and take advantage of that
oer to make a pure prot for sure. The replicating formulas are below:
100:1 = 101 (1)
100:2 = 2 (1) + 102 (2)
100:3 = 3 (1) + 3 (2) + 103 (3)
100:4 = 4 (1) + 4 (2) + 4 (3) + 104 (4)
100:5 = 5 (1) + 5 (2) + 5 (3) + 5 (4) + 105 (5)

(9)
(10)
(11)
(12)
(13)

The logic behind this approach is the following: we dont know what (1)
through (5) are, but if you did know them, youd be able to price the very
bonds that the market is trading. So you would know that 100.1 had to equal
101 times (1). And youd know that 100.2, the 2 year zero Treasury bond,
whose price is 100.2, would have to be 2 times (1) plus 102 times (2):
Because (1) is the price you pay today for 1 dollar 1 year from now, 101
dollars, 1 year from now, costs 101 (1). If you knew (1) and (2), you could
gure out the price of the 2 year Treasury bond, because 2 dollars at time 1
cost 2 (1) and 102 dollars at time 2 cost 102 (2). And then the 3 year is 100.3
= 3 (1) + 3 (2) +103 (3), etc.
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So you dont know the 0 s, but you do know the bond prices, because the
market tells you, and you know the payos of all the bonds, because thats
just written on them, literally, so you can just read what the payos are. You
know the governments going to keep its promise. So rather than doing the
complicated computations, trying to gure out the 0 s, you assume you had
the 0 s. And then if you had the 0 s, they would tell you what the prices of
everything were.
However, given that we have ve equations and ve unknowns we can use
Excel to gure out this system of linearly independent equations.

0.1

Forward Interest Rates

The forward interest rates 1 + ift is the number of dollars at t + 1 in exchange for
1 dollar at t. This is like the interest rate that you might pay at time t. You give
up a dollar at time t, how much do you get at time t + 1? This is the interest
rate from t to t + 1 we are agreeing upon today. When time t arrives, somebody
is going to hand over one dollar, and when times t + 1 arrives, somebody else
is going to give back a certain number of dollars. This is called the period t
interest rate forward, because were locking it in today for a forward period of
time, but its really just the normal time t interest rate for one year:
1 + ift =

(14)

t+1

The forward rate is a trade-o between dollars at times t and t + 1. Please

note that the forward rates will always be a positive number even if the yield
curve is downward sloping (i.e., nominal interest rates cannot be negative).
Suppose that the yield curve is uppward sloping. The Excel spreadsheet details
all the calculations required to nd the forward rates. One can notice that
forward rates increaseq
at faster rate than the yield rates and than the zero rates
1
t
(remeber that y(t) = 1+1 t 1 or t = (1+y(t))
t ) . In other words, the 4-year
yield for example is in a sense averaging the payos of the rst 4 years, while
the 5-year yield is averaging it over 5 years. So if the 5-year yield has gone up,
it means that the forward rate in year 4 has gone up a lot to bring the long run
average up.

0.2

Interest Rates Under Certainty

If the world were one of total certainty, so everybody trading today had a
perfect forecast of what was going to happen in the future, the forward rates in
the market today would have to be exactly equal to the forward interest rate.
To say it backwards, if you assume everybody knows for sure what is going to
happen in the future, then the forward rates would be exactly equal to what
everyone is expecting to happen in the future. To say it slightly dierently,
if you happen to be the one ignoramus in the world who didnt know what
was going to happen in the future, but you knew that everybody else who was
trading in the market did know what was going to happen in the future, and
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you saw a forward rate of 5 percent, then you could deduce, even though you
were an ignoramus, that actually 2 years from now, the interest rate was going
to be 5 percent.
What are the reasons that the yield curve is upward sloping? On one hand,
Irving Fisher has already told us that when the market gets more productive,
then one is more optimistic about what is going to happen later and the real
interest rate goes up. And if ination is constant, and the real interest rate goes
up, the nominal interest rate has to go up.
The other possibility is that the real interest rate stays the same, but there
is ination in the future. The real interest rate plus the ination is the nominal
interest rate. That is another explanation for why people might expect the
nominal interest rate to go up.