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Structure of Interest Rates

Outline

Interest rate risk

Duration

Bond immunization

Term structure of interest rates

Present value calculation under a yield curve

Explanations for the term structure

Using the term structure to forecast interest rates

Related readings: BKM Chapter 11, ME Chapter 3, 5.

time.

The change of interest rate can affect bond prices

significantly. Such uncertainty in bond prices that results

from interest-rate changes is so important that it has been

given a special name, interest-rate risk.

in Yield to Maturity

From the Figure 11.1, in each of the following cases, all others

being equal, bond prices are more sensitive to changes in

interest rates when

(1) time to maturity is longer or shorter? (longer)

(2) coupon rate is higher or lower? (lower)

(3) current YTM is higher or lower? (lower)

How to measure the sensitivity of bond prices to interest rate

changes?

Duration ()

The bond price as a function of YTM (CFt is the bond cash flow

at time t)

T

CFt

P(r )

t

(1

r

)

t 1

Definition of duration:

CFt / (1 r )

D t

P(r )

t 1

T

Weight

for t

interpreted as a weighted average of time, which can be

thought as the effective bond maturity.

dP (r )

P( r )

D

dr

1 r

1 r dP(r )

P (r ) dr

P

r

D

D r

P

1 r

interest rate increases 1%, the bond price decreases by 5%.

Rule 1: The duration of a zero-coupon bond equals its time to

maturity.

Rule 2: All others being the same, duration is lower when the

coupon rate is higher.

Rule 3: All others being the same, duration generally

increases with its time to maturity (always true for bonds

selling at par or over par; not necessarily true for deeply

discounted bonds)

Rule 4: All others being the same, duration is higher when the

YTM is lower.

a counter-example

Duration of a portfolio

Suppose there are m fixed income securities with values and

durations of Pi and Di, i = 1,2,, m, all computed at a common yield.

The portfolio value and portfolio duration are then given by

P = P1 + P2 + + Pm

where

Pi

Wi

,

P1 P2 Pm

i 1,2,, m.

Duration of a Portfolio

dPm (r )

dP(r ) dP1 (r )

dr

dr

dr

1

D1P1 (r ) Dm Pm (r )

1 r

Pm ( r )

P(r ) P1 (r )

Dm

D1

1 r P(r )

P(r )

Compare to dP (r ) P (r ) D

dr

1 r

Example

A

B

C

D

$10 million

$40 million

$30 million

$20 million

0.10

0.40

0.30

0.20

= 5.4.

4

7

6

2

change 1%, the portfolio value will change by approximately

5.4%.

Liabilities

have mismatch between their assets and liabilities.

Banks:

Deposits (liabilities): shorter term

Loans (assets): longer term

Pension funds

Promise to make payments to retirees: long term

Assets: shorter term

Example: In year 2003, the gap between assets and liabilities

grew by 45 billion USD for US pension funds, despite that the

return in the US stock market exceeded 25% in that year. The

stock market gains are mainly driven by falling rates, and due to

mismatch of asset and liability maturities, liability value is

affected more.

The insurance company issues a guaranteed investment contract

(GIC), which is popular for retirement-savings account.

GIC: Investors pay $1000 to the insurance company now and gets

the money back with 5% annual rate of return after 7 years.

Insurance companys obligation in year 7:

1000*(1+5%)7=$1407.10

If the insurance company can find a 7 year zero-coupon bond with

YTM 5% then the obligation will be met.

However, such bonds may be hard to find in the market.

Suppose the market offers the following two zero-coupon

bonds with current YTM = 5%:

5-year and 10-year.

We will consider two strategies:

(1) The insurance company invests $1000 in the 5-year bond.

(2) The insurance company invests $1000 in the 10-year bond.

5-year Bond

1000*(1+5%)5=1276.28. This amount will be reinvested until

the end of year 7.

Suppose t=5, the interest rate becomes

Interest

Rate

6%

5%

4%

Investment Obligation

1434.03

1407.10

1380.43

1407.10

1407.10

1407.10

Difference

26.93

0.00

-26.67

obligation due to lower reinvestment rate.

10-year Bond

After seven years, the bond will be sold to meet the obligation.

Its price = 1000(1+5%)10/(1+r)3, where r is the interest rate at

t=7.

Interest

Investment Obligation Difference

Rate

6%

1367.6513

1407.10

-39.45

5%

1407.1004

1407.10

0.00

4%

1448.0814

1407.10

40.98

obligation due to the decrease in the bonds price.

Immunization

liabilities from interest rate movement.

We use both the 5-year and the 10-year bond. The total

investment amount is equal to the current obligation value

$1000.

Let w1 and w2 be the proportion invested in the 5-year and

10-year bond respectively.

w1+ w2 = 1

(1)

We match the duration of the bond portfolio with the

duration of the obligation

5w1+ 10w2 = 7

(2)

Solving Eq.(1) and (2), gives us

w1=0.6, w2 = 0.4.

At time 0, the yield = 5%. Suppose the yield suddenly changes

to a new level r, and remains at that level thereafter.

At t=7,

5-year bond value: 1000*0.6*(1+5%)5*(1+r)2

10-year bond value: 1000*0.4*(1+5%)10/(1+r)3

Interest

5-yr bond

Rate

10-yr bond

Total

Obligation Difference

Investment

6%

860.42

547.06

1407.48

1407.10

0.38

4%

828.26

579.23

1407.49

1407.10

0.39

Subscript O refers to the obligation and P refers to

the bond portfolio.

Recall PO (r ) PP (r )

Do

DP

PO (r ) PP (r ) PO (r )

r PP (r )

r

1 r

1 r

D Do

PO (r ) P

r

1 r

obligation is offset by the change in the value of the bond

portfolio. For large r , this may not be true as duration

approximation is only a first-order approximation! But

large interest rate change in a very short time is unlikely.

Hence this strategy is effective in practice.

Now suppose the 10-yr zero-coupon bond is not available. We

can only find a 10-yr bond with coupon rate 5% selling at par

at time 0. The duration of this bond at time 0 is 8.10.

Now we have w1+ w2 = 1, 5w1+ 8.1w2 = 7. Hence

w1=0.3548, w2 = 0.6452.

Bond Immunization

(1) the value of the bond portfolio must equal the value of the

liabilities.

(2) The proportion invested in each bond must be selected

such that the durations are matched.

In practice, the strategy we found at time zero only protects

the difference of assets and liabilities from interest rate

movements at time 0. As time moves on, the duration of the

bond portfolio and the liability no longer match, so portfolio

managers have to rebalance the bond portfolio to match

duration again.

Another factor that influences the interest rate on a bond

is its term to maturity: bonds with identical risk and

liquidity characteristics may have different interest rates

because the time remaining to maturity is different.

A plot of the yields on bonds with differing terms to

maturity is called a yield curve/term structure of interest

rates.

Upward-sloping: long-term rates are above

short-term rates

Upward sloping curve: the long-term interest rate are above

the short-term interest rates.

It is the most usual case in the market.

Sometimes, long term lending happen to have lower yields

than short term. The result is said an inverted yield curve.

Contents

Present value calculations under a given yield curve.

We want to study theories that explain various shapes of the

yield curve.

Expectations Theory

Liquidity Premium Theory

Spot Rates

The spot rate

is the interest rate, expressed in

annual terms, charged for money held from the

present time

until time .

You can also understand as the YTM of a zerocoupon bond with maturity .

The term structure indicates that

is not a

constant for different . The corresponding spot

rate should be used when calculating interests of

some amount of money held in a period of time.

Suppose that a bond maturing in 5 years pays 8%

coupon each year. Its face value is $100. The spot

interest rates are given by

Year

Rate

(%/yr)

5.6

6.1

6.6

6.9

7.4

7.7

8.0

8.3

8.6

The formula of bond price changes to the following under the

interest term structure

C

F

P

n

(1 sN ) N

n 1 (1 sn )

N

present value of the cash flows is

xN

x1

x2

P

...

2

1 s1 (1 s2 )

(1 sN ) N

Our previous discussion about duration assumes there is only

a single interest rate for all maturities.

One can generalize to the case where we have a term

structure of interest rates.

We do not consider such generalization in this course.

Fact 1: Interest rates on bonds of different maturities move

together over time.

Fact 2: When short-term interest rates are low, yield curves

are more likely to have an upward slope; when short-term

rates are high, yield curves are more likely to slope downward

and be inverted.

Fact 3: Yield curves is almost always slope upward.

Liquidity premium theory can explain all three facts.

Expectations Theory

The expectations theory assumes that bonds of different

maturities are perfect substitutes: the expected return on

these bonds is equal in a common horizon.

Example: Consider two investment strategies

another one-year bond.

Purchase a two-year bond and hold it until maturity.

The expectations theory assume that the investor is indifferent

between these two strategies.

What should the two-year bond interest rate be? Here all bonds are

zero-coupon bonds.

Expectations Theory

Consider an investment of $1 in both strategies.

Using the definitions

= todays interest rate on a one-year bond

next year

We have

(1 it )(1 ite1 ) (1 i2t ) 2

e

2

i

i

,

i

Ignore the very small terms t t 1 2t , we get

Expectations Theory

We will find that the interest rate of

bond must be

on an n-period

interest rate on a long-term bond will equal an average of

the short-term interest rates that people expect to occur

over the life of the long-term bond.

suggests that short-term interest rates are expected to rise in the

future.

When the yield curve is inverted, it implies that short-term interest

rates are expected to fall in the future.

An Example

The one-year interest rate over the next 5 years are expected

to be 5%, 6%, 7%, 8%, and 9%. What is the yield curve up to 5

years according to the expectations theory?

Yield Curve under the Expectations Theory

7.50%

7.00%

6.50%

6.00%

5.50%

5.00%

4.50%

4.00%

A rise in short-term rates today also raises peoples

expectation of future short-term rates.

Since the long-term rate today is an average of expected

future short-term rates, the long-term rate also increases.

Thus, the short-term and long-term rates move together.

When the current short-term rate is low, people generally

expect it to rise to some normal level in the future, and

the average of future expected short-term rates is high

relative to the current short-term rate. Therefore, longterm interest rates will be higher than the current shortterm rate, and the yield curve would be upward-sloping.

When the current short-term rate is high, people generally

expect it to drop to some normal level in the future, so the

long-term rate will be lower than the current short-term

rate, giving an inverted shape.

in the Past 5 Years

The typical upward slope of yield curves implies that shortterm interest rates are usually expected to rise in the future.

However, in practice, short-term interest rates are just as

likely to fall as they are to rise.

Bonds of different maturities are not perfect substitutes,

but substitutes:

The expected return on one bond does influence the expected

return on another bond of a different maturity

But investors tend to prefer shorter-term bonds because these

bonds bear less interest-rate risk.

premium to induce them to hold bonds of longer

maturities.

Built upon the expectations theory, the liquidity premium

theory states that the interest rate on a long-term bond

will equal an average of short-term interest rates expected

to occur over the life of the long-term bond plus a

liquidity premium.

always positive and rises with the term to maturity of the

bond.

It is written as

which is always positive and rises with the term to

maturity of the bond.

In this drawing, we

assume the yield

curve is flat under the

expectations theory

An Example

As in the previous example, lets suppose that the one-year interest rate

over the next 5 years are expected to be 5%, 6%, 7%, 8%, and 9%.

Investors preferences for holding short-term bonds have the liquidity

premium for one-year to five-year bonds as 0%, 0.25%, 0.5%, 0.75%,

and 1.0%. What does the yield curve up to 5 years look like now and

how does it compare to the previous one under the expectations theory?

9.00%

and the Expectations Theory

8.00%

7.00%

6.00%

5.00%

4.00%

Expectations Theory

The liquidity premium theory can explain why yield curves

typically slope upward (Fact 3).

Liquidity premium rises with a bonds maturity.

occasional appearance of inverted yield curves.

future that the resulting long-term rate will still be lower than the

current short-term interest rate, even when the positive liquidity

premium is added to the average.

What do these yield curves tell us about the publics expectations of future

movements of short-term interest rates

Bonds

were expected to decline sharply in the future.

1980 and 1997 (moderate upward-sloping): short-term

interest rates were expected neither to rise nor to fall much in

the future.

1985 and 2000 (steep upward-sloping): short-term interest

rates were expected to climb in the future.

The yield curve given today contains useful information for

expected future interest rates.

Expectations Theory,

2

(1

i

)

2t

ite1

1

1 it

ite n is the market expected one-year interest rate n years from

today.

(1 int ) n (1 ite n ) (1 in 1t ) n 1

ite n

(1 in 1t ) n 1

1

n

(1 int )

Liquidity Premium

ite n

(1 in 1t ln 1t ) n 1

1

n

(1 int lnt )

to be estimated first.

An Example

customer a one-year loan at an interest rate of 8% one year from now. To

compensate for the costs of making the loan, the bank needs to charge

one percentage point more than the expected interest rate on a Treasury

bond with the same maturity if it is to make a profit. If the bank manager

estimates the 1-year liquidity premium to be zero but 2-year liquidity

premium to be 0.4%, and the one-year Treasury bond rate is 6% and the

two-year bond rate is 7%, should the manager be willing to make the

commitment?

2

2

(1

l

)

(1

0.07

0.004)

2t

2t

ite1

1

1 7.2%

1 i1t l1t

1 0.06

The loan is not attractive to the bank as it needs to earn at least 8.2% to

be profitable.

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