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SEEM2520 Lecture 5

Interest Rate Risk and the Term


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.

Interest Rate Risk

Interest Rate Risk

As we have seen in Lecture 2, interest rates change over


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.

Figure 11.1 Change in Bond Prices as a Function of Change


in Yield to Maturity

Conclusions From Figure 11.1


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

D is called duration or Macaulays duration. It is often


interpreted as a weighted average of time, which can be
thought as the effective bond maturity.

Why does Duration Measure Sensitivity


dP (r )
P( r )
D
dr
1 r

Another way to define duration D

1 r dP(r )
P (r ) dr

When the change in r is small (note that 1 r 1 )


P
r
D
D r
P
1 r

Suppose D=5. The above formula says roughly speaking, the


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

Duration Approximation is First Order

Rules for Duration


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.

Figure 11.2 Duration as Function of Maturity

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

D = W1D1 + W2D2 + + WmDm


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

We get D = W1D1 + W2D2 + + WmDm

Example

Bond Market value


A
B
C
D

$10 million
$40 million
$30 million
$20 million

Portfolio weight Duration


0.10
0.40
0.30
0.20

Portfolio duration = 0.1 4 + 0.4 7 + 0.3 6 + 0.2 2


= 5.4.

4
7
6
2

Roughly speaking, if all the yields affecting the four bonds


change 1%, the portfolio value will change by approximately
5.4%.

Mismatch Between Maturities of Assets and


Liabilities

Banks, pension funds () and insurance companies often


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 Mismatch Problem of an Insurance Company


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.

Two Available Bonds


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

After 5 years, the insurance company gets


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

If the interest rate drops, this strategy fails to meet the


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

If the interest rate increases, this strategy fails to meet the


obligation due to the decrease in the bonds price.

Immunization

Immunization: a strategy to shield the difference of assets and


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.

Scenario Analysis for the Bond Portfolio


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

Why does matching duration work

P(r) be the present value under interest rate r.


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

If D p DO , for small r , the change in the value of the


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.

Use of Coupon Bonds


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.

Term Structure of Interest Rates

Term Structure of Interest Rates


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.

Different Shapes of Yield Curves


Upward-sloping: long-term rates are above
short-term rates

Flat: short- and long-term rates are the same

Inverted: long-term rates are below short-term rates

Upward Sloping Curve


Upward sloping curve: the long-term interest rate are above
the short-term interest rates.
It is the most usual case in the market.

Inverted Yield Curve


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.

Calculation under the Term Structure


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

What is the price of the bond?

7.7

8.0

8.3

8.6

Calculation under the Term Structure


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

In general, if we have a cash flow


present value of the cash flows is

in time , then the

xN
x1
x2
P

...
2
1 s1 (1 s2 )
(1 sN ) N

Duration under Term Structure


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.

Some Stylized Facts about the Term Structure


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.

Two Theories to Explain The Facts

Expectations theory explains the Fact 1 and 2 but not 3.


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

Purchase a one-year bond, and when it matures in one year, purchase


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

= interest rate on a one-year bond expected for


next year

= todays interest rate on a two-year bond


We have
(1 it )(1 ite1 ) (1 i2t ) 2

it ite1 it ite1 2i2t i22t

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

The implication of the expectations theory is that the


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.

When the yield curve is upward-sloping, the expectations theory


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%

Expectations Theory Explains Fact 1


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.

Expectations Theory Explains Fact 2


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.

3-Month US Bill Yield (short-term interest rate)


in the Past 5 Years

Expectations Theory Cannot Explain Fact 3


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.

Liquidity Premium Theory


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.

Investors must therefore be offered a positive liquidity


premium to induce them to hold bonds of longer
maturities.

Liquidity Premium Theory


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.

is the liquidity premium for the n-year bond, which is


always positive and rises with the term to maturity of the
bond.

Liquidity Premium and Expectations Theory


It is written as

is the liquidity premium for the n-year bond,


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%

Yield Curve under the Liquidity Premium Theory


and the Expectations Theory

8.00%
7.00%
6.00%
5.00%
4.00%

Expectations Theory

Liquidity Premium Theory

Liquidity Premium Theory


The liquidity premium theory can explain why yield curves
typically slope upward (Fact 3).
Liquidity premium rises with a bonds maturity.

The liquidity premium theory can also explain the


occasional appearance of inverted yield curves.

Short-term interest rates are expected to fall so much in the


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.

Interpreting Yield Curves for U.S. Government Bonds

What do these yield curves tell us about the publics expectations of future
movements of short-term interest rates

Interpreting Yield Curves for U.S. Government


Bonds

1981 (steep downward-sloping): short-term interest rates


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.

Forecasting Interest Rates


The yield curve given today contains useful information for
expected future interest rates.

From the yield curve today, we know it , i2t . From the


Expectations Theory,

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

2
(1

i
)
2t
ite1
1
1 it

ite1 is called the forward rate, which is the market expected

one-year interest rate one year from today.

General Forward Rate Formula


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 )

General Forward Rate Formula Considering


Liquidity Premium

Using the liquidity premium theory,

ite n

(1 in 1t ln 1t ) n 1

1
n
(1 int lnt )

is the liquidity premium for the n-year bond, which needs


to be estimated first.

An Example

A customer asks a bank if it would be willing to commit to making the


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.