FINS2624 WEEK 2

CHAPTER 15 – TERM STRUCTURE OF INTEREST RATES

The Yield Curve

 Yield curve: plot of YTM as a function of time to maturity

o Central to bond valuation
o Allows investors to gauge their expectations for future interest rates against those of the
market

Bond Pricing

 Treasury stripping suggests exactly how to value a coupon bond

 If each cash flow can be sold off as a separate security, then the value of the whole bond should be
the same as the value of its cash flows bought piece by piece in the STRIPS market
o If not – arbitrage profits can be made
 Bond stripping: buying bonds, stripping them into standalone zero-coupon securities, and selling off
the stripped cash flows
 Bond reconstitution: buying individual zero-coupon securities in STRIPS market and reconstituting
the cash flows into a coupon bond, selling the whole bond
 Pure yield curve: curve for stripped, or zero coupon, treasuries
 On the run yield curve: plot of yield as a function of maturity for recently issued coupon bonds
selling at or near par value

The Yield Curve and Future Interest Rates

Yield curve under certainty

 t spot rate: fixed interest rate for an investment starting today and ending at time t
o Together, the spot rates make up the term structure of interest rates or the pure yield curve
o Denoted yt
 Yield curve will take on different shapes at different times
o When next year’s spot rate is higher than today’s rate, the yield curve slopes upward
o When next year’s spot rate is less than today’s rate, yield curve slopes downward
 At least in part, the yield curve reflects the market’s assessments of coming interest rates
 The yield or spot rate on a long term bond reflects the path of short rates anticipated by the market
over the life of the bond

Inferring the term structure

A three year bond with coupons will be depicted thus:

 Market bond prices will imply the term structure

Spot rates of zero coupon bonds can be backed out using the following method:

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For two year bonds:

 As there are two unknowns and one equation, the spot rates have to be backed out using
bootstrapping

(1) Find yt from a one year zero coupon bond

(2) Substitute into equation for P2 – we now have one equation and one unknown

Arbitrage (pt 2)

Example: suppose that the following bonds trade in the market

(1) Back out implied term structure from pricing equations of bond A and B

(2) Use term structure to calculate arbitrage-free (or implied) price of bond C

(3) Construct synthetic version of Bond C from bonds A and B

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 a. As bond C trades for less than arbitrage free price, it is ‘too cheap’
b. Should buy underpriced real bond and sell overpriced synthetic bond
c. Synthetic bond’s cash flows need to replicate the CFs of the C bond

Must achieve:

As each A bond gives CF1 = 100, synthetic bond containing XA A-bonds must satisfy:

Similarly, the synthetic bond contains XB B-bonds so that XB satisfies:

(4) Exploitation of the mispricing: cash flows received are

a. This is a riskless profit at t=0

b. When doing so, the supply and demand of people’s trades that exploit the arbitrage opp
will push bond prices to their arbitrage free values

Reinvestment risk

 Whether longer term investor is willing to engage in a rollover strategy may be dependent on the
expected returns of the bond compared to that of the longer bond
o Unless they are certain of the final value of the rollover
o Generally would not be willing to hold short term bonds unless those bonds offered a
reward for bearing interest rate risk
 If issuers typically have shorter investment horizons than investors, we’d get a downward sloping
term structure

Example: for a two year bond, where in the first year the bond is expected to have a spot rate of 5%

1.06 ¿2=(1.05)(1+ f 2 )
( 1.05 ) [ 1+ E ( r 2 ) ] >¿

 Investor would require that expected value of next year’s short rate exceed the forward rate
 Hence, if all investors were long-term investors, no one would be willing to hold short term bonds
unless those bonds offered a reward for bearing interest rate risk

Holding period return

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Example: supposing an investor has an investment horizon of two years, but must reinvest at t = 1 to get all
cash flows at t = 2

Where spot rate valid at time 1 for an investment maturing at time 2 is denoted by 1y2, the cash flows at t=2
will be:

CF2 = FV + c + c(1 + 1y2)

• Since 1y2 is unknown at t = 0, so is CF2 – as there is a risk here, the return made on the investment
is also risky

To emphasize that we mean the (risky) investment return, we sometimes refer to this as the holding period
return, HPR:

Forward rates

 Def’n: interest rates for investments we agree on today but that take place in the future
o Denoted sft for a forward rate (determined today) that starts at time s and ends at time t
 In the absence of arbitrage opportunities, the term structure determines all forward rates (and vice
versa)

Determining forward rates

Example: To determine the forward rate between year 2 and 3 (denoted 2f3)

Cash flow consequences of investing $1 at this rate:

(1) Achieve the negative CF of $1 at t=2

a. Borrow

b. This requires repayment with interest,

(2) Invest money borrowed for three years to achieve CF at t=3 of:
(3) As the CFs replicates the CFs of the forward rate, the t= 3 cash flows can be equated:

Look to slides for second example

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Whether forward rates will equal expected future spot rates depends on investors’ readiness to bear
interest rate risk, as well as their willingness to hold bonds that do not correspond to their investment
horizons

Theories of the term structure

Liquidity risk

 Liquidity preference/preferred habitat theory: theory that liquidity premia determine the shape of
the term structure
 When liquidity risk occurs: Arises where investment horizon is not matched with cash flows
 When bond prices reflect a risk premium, the forward rate no longer equals expected spot rates
 To persuade short-term investors to hold bonds with a longer maturity, a risk-averse investor would
be willing to hold the long-term bond only if the expected value of the spot rate is less than the
break-even value, f2

Example: suppose we have an investment horizon of one year and we hold a coupon bond maturing at t = 2,
we must sell it at t = 1 to achieve our period 1 cashflow

(1) Calculate bond price at t = 1

P1 = (c + FV)/(1 + 1y2)

This means CF at t = 1 will be CF1 = c + P1

(2) Calculate HPR

How is this risky? Since 1y2 is unknown at t = 0, so is P1 and HPR

 Though in principle we could pick a bond with a maturity matching our horizon, markets must clear
and somebody must carry some risk
 Liquidity premium: premium offered to induce investors to hold bonds whose maturity does not
match their horizon (risk is given a price)
 If issuers typically have a longer investment horizons than investors, we’d get an upwards sloping
term structure

Expectations Hypothesis

 Theory: market expectations on future interest rates shape the term structure
o Forward rate equals the market consensus expectation of the future short interest rate
o Liquidity premiums are zero

 YTM are determined solely by current and expected future one-period interest rates
o Upward sloping yield curve would be clear evidence that investors anticipate increases in
interest rates

Look to slides for example

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Consolidating the two theories

 It is likely that both theories are at work, such that:

L is the liquidity premium the market demands to hold bonds of that maturity

 EH performs poorly according to data

 When would EH be true?
o If there was no uncertainty about future interest rates, there would be no reinvestment or
liquidity risk, and EH would be true
o If investors are risk neutral, i.e. do not require compensation for taking on risk, then EH
would be true

Interpreting the term structure

 Term structures can infer the expectations of other investors in the economy, and can also be used
as benchmarks for analysis
 Complexities in interpreting the term structure
o While yield curve does reflect expectations of future interest rates, it also reflects other
factors such as liquidity premiums
o Forecasts of interest rate changes may have different investment implications depending on
whether those changes are driven by changes in expected inflation rate or real rate
 Factors accounting for rising yield curve
o Where forward rate for coming period is greater than yield at that maturity: y1 < y2 < 1f2
o Where investors demand a premium for holding longer-term bonds
 However, note that a rising yield curve does not in and of itself imply expectations of higher future
interest rates  possibility of liquidity premiums confound simple attempt to extract expectations
from the term structure
 Factors accounting for a falling interest rate (falling yield curve)
o There are two factors to consider – real rate and inflation premium

1 + Nominal rate = (1 + Real rate)(1 + Inflation rate)

o Expected change in interest rates can be due to changes in either expected real rates or
expected inflation rates

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