The Yield Curve

The Yield Curve

The yield curve., Or the term structure of interest rates, shows how YTM is related to term to maturity
for bonds that are similar in all respects, expecting maturity.

FACE INTEREST MATURITY CURRENT YIELD TO

VALUE RATE (YRS) PRICE MATURITY
100,000 0 1 88.968 12.40
100,000 12.75 2 99,367 13.13
100,000 13.50 3 100,352 13.35
100,000 13.50 4 99,706 13.60
100,000 13.75 5 99,484 13.90

Yield Curve
14.50%

14.00%

13.50%

13.00%

12.50%

12.00%

11.50%
1 2 3 4 5
 Positively Sloped Yield Curve

This yield curve indicates that borrowers who wish

to borrow for long periods of time pay a higher rate
of interest than the medium-term borrowers who in
turn pay, higher rate of interest than short-term
borrowers.
 Negatively Sloped Yield Curve

• This indicates that borrowers who wish to borrow in

short-term pay a higher rate of interest than long-
term borrowers.
 Flat Yield Curve

• Borrowers at the short, medium, and long terms are

able to borrow at the same rate of interest.
 Term Structure of Interest Rates

 Expectations theory

 Liquidity preference theory

 Preferred habitat theory

 Market segmentation theory

 Market Expectations Theory
Shape of Yield curve depends on expectations of those who
participate in market
Any long term rate is equal to the geometric mean of the current and future
one year rates expected by the market participants
(1 + tRn) = [ (1 + tR1) (1 + t+1R1) … (1 + t+n-1Rn)]1/n
Rn = actual long term rate; n= term to maturity, R1= current year rate, t+1R1 =
expected one year rate during some future period (i = 1,….., n-1)
Thus, expectation hypothesis can explain any shape of yield curve
Yield Curve Explanation
Ascending Short-term rates rise in future
Descending Short-term rates … fall in future
Humped Short-term rates … rise …. fall
Flat Short-term rates . . unchanged in future
 Liquidity Preference Theory
Investors are risk averse, future unknown
Want a long term rate which is higher than average of expected
future rates
Forward rates should incorporate interest rate expectations as well
as a risk (or liquidity) premium
(1 + tRn) = [ (1 + tR1) (1 + t+1R1+L2) … (1 + t+n-1Rn +Ln)]1/n
Rn = actual long term rate; n= long term to maturity, R1= current one year rate, t+1R1
= expected one year rate during some future period (i = 1,….., n-1), L1 is the risk
(liquidity premium) for year i = (2, …..n)

An upward-sloping yield curve suggests that future interest rates will rise (or will
be flat) or even fall if the liquidity premium increases fast enough to compensate
for the decline in the future interest rates.
 Preferred Habitat Theory
• Investors prefer to match the maturity of investment to their investment objective
• Borrowers . . Too prefer to match borrowing horizons with their investment objective
• Investors with long term investment horizons would invest in long term securities,
otherwise they would be exposed to reinvestment risk & vice versa
• If mismatch … inducement to shift out of their preferred maturity ranges
 Market Segmentation Theory

• Extreme form of preferred habitat theory

• Investors & borrowers are unwilling to shift from their
preferred maturity range e.g. pensioners may be more
inclined to invest on long term, financial institutions may
invest in the short term
• Hence yield curve shape determined entirely by the supply
and demand forces within each maturity range
Interest Rate Risk and Bonds
• Price of a bond is dependent upon ytm or expected rate of return
• Expected Rate of Return is linked to Market rate of interest
• Interest rate is dependent on demand and supply of money in the
market
• Investor of a coupon paying bond will reinvest coupon interest at
market rate
• As the market interest rate falls, return on reinvestment of interest will
get lesser realization but the price of bond will go up. Vice versa for the
market interest rate going up.
• Realised return and maturity amount, thus may be different from
anticipated amount, other than ZCB.
• This is outcome of interest rate risk on investment in Bonds
Interest Rate Risk and Bonds
• Thus, someone who invests in even default-free
fixed-income securities face risk
• Reinvestment risk
• Price fluctuation risk
• Variability of return resulting from reinvestment of a
bond’s coupon at fluctuating interest rates
• Can be avoided by investing in zero coupon bonds
 Duration
• Duration is a measure of effective maturity of a bond and is different from
time to maturity, though measured in number of years.
• Duration is computed as the weighted average of the time slots until each
payment is received, with the weights proportional to the present value of the
payment. Duration is shorter than maturity for all bonds except zero coupon
bonds.
• It can be proved mathematically that if a bond is held for its duration
• in case market interest rate goes up, the amount of higher interest realized on coupon
interest reinvested, will be exactly equal to the fall in price of the bond
• and vice versa for market interest rate to fall
• Duration is equal to maturity for zero coupon bonds.
 Duration: Calculation

t
w t  CF t (1  y ) Price
T
D  t w
t 1
t

CF t  Cash Flow for period t

 Duration Calculation

8% Time Payment PV of CF Weight C1 X

Bond years (10%) C4

.5 40 38.095 .0395 .0197

1 40 36.281 .0376 .0376

1.5 40 34.553 .0358 .0537

2.0 1040 855.611 .8871 1.7742

sum 964.540 1.000 1.8852

 Duration/Price Relationship
Price change is proportional to duration and not to maturity.
P/P = -D x [(1+y) / (1+y)
D* = modified duration, D* = D / (1+y)
P/P = - D* x y
 Interest Rate Immunization
A bond, held for its duration, rather than time to maturity, protects the
investor’s realized yield from effects of interest rate change.
Thus duration is an effective tool to achieve interest rate immunization in
bond portfolio investments.
Price change of a bond is proportional to its duration
P/P = -D x [(1+y) / (1+y)
We define, D* = modified duration, D* = D / (1+y)
P/P = - D* x y
( % Change in price of a bond is directly proportional to change in ytm (y)
with D* as the constant to make it equal.
 Rules for Duration
Rule 1 The duration of a zero-coupon bond equals its time to maturity.
Rule 2 Holding maturity constant, a bond’s duration is higher when the
coupon rate is lower.
Rule 3 Holding the coupon rate constant, a bond’s duration generally
increases with its time to maturity.
Rule 4 Holding other factors constant, the duration of a coupon bond is
higher when the bond’s yield to maturity is lower.
 Rules for Duration
Rules 5 The duration of a level perpetuity is equal to:
(1  y)
y

Rule 6 The duration of a level annuity is equal to:

1 y T

y (1  y ) T  1
 Rules for Duration
Rule 7 The duration for a corporate bond is equal to:

1  y (1  y )  T (c  y )

y c[(1  y ) T  1]  y
 Portfolio Duration
Duration of a portfolio of bonds

Dp= Swn*Dn
wn= Weight of the Bond n as its value/ total value of portfolio
Dn= Duration of Bond n
 Interest Rate Immunization- Rebalancing
• A bond’s duration does not decrease on a one-to-one basis with time
• Market interest rates impact durations
• For these reasons portfolios must be rebalanced to maintain a duration that
will eliminate interest rate risk
• Annual or semi-annual rebalancing may be sufficient for certain assets/liability
characteristics
 Bond Pricing Relationships
• Inverse relationship between price and yield.
• An increase in a bond’s yield to maturity results in a smaller price decline than
the gain associated with a decrease in yield.
• Long-term bonds tend to be more price sensitive than short-term bonds.
• As maturity increases, price sensitivity increases at a decreasing rate.
• Price sensitivity is inversely related to a bond’s coupon rate.
• Price sensitivity is inversely related to the yield to maturity at which the bond is
selling.
• Convexity takes care of this gap in price change prediction.
 Duration and Convexity
Price

Pricing Error
from convexity

Duration

Yield
 Correction for Convexity
1 n
 CFt 
Convexity 
P  (1  y ) 2
  (1  y ) t (t  t ) 
t 1 
2


Correction for Convexity:

P
  D   y  1 [Conveixity  (  y ) 2 ]
P 2
Convexity is a measure of degree of price sensitivity of a bond
with respect to change in ytm
Bond Portfolio Management
 Bond Portfolio Management
Basic Strategies
• Active strategy
• Trade on interest rate predictions
• Trade on market inefficiencies
• Passive strategy
• Control risk
• Balance risk and return
 Passive Management
• Bond-Index Funds
• Immunization of interest rate risk:
• Net worth immunization
Duration of assets = Duration of liabilities
• Target date immunization
Holding Period matches Duration

• Cash flow matching and dedication

Active Management: Swapping Strategies

• Substitution swap
• Inter-market swap
• Rate anticipation swap
• Pure yield pickup
• Tax swap
 Yield Curve Ride
Yield to
Maturity %

1.5
1.25
.75

Maturity
3 mon 6 mon 9 mon
 Contingent Immunization
• A combination of active and passive management.
• The strategy involves active management with a floor rate of return.
• As long as the rate earned exceeds the floor, the portfolio is actively
managed.
• Once the floor rate or trigger rate is reached, the portfolio is
immunized.