CHAPTER 15

The Term Structure of Interest

Rates

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Overview of Term Structure

• The yield curve is a graph that displays

the relationship between yield and
maturity.

• Information on expected future short

term rates can be implied from the yield
curve.

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 Figure 15.1 Treasury Yield Curves

See Many other interesting links, for example:

Treasury.gov stockcharts.com
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Figure 15.1 Treasury Yield Curves

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 Bond Pricing
• Yields on different maturity bonds are not all
equal – there is a term structure.
• We need to consider each bond cash flow as
a stand-alone zero-coupon bond.
• The value of the bond should be the sum of
the values of its parts.
• Bond stripping and bond reconstitution offer
opportunities for arbitrage.

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Table 15.1 Prices and Yields to Maturities on
Zero-Coupon Bonds ($1,000 Face Value)

These prices are in the form:

CashFlowt
Price 
1  ytmt

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 Example 15.1 Valuing Coupon Bonds
• Value a 3 year, 10% coupon bond using
discount rates from Table 15.1:
$100 $100 $1100
Price   2
 3
1.05 1.06 1.07
• Price = $1082.17
• YTM = 6.88%
• 6.88% is less than the 3-year rate of 7%.

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 Two Types of Yield Curves
Pure Yield Curve On-the-run Yield Curve
• The pure yield curve • The on-the-run yield
uses stripped or zero curve uses recently
coupon Treasuries. issued coupon bonds
• The pure yield curve selling at or near par.
may differ • The financial press
significantly from the typically publishes on-
on-the-run yield the-run yield curves.
curve.

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 Yield Curve Under Certainty
• Suppose you want to invest for 2 years:
– Buy and hold a 2-year zero
or
– Rollover a series of 1-year bonds
• Equilibrium (or no arbitrage) requires that
both strategies provide the same return.

1+r1 1+r2
(1+y2)2

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Figure 15.2 Two 2-Year Investment Programs

(1+y2)2

1+r1 1+r2

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 Yield Curve Under Certainty
• Buy and hold vs. rollover:
1  y2 2
 1  r1  1  r2 
1+r1 1+r2
1  y2  1  r1  1  r2 
1
2
(1+y2)2
• Next year’s 1-year rate (r2) is just enough to
make rolling over a series of 1-year bonds
equal to investing in the 2-year bond.

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 Spot Rates vs. Short Rates
• Spot rate – the rate that prevails today for a
given maturity
• Short rate – the rate for a given maturity
(e.g. one year) at different points in time.
• A spot rate is the geometric average of its
component short rates.

yn  1  r1  1  r2  ...  1  rn  n  1
1

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 Short Rates and Yield Curve Slope

• When next year’s short • When next year’s short

rate, r2 , is less than this rate, r2 , is greater than
year’s short rate, r1, the this year’s short rate, r1,
yield curve slopes down. the yield curve slopes
– May indicate up.
market expects – May indicate
rates to fall. market expects
rates to rise.

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Figure 15.3 Short Rates versus Spot Rates

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Forward Rates from Observed Rates

(1  yn ) n
(1  f n )  n 1
(1  yn 1 )
fn = one-year forward rate for period n
yn = yield for a security with a maturity of n
n 1
(1  yn 1 ) (1  f n )  (1  yn ) n

1+fn
(1+yn-1)n-1
(1+yn)n

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 Example 15.4 Forward Rates
• The forward interest rate is a forecast of a
future short rate implied by the market.
• Example: compute forward rate for year 4:
– rate for 4-year maturity = 8%
– rate for 3-year maturity = 7%

1 f4 
1  y4 
4

1.08 4
 1.1106
1  y3 3
1.07 3

f 4  11.06%
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 Interest Rate Uncertainty
• Suppose that today’s rate is 5% and the
expected short rate for the following year is
E(r2) = 6%. The value of a 2-year zero is:

$1000
 $898.47
1.051.06
• The value of a 1-year zero is:
$1000
 $952.38
1.05
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 Interest Rate Uncertainty
• The investor wants to invest for 1 year.
– Buy the 2-year bond today and plan to sell
it at the end of the first year for $1000/1.06
=$943.40.
or:
– Buy the 1-year bond today and hold to
maturity.

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 Interest Rate Uncertainty
• What if next year’s interest rate is
more (or less) than 6%?

–The actual return on the 2-year

bond is uncertain!

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 Interest Rate Uncertainty
• Investors require a risk premium to hold
a longer-term bond.

• This liquidity premium compensates

short-term investors for the uncertainty
about future prices.

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 Theories of Term Structure
• Expectations
–Forward rates come from market
consensus
• Liquidity Preference
–Upward bias over expectations due to
premium the market requires

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 Expectations Theory
• Observed long-term rate is a function of
today’s short-term rate and expected
future short-term rates.

(1  y2 )  (1  y1 )(1  f 2 )
2

(1  y2 )  (1  y1 )(1  Er2 )
2

• fn = E(rn) and liquidity premiums are

zero.
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 Liquidity Premium Theory
• Long-term bonds carry more risk; therefore,
fn generally exceeds E(rn)
• The excess of fn over E(rn) is the liquidity
premium
• The yield curve has an upward bias built into
the long-term rates because of the liquidity
premium

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Figure 15.4 Yield Curves - A

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Figure 15.4 Yield Curves - B

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Figure 15.4 Yield Curves - C

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Figure 15.4 Yield Curves - D

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Yield Curves

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Yield Curves (cont.)

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 Interpreting the Term Structure
• The yield curve reflects expectations of future
interest rates.
• The forecasts of future rates are clouded by other
factors, such as liquidity premiums.
• An upward sloping curve could indicate:
– Rates are expected to rise
– And/or
– Investors require large liquidity premiums to hold
long term bonds.

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 Interpreting the Term Structure
• The yield curve is a good predictor of the
business cycle.
– Long term rates tend to rise in anticipation of
economic expansion.
– Inverted yield curve may indicate that interest
rates are expected to fall and signal a
recession.

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Figure 15.6 Term Spread: Yields on 10-year vs.
90-day Treasury Securities

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 Forward Rates as Forward Contracts
• In general, forward rates will not equal the
eventually realized short rate
– Still an important consideration when trying
to make decisions:
• Locking in loan rates

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Figure 15.7 Engineering a Synthetic Forward
Loan

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