Introduction to Fixed Income

Lecture 3: Term Structure of Interest Rates:

Empirical Properties, Derivation and Classical
Theories

Joëlle Miffre

Term Structure of Interest Rates:

Empirical Properties, Derivation and Classical Theories
• Empirical Properties of the Term Structure (TS)
– Shapes of the TS
– Dynamics of the TS
– Stylized Facts

• Deriving the Zero-Coupon Yield Curve: Bootstrap Method

• Theories of the Term Structure

– Pure Expectations
– Pure Risk Premium
• Liquidity Preference Theory
• Preferred Habitat
– Market Segmentation
– Biased Expectations
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1
 Types of Term Structures

• The term structure of interest rates is the series of interest rates ordered
by term-to-maturity at a given time

• The nature of interest rate determines the nature of the term structure
– The term structure of yields to maturity
– The term structure of zero-coupon rates
– The term structure of forward rates

• TS shapes
– Quasi-flat
– Increasing
– Decreasing
– Humped

Shape of the TS: Quasi-Flat

US YIELD CURVE AS ON 11/03/99

7.00%

6.50%

6.00%
par yield

5.50%

5.00%

4.50%

4.00%
0 5 10 15 20 25 30

maturity

Quasi-Flat

2
 Shape of the TS: Increasing

JAPAN YIELD CURVE AS ON 04/27/01

2.50%

2.00%

1.50%
par yield

1.00%

0.50%

0.00%
0 5 10 15 20 25 30

maturity

Increasing

Shape of the TS: Decreasing

UK YIELD CURVE AS ON 10/19/00

6.00%

5.50%
par yield

5.00%

4.50%
0 5 10 15 20 25 30

maturity

Decreasing (or
inverted)
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3
 Shape of the TS: Humped (1)

EURO YIELD CURVE AS ON 04/04/01

5.50%

5.00%
par yield

4.50%

4.00%
0 5 10 15 20 25 30

maturity

Humped (decreasing then increasing)

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Shape of the TS: Humped (2)

US YIELD CURVE AS ON 02/29/00

7.00%

6.50%
par yield

6.00%

5.50%
0 5 10 15 20 25 30

maturity

Humped (increasing then decreasing)

4
 Dynamics of the Term Structure

• The term structure of interest rates changes in response to

– Wide economic shocks
– Market-specific events

• Example
– On 10/31/01, Treasury announces that there will not be any further issuance
of 30-year bonds
– Price of existing 30-year bonds is pushed up (buying pressure)
– 30-year rate is pushed down

Dynamics of the Term Structure

Example – US YTM TS

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5
 Stylized Facts (1): Mean Reversion

• Mean reversion: high (low) values tend to be followed by low (high) values
• Example: Fed Fund Rate versus S&P500 Composite Index

Source: Federal Reserve Bank of St Louis and Datastream 11

Stylized Facts (2): Correlation

• Rates with different maturities are

– Positively correlated to one another
– Not perfectly correlated (more than one factor)
– Correlation decreases with difference in maturity

• Example: France (1995-2000)

1M 3M 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y
1M 1
3M 0.999 1
6M 0.908 0.914 1
1Y 0.546 0.539 0.672 1
2Y 0.235 0.224 0.31 0.88 1
3Y 0.246 0.239 0.384 0.808 0.929 1
4Y 0.209 0.202 0.337 0.742 0.881 0.981 1
5Y 0.163 0.154 0.255 0.7 0.859 0.936 0.981 1
7Y 0.107 0.097 0.182 0.617 0.792 0.867 0.927 0.97 1
10Y 0.073 0.063 0.134 0.549 0.735 0.811 0.871 0.917 0.966 1

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 Stylized Facts (3): 3 Main Factors Explain the Quasi-
Totality of Rates Changes
• The evolution of the interest rate curve can be split into 3 standard
movements
– Shift movements (changes in level), which account for more than 60% of
observed movements on average
– A twist movement (changes in slope), which accounts for 5% to 30% of
observed movements on average
– A butterfly movement (changes in curvature), which accounts for 1% to 10% of
observed movements on average

• That 3 factors can account for more than 90% of the changes in the TS is
valid
– Whatever the time period
– Whatever the market

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Term Structure of Interest Rates:

Empirical Properties, Derivation and Classical Theories
• Empirical Properties of the Term Structure (TS)
– Shapes of the TS
– Dynamics of the TS
– Stylized Facts

• Deriving the Zero-Coupon Yield Curve: Bootstrap Method

• Theories of the Term Structure

– Pure Expectations
– Pure Risk Premium
• Liquidity Preference Theory
• Preferred Habitat
– Market Segmentation
– Biased Expectations
14

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 Spot or Zero-Coupon Rate as Mentioned In Lecture 2

• Spot zero-coupon (or discount) rate R(0,t) is the annual rate on a pure discount or
zero-coupon bond (bond with only one cash payment at maturity)

• Example: Consider a 2-year zero-coupon bond that trades at $92. The 2-year zero-
coupon rate R(0,2) is such as
= $92 ⇒ R (0,2 ) = 4.26%
$100
(1 + R(0,2))2

• B(0,t), called discount factor, is the market price at date 0 of a bond paying $1 at
date t (PV of $1 received at date t)
= B(0, t )
$1
(1 + R(0, t ))t

T T
= ∑ Ft × B (0, t )
Ft
• General pricing formula P0 = ∑
t =1 (1 + R(0, t )) t =1
t

15

Deriving the Spot or Zero-Coupon Yield Curve

Bootstrap Method
• Problem: To price a portfolio of N coupon-paying bonds, we need a wide
range of zero-coupon discount rates with each discount rate matching the
timing of the cash-flows on the N bonds

• Bad news: No such abundance of zero-coupon bonds exists in the real

world

• Good news: We can compute the spot rate by extracting it from the prices
of coupon-paying bonds

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8
 Deriving the Spot or Zero-Coupon Yield Curve
Bootstrap Method
• Consider two securities (Nominal: $100)
– One-year pure discount bond selling at $95
– Two-year 8% bond selling at $99

⇒ R (0,1) = 5.26%
100
• One-year spot rate 95 =
(1 + R(0,1))

• Two-year spot rate

⇒ R(0,2 ) = 8.7%
8 108 8 108
99 = + = +
(1 + R(0,1)) (1 + R(0,2))2 1.0526 (1 + R(0,2 ))2

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Deriving the Zero-Coupon Yield Curve

Bootstrap Method
• If you can find different bonds with same anniversary date (cash-flows are paid at
the same dates), then you can directly get the spot rates
Annual Maturity
Price
coupon (Years)
Bond 1 5 1 101
Bond 2 5.5 2 101.5
Bond 3 5 3 99
Bond 4 6 4 100

• Solve the following system

– 101 = 105 × B(0,1)
– 101.5 = 5.5 × B(0,1) + 105.5 × B(0,2)
– 99 = 5 × B(0,1) + 5 × B(0,2) + 105 × B(0,3)
– 100 = 6 × B(0,1) + 6 × B(0,2) + 6 × B(0,3) + 106 × B(0,4)

• And we obtain the following discount factors and zero-coupon rates

– B(0,1) = 0.9619, B(0,2) = 0.9114, B(0,3) = 0.85363, B(0,4) = 0.7890
– R(0,1) = 3.96%, R(0,2) = 4.717%, R(0,3) = 5.417%, R(0,4) = 6.103% = (1 / B(0,4))1/4 - 1 18

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 Deriving the Zero-Coupon Yield Curve
Bootstrap Method
• Suppose that we know from market prices the following zero-coupon rates (LHS).
Consider also the bonds priced by the market until 3-year maturity (RHS)
Zero-coupon
Maturity
rate (%)
Overnight 4.40 Coupons
Maturity Gross price
1 month 4.50 (%)
2 months 4.60 1 year and 2 months 5 103.7
1 year and 9 months 6 102
3 months 4.70
2 years 5.5 99.5
6 months 4.90 3 years 5 97.6
9 months 5
1 year 5.10

5 105 5 105
• 1-year and 2-month rate 103.7 = + = + ⇒ x = 5.41%
(1 + R(0,2mths ))12 (1 + R(0,1year − 2mths ))1+12 (1.046 )12 (1 + x )1+12
2 2 2 2

• 1-year and 9-month rate 6 106

102 = 9
+ 9
⇒ y = 5.69%
(1 + 5% )12 (1 + y )1+12
• 2-year rate 99.5 =
5. 5
+
105.5
⇒ z = 5.79%
(1 + 5.10% ) (1 + z )2
• 3-year rate 5 5 105
97.6 = + + ⇒ u = 5.91%
(1 + 5.10% ) (1 + 5.79% )2 (1 + u )3 19

Deriving the Zero-Coupon Yield Curve

Bootstrap Method with Linear Interpolation
• Interpolation
– Term structure is a mapping θ ⇒ R(t,θ) for all possible θ
– Need to interpolate

• Linear interpolation
– We know discount rates for maturities t1 and t2
– We are looking for the rate with maturity t such that t1 < t < t2; e.g., A / B = C / D

R (0, t ) =
(t2 − t )R(0, t1 ) + (t − t1 )R(0, t 2 ) R(0,t2)
(t2 − t1 ) R(0,t)
B A
R(0,t1)
• e.g. R(0,3) = 5.5% and R(0,4) = 6%
t1 t t2
0.25 × 5.5% + 0.75 × 6%
R (0,3.75) = = 5.875% C
1
D 20

10
 Deriving the Zero-Coupon Yield Curve
Bootstrap Method with Polynomial (Cubic) Interpolation

• Cubic interpolation for different segments of the term structure

– Define the first segment: Maturities ranging from t1 to t4 (say, 1 to 2 years)
– We know R(0,t1), R(0,t2), R(0,t3), R(0,t4)

• The interpolated discount rate R(0,t) with t ∈ [t1; t4] is defined by

R(0, t ) = at 3 + bt 2 + ct + d

• Impose constraints that R(0,t1), R(0,t2), R(0,t3) and R(0,t4) are on the curve

 R (0, t1 ) = at13 + bt12 + ct1 + d


 R(0, t 2 ) = at 2 + bt 2 + ct2 + d
3 2


 R (0, t3 ) = at3 + bt3 + ct3 + d
3 2

 R(0, t ) = at + bt 2 + ct + d
3
 4 4 4 4
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Deriving the Zero-Coupon Yield Curve

Bootstrap Method with Polynomial (Cubic) Interpolation
• We have computed the following rates
– R(0,1) = 3%  R (0,1) = a13 + b12 + c1 + d = a + b + c + d = 3%

 R (0,2 ) = a 2 + b2 + c 2 + d = 8a + 4b + 2c + d = 5%
– R(0,2) = 5% 3 2


 R (0,3) = a3 + b3 + c3 + d = 27 a + 9b + 3c + d = 5.5%
– R(0,3) = 5.5% 3 2

– R(0,4) = 6%  R (0,4 ) = a 43 + b 4 2 + c 4 + d = 64a + 16b + 4c + d = 6%

• Compute the 2.5 year rate

– R(0,2.5) = a × 2.53 + b × 2.52 + c × 2.51 + d = 5.34375%
with −1
a  1 1 1 1  3 %   0.0025 
       
b  8 4 2 1  5 %   − 0 .0225 
 c  =  27 9 3 1
=
 5 .5 %   0 .07 
       
 d   64 16 4 1  6%   − 0 .02 
      

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 Deriving the Zero-Coupon Yield Curve
Bootstrap Method
• Given a, b, c and d, we can draw the term structure of discount rates

Zero-coupon yield curve - Polynomial versus Linear Interpolation

7%

6%
6% 5,88%
5,75%
5,63%
5,43% 5,50%
5,34% 5,79%
5,21% 5,66%
5,57%
Zero-coupon rate

5% 5,38%
5% 5,25%
4,70% 5,13%

4,28%
4,5%
4% 3,72% 4%

3% 3,5%

3%

2%
1 1,25 1,5 1,75 2 2,25 2,5 2,75 3 3,25 3,5 3,75 4
Maturity (years)

Piecewise Polynomial Piecewise Linear

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Term Structure of Interest Rates:

Empirical Properties, Derivation and Classical Theories
• Empirical Properties of the Term Structure (TS)
– Shapes of the TS
– Dynamics of the TS
– Stylized Facts

• Deriving the Zero-Coupon Yield Curve: Bootstrap Method

• Theories of the Term Structure

– Pure Expectations
– Pure Risk Premium
• Liquidity Preference Theory
• Preferred Habitat
– Market Segmentation
– Biased Expectations
24

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 Theories of the Term Structure

• Term structure theories attempt to account for the relationship between

interest rates and their maturity

• They fall within the following categories

– Pure expectations
– Pure risk premium
• Liquidity premium
• Preferred habitat
– Market segmentation

• To these main types, we can add

– The biased expectations theory, that combines the first two theories

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Pure Expectations

• TS reflects market expectations of future short-term rates

– An increasing (resp. flat, resp. decreasing) structure means that the market expects an
increase (resp. a stagnation, resp. a decrease) in future short-term rates

• Example: Change from a flat curve to an increasing curve

– The current TS is flat at 5%
– Investors expect a 100bp increase in rates within one year
– For simplicity, assume that the short (resp. long) segment of the curve is the one-year
(resp. two-year) maturity
– Then, under these conditions, the interest rate curve will not remain flat but will be
increasing
– Why?
Year 1 Year 2
r (0,1) = 5% E (r (1,2)) = 6%
r (0,2) = 5% r (0,2) = 5%

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 Pure Expectations

• Consider a long-term investor (2-year horizon) who wants to maximize his return.
He contemplates two alternatives
– Maturity strategy: Invests in 1 security with a long 2-year maturity
– Roll-over strategy: Invests in a short 1-year security then reinvests in one year the
proceeds in another 1-year security at the then-prevailing spot rate

• Before interest rates adjust at the 6% level,

– Annual return on maturity strategy: 5% over two years: $1 × (1.05)2 = $1.1025 in 2 years
– Roll-over strategy returns 5% in the first year and, according to expectations, 6% in the
second year: $1 × (1.05) × (1.06) = $1.1130 in 2 years

• Investor will thus buy short bonds (one year) rather than long bonds (two years)
– The price of the one-year bond will increase (its yield r(0,1) will decrease)
– The price of the two-year bond will decrease (its yield r(0,2) will increase)
– The curve will steepen

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Pure Expectations

• Vice versa, if the market expects interest rates to fall, the yield curve will not
remain flat but will become downward-sloping

Year 1 Year 2
r (0,1) = 5% E (r (1,2)) = 4%
r (0,2) = 5% r (0,2) = 5%

– Maturity strategy in 2 years: $1 × (1.05)2 = $1.1025

– Roll-over strategy in 2 years: $1 × (1.05) × (1.04) = $1.092
– Investors will buy LT bonds (r(0,2) will fall) and sell ST bonds (r(0,1) will rise)
– Yield curve will become downward-sloping

• If the market expects interest rates to remain constant, the yield curve will be flat

• If the market expects interest rates to first rise (fall) and then fall (rise), the yield
curve will be humped
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 Pure Expectations

• Investors are collectively indifferent between the different maturities as in

equilibrium the returns from holding short bonds over and over again is
the same as the returns from holding long bonds

• If so, the forward rates are perfect predictors of future spot rates

f (1,2 ) = E (r (1,2 ))

• The pure expectations theory has important limitations

– Investors are assumed to be risk-neutral
– They do not take reinvestment risk into account
– They do not take price risk into account

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Pure Risk Premium

• Both the roll-over and maturity strategies are risky

– Future interest rates are unknown (reinvestment risk)
– Future bond prices are unknown (market risk)

• Example: An investor with a 3-year horizon

– May invest in a 3-year zero-coupon bond and hold it until maturity
– May invest in a 5-year zero-coupon bond and sell it in 3 years
– May invest in a 10-year zero-coupon bond and sell it in 3 years

• What would you prefer?

– Return of the 1st investment is known ex-ante with certainty
– Not the case for the 2nd and 3rd
– We don’t know the prices of these instruments in 3 years

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 Pure Risk Premium

• Long bonds are more risky than short bonds: A 1% increase in IR decreases
the price of a long bond more than it decreases the price of a short bond

• Assume interest rates increase from 5% to 6%. What is the impact on the
price of 1-year and the 2-year 5% coupon bonds?
– Initially both bonds trade at par
– The long bond price will fall to 5 ⁄ 1.06 + 105 ⁄ 1.062 = 98.17
– The short one will fall to 105 ⁄ 1.06 = 99.06
– Decrease in 2-year bond price nearly twice as big as decrease in 1-year bond
price

• Pure risk premium theory: TS reflects risk premium required by the market
for holding long bonds

• The two versions of this theory (liquidity and preferred habitat) differ
about the shape of the risk premium
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Pure Risk Premium – Liquidity

• Theory takes into account

– the preferences of investors for short bonds and
– the substantial liquidity risk premium L = L2 + … + Lt they require to invest in
long bonds (i.e., to offset price risk)

(1 + r (0 , 2 ))2 = (1 + r (0 ,1))(1 + L 2 )
(1 + r (0, t ))t = (1 + r (0 ,1))(1 + L2 )(1 + L3 )...(1 + Lt )
with 0 < L2 < L3 < … < Lt

• Limitations
– Since 0 < L2 < L3 < … < Lt, the TS is either increasing or quasi-flat – Cannot
explain decreasing and humped curves
– Does not take into account reinvestment risk

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 Pure Risk Premium – Preferred Habitat

• Postulates that risk premium is not uniformly increasing

• Indeed, investors have a preferred investment horizon dictated by the nature of

their liabilities (shorter is not always better)
– Pension funds and life-insurance companies prefer to invest LT
– Commercial banks prefer ST investments

• Similarly, borrowers have their preferred habitats that match the maturity of their
assets (e.g., firms finance LT projects with LT bonds and ST projects with ST funds)

• Nevertheless, depending on bond supply and demand on specific segments

– Some lenders and borrowers are ready to move away from their preferred habitat
– Provided that they receive a risk premium that offsets their price or reinvestment risk
aversion

• Thus, all curves shapes can be accounted for

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Market Segmentation

• Extreme version of pure risk premium theory

– Investors never move away from preferred habitat
– Assumes complete rigidity on behalf of investors

• Examples
– Commercial banks invest on a short/medium term basis
– Life-insurance companies and pension funds invest on a long to very long term basis
– Custom, preferences of some people who are used to lending ST and would not lend LT
even for an infinite risk premium

• The shape of the yield curve is determined by supply and demand on short and
long term bond markets
– Quasi-flat: r(0,1) ≤ r(0,2); so P(0,1) ≥ P(0,2) because banks have slightly more funds to
invest than insurance companies
– Upward-sloping: r(0,1) << r(0,2); so P(0,1) >> P(0,2) because banks have far more funds
to invest than insurance companies
– Downward-sloping: r(0,1) >> r(0,2); so P(0,1) << P(0,2) because banks have far less
funds to invest than insurance companies
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 Biased Expectations Theory

• Biased expectations theory is an integrated approach

– Combines pure expectations theory and risk premium theory
– TS reflects market expectations of future interest rates AND permanent
liquidity premia that vary over time

• The forward rate is an upward-biased estimate of the future spot rate; it

also includes a positive liquidity risk premium required by investors to
invest in long bonds
f (1,2 ) = E (r (1,2 )) + L2

• All curve shapes can be accounted for

35

Biased Expectations Theory

• How does the biased expectations theory explain the shapes of the yield
curve?

• Example: Assume a liquidity risk premium of 0.5% and an upward-sloping

yield curve
Year 1 Year 2
r (0,1) = 5% E (r (1,2)) = ?%
r (0,2) = 6% r (0,2) = 6%

– Maturity strategy: $1 × (1.06)2 = $1.1236

– f(1,2) = 7.01% = E(r(1,2)) + L2 ⇒ E(r(1,2)) = 6.51%
– The market expects ST interest rates to rise from 5% to 6.51%
– Note that the pure expectations theory predicts a sharper rise (7.01%)
– Roll-over strategy: $1 × (1.05) × (1 + E(r(1,2)) = $1.11835 < $1.1236

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 Biased Expectations Theory

• If instead the yield curve is downward-sloping,

Year 1 Year 2
r (0,1) = 5% E (r (1,2)) = ?%
r (0,2) = 4% r (0,2) = 4%

– Maturity strategy: $1 × (1.04)2 = $1.0816

– f(1,2) = 3.01% = E(r(1,2)) + L2 ⇒ E(r(1,2)) = 2.51%
– The market expects ST interest rates to fall sharply (from 5% to 2.51%)
– Note that the pure expectations theory predicts a smaller fall (to 3.01%)
– Roll-over strategy: $1 × (1.05) × (1 + E(r(1,2))) = $1.07635 < $1.0816

37

Biased Expectations Theory

• Now assume a quasi-flat yield curve

Year 1 Year 2
r (0,1) = 4% E (r (1,2)) = ?%
r (0,2) = 4.3% r (0,2) = 4.3%

– Maturity strategy: $1 × (1.043)2 = $1.0878

– f(1,2) = 4.6% = E(r(1,2)) + L2 ⇒ E(r(1,2)) = 4.1%
– The market expects ST interest rate stability (from 4% to 4.1%)
– Note the pure expectations theory predicts IR to rise slightly (to 4.6%)
– Roll-over strategy: $1 × (1.04) × (1 + E(r(1,2))) = $1.0826 < $1.0878

• A humped yield curve is due to interest rates expected to rise slightly and
then fall sharply

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