Chapter 15

Denitsa Stefanova
The Term Structure of
Interest Rates
The Yield Curve
So far we have considered t he case where t he same
int erest rat e is used t o discount cash flows for all
mat urit ies when valuing bonds
Usually bonds wit h different mat urit ies sell at different
yields
The yi el d cur ve: a graphic represent at ion of t he
relat ionship bet ween yield and mat urit y
I nvest ors can form expect at ions of fut ure int erest rat es using
t he yield curve
2
The Living Yield Curve
3
Source: ht t p: / / www. smart money. com/ invest ing/ bonds/ t he- living- yield- curve-
7923/
Bond pricing
Consider t he following yields of st ripped
Treasuries:
4
Maturity Yield Price
1 5% 952,38
2 6% 890,00
3 7% 816,30
Bond pricing
Now price coupon bonds using t hese different rat es t o
discount t he cash flows at t he coupon dat es
5
10% coupon bond 4% coupon bond
Maturity coupons Price Maturity coupons Price
1 100 95,24 1 40 38,10
2 100 89,00 2 40 35,60
3 1100 897,93 3 1040 848,95
YTM 6,88% 1082,17 YTM 6,94% 922,65
The yield curve and fut ure int erest
rat es under cert ai nt y
An upward sloping yield curve implies
t hat short t erm rat es are going t o be
higher next year. To see why:
Consider t he following t wo st rat egies:
1. Buy and hold a 2-year zero (t able on p.4)
2. I nvest t he same sum in a 1-year zero, t hen
aft er it s mat urit y invest t he proceeds in
anot her 1-year zero in year 2.
6
The yield curve and fut ure int erest
rat es under cert ai nt y
We have assumed a cert ain world t he
ret urns on bot h st rat egies should be equal:
Solving for r
2
:
r
2
> 1-year yield < --> upward sloping yield curve
7
2
2
buy and hold 2-year zero
roll over 1-year zeros for 2 years
$890 1.06 $890 1.05 (1 ) r = +

2
7.01% r =
Short rat es vs. spot rat es
8
Forward rat es
9
( ) ( ) ( )
1
1
1 1 1
- the yield of a -year zero
- one-year forward rate for period
n n
n n n
n
n
y y f
y n
f n

+ = + +
( )
( )
1
1
1
1
1
n
n
n
n
n
y
f
y

+
=
+
The break-even
interest rate
Forward rat es
10

n = 1 n = 2 n = 4 n = 3
y
3
f
4
y
4
( ) ( ) ( )
3 4
3 4 4
1 1 1 y f y + + = +
Finding the 1-year forward rate at period 4 (f
4
) using the 1-year
spot rate y
1
and the 4-year spot rate y
4:
Forward rat es and t he yield curve
11
zero coupon rates maturity 1yr FWD rate
12% 1
11,75% 2 11,50%
11,25% 3 10,26%
10% 4 6,33%
9,25% 5 6,30%
Obt ain t he 1-year FWD rat e for periods 2 t o 5
using t he yield curve
The yield curve and fut ure int erest
rat es under uncert ai nt y
Consider a short horizon (1-year) invest or who
has t he following t wo opt ions:
1. I nvest in a 1-year zero t reasury bond wit h yield y
1
aft er 1 year he will have it s face value for cert ain
2. I nvest in a 2-year zero t reasury bond wit h yield y
2
and sell it at t he end of t he 1
st
year
Now assume t hat fut ure rat es are not known
t oday: t hey are uncert ain
12
The yield curve and fut ure int erest
rat es under uncert ai nt y
What yield will t he invest or ask for t he 2-year
bond? I f t he invest or cares only about t he
expect at ions of next years int erest rat e, t hen:
13
( ) ( ) | | ( )
2
2 1 2
1 1 1 y y E r + = + +
Expected short rate for
the following year
| |
2 2
f E r =
The yield curve and fut ure int erest
rat es under uncert ai nt y
I f next year int erest rat es t urn out t o be above
expect at ions, t he bond price of t he 2-year bond next
year will be lower t han expect ed, and vice versa
i nt er est r at e r i sk
The expect ed rat e of ret urn of bot h st rat egies is t he
same, but t he second one is risky! Then t he short -
horizon invest or will demand a risk premium in order
t o bear t he int erest rat e risk of t he long-t erm bond
a higher yield t han y
2
14
| |
2 2
Liquidity premium = 0 f E r >
Theories of t he t erm st ruct ure
Expect at i on hypot hesi s
Zero liquidit y premium
Upward sloping yield curve means t hat invest ors ant icipat e
increase in int erest rat es
Li qui di t y pr ef er ence
I nvest ors demand a premium t o hold long t erm bonds
Liquidit y premium is posit ive, which implies an upward sloping
yield curve
15
| |
2 2
f E r >
Yield curves
16
| |
Liquidity premium
n n
f E r = +
( ) ( ) ( )
1
1
1 1 1
n n
n n n
y y f

+ = + +
Source: Investments, 8
th
edition,
Bodie, Kane and Marcus
I nt erpret ing t he t erm st ruct ure
An upward sloping yield curve is associat ed
wit h t he fact t hat t he FWD rat e for t he coming
period is higher t han t he current yield
What explains an increase of t he FWD rat e?
Expect at ions of rising int erest rat es
Premium for holding longer-t erm bonds
17
| |
Liquidity premium
n n
f E r = +
The t erm spread
18
Creat ing a synt het ic forward
loan
How can we lock in rat es for fut ure loans?
Consider t he following st rat egy at t ime 0:
1. Buy a 1-year zero at P
0
(1)
2. Sell (1+ f
2
) wort h of 2-year zeros at P
0
(2)
The init ial cash flow for t he st rat egy is 0:
19
( ) ( ) ( )
( )
( )
0 2 0
2
2
1
2
1 1 2
1 0
1
1
P f P
F F
f
y
y
+ +
= + + =
+
+
Const ruct ing t he yield curve
Obt ain t he zero yield curve from coupon
bond yields of different mat urit ies
St eps:
Obt ain t he yield curve for t he observed
mat urit ies
Reconst it ut e t he yield curve for t he
unobserved mat urit ies
I nt erpolat ion
Assume a funct ional form
20
Const ruct ing t he yield curve
St eps t o reconst it ut e t he yield curve
1. Det ermine t he cash-flows of each of t he bonds
2. Assume an init ial zero yield curve
3. Obt ain t he price of each bond:
i. Using it s yield
ii. Discount ing it s cash-flows using t he zero yield curve
4. By no arbit rage argument s price (i) should
equal price (ii) use t his t o const ruct a t arget
funct ion t o minimize (t he sum of squared price
differences) in order t o recover t he zero yield
curve
21
The yield curve from coupon
bonds: an example
Coupon bond dat a:
10% coupon bond wit h mat urit y of 3 yrs, yield of
6.88%
4% coupon bond wit h mat urit y of 3 yrs, yield of
6.94%
4% coupon bond wit h mat urit y of 2 yrs, yield of
5.98%
All bonds have a face value of $1000 and make
annual coupon payment s
22
The yield curve from coupon bonds: an
example
23
Price obtained using discounted
cash-flows with the zero curve
yields
Price obtained using the yield to
maturity of each bond
Sum of squared
price differences
Fit t ing t he yield curve
Find yields for non-observed mat urit ies
The idea: find a funct ion of t he yield curve
t hat mat ches as closely as possible t he
observed YTMs
Different approaches
Direct int erpolat ion (linear, cubic, et c.)
I ndirect met hods:
Splines (precise fit but large number of
paramet ers)
Nelson-Siegel (easier t o implement , fewer
paramet ers, but may be less precise)
24
Nelson & Siegel
The Nelsen-Siegel funct ion:
25
( )
1 1
1
0 1 2
1 1
1 1
0,
T T
T
c
e e
R T e
T T

| | | |
| |

| |
= + +
| |
| |
\ . \ .
( )
0, implied spot rate for maturity T
c
R T =
Paramet er est imat ion
Est imat ing t he paramet ers:
Let r(0,T) denot e t he market (observed) spot
rat e.
Est imat e t he paramet ers
0
,
1
,
2
and
1
by
minimizing t he sum of squared differences
bet ween implied and observed rat es:
26
{ }

( ) ( )
( )
0 1 2 1
2
1 , , ,
min 0, 0,
N
c c
i i
i
r T R T
=
| |

|
\ .

Paramet er int erpret at ion

dium-term components
Nelson & Siegel
So far we have est imat ed t he paramet ers of t he
N&S funct ion: * = {
0
,
1
,
2
,
1
}
We have est imat ed a cont inuous t erm st ruct ure
R
c
(0,T), i.e. t he spot rat e for any mat urit y T.
Using it , we can est imat e t he zero-coupon bond
prices of arbit rary mat urit y T wit h a face value
of F:
28
( )
( )
0,
0,
c
R T T
B T Fe

=
A model for t he yield curve
So far we have used t he spot rat e for a given
mat urit y R
c
(0,T)
Most of t he yield curve models are based on t he
inst ant aneous spot rat e, i.e. t he short rat e (t he
rat e for an inst ant aneous mat urit y)
I n pract ice it can be t hought of being a short
t erm spot rat e (e.g. overnight rat e)
29
Cont inuous t ime processes:
a primer
Consider a variable W whose value changes
cont inuously
The change of W for a small int erval t is W
This variable is said t o follow a Wiener process if:
The expect ed value and variance of it s increment s
are given by:
30
( )
where is a random draw from 0,1
The values of for 2 different dates are independent
W t N
W
=

( ) ( )
( ) ( ) ( )
0 E W t W t t
Va rW t W t t t
= (

=
Generalizing t he basic model
A Wiener process has a drift rat e (average
change per unit of t ime) of 0 and a variance of 1
I n a generalized Wiener process t he drift rat e
and t he variance can be set equal t o given
const ant s:
31
| |
( )
2
. .
x t t
s t
E x t
Var x t

= +
=
=
Simulat ing t he Weiner process
Consider
I f we fix an init ial value x
0
, t hen we can comput e
t he subsequent ones:
32
1
t t
t t t
x t t
x x x

= +
=
1 0 1
2 1 2
x x t t
x x t t


= + +
= + +
Mean reversion
Consider t he following model for t he short rat e:
Why isnt it appropriat e for t his case?
We need mean-reversion:
For example:
33
t t
r t t = +
( )
t t t
r r t t = +
( )
t t t
r a b r t t = +
The Vasicek model
Evolut ion of t he short rat e:
Thus, a small change in t he short rat e (dr) over
an infinit esimally small t ime increment dt has
t wo component s:
a drift back t o it s level b at a rat e a
a volat ilit y t erm t hat represent s t he uncert aint y via
dW normally dist ribut ed wit h a mean of 1 and a
variance of dt .
34
( )
t t t
dr a b r dt dW = +
Risk-neut ral valuat ion
Tradit ional finance t heory: t he current value of a
securit y is t he present value of it s cash flows or
it s fut ure value:
Derivat ives valuat ion t heory: we can comput e
t he current price of a securit y using expect at ions
under risk-neut ral probabilit ies:
35
| |
mT
t T
V e E V

=
| |
rT
t T
V e E V

=

Risk-neut ral valuat ion
The current price of a zero-coupon bond wit h
mat urit y T: t he discount ed expect ed value in a
risk-neut ral world of it s fut ure value (e.g.
st andardized t o 1):
Where we use risk-neut ral expect at ions
And r is t he short rat e
36
( ) ( )
{ }
, exp 1
T
t
B t T E r u du
(
=
(

The price of a zero-coupon bond

=

| |

|

\ .
=
`


)

=
=
The price of a zero-coupon bond
I mplement at ion of Vasiceks model requires:
The current value of t he short rat e r
t
The t hree paramet ers of t he short rat e process (a, b
and ) t hat can be est imat ed using hist orical dat a
(e.g. t he 1-mont h Treasury rat e)
One caveat : Vasiceks model allows for negat ive
int erest rat es
Cox I ngersoll & Ross model (CI R) rules out
negat ive int erest rat es
38
APPENDI X
39
Cont inuous compounding
The fut ure value (FV) of $1 invest ed for 1 year
at an annually compounded rat e R is (1+ R)
The FV of $1 invest ed for 1 year at an semi-
annually compounded rat e R is (1+ R/ 2)
2
The FV of $1 invest ed for n years at
compounded rat e R for m subperiods is
(1+ R/ m)
nxm
40
Cont inuous compounding
The FV of $1 invest ed for n years at a
cont inuously compounded rat e r is:
I n pract ice, rat es are compounded at discret e
int ervals, but t he cont inuously compounded rat e
is more convenient in many cases
The following relat ionship bet ween t he t wo
holds:
41
r n
e

1
n m
r n
R
e
m

| |
+ =
|
\ .