Fixed Income Securities

Lecture 04:
Prof. Jerchern Lin Forwards, Term
Structure Theories

 Forwards
 Term Structure Theories

Readings:
TUCKMAN Chapter 2 and pp. 207-211, 214-219
MARTELLINI Chapters 3, and 11

1
 Questions/Summary
 What is the forward price? Do you pay it now?

 What is the forward rate? How do we compute it?

 Is it the same as the spot rate? If yes why? If not how do they differ?
 Do you have to pay now anything in order to get into a forward
agreement? What is the cost of this agreement today?

 How do we understand forward rates? Intuition?

 Term Structure Theories! What are their implications for the yiled
curve shapes?

 How inflation affects the term structure?

2
 Outline
 Bond pricing basics

A. The discount function

B. Valuing fixed cash flows
C. Yields
D. Forward rates
E. Term structure theories

3
Key Concepts and Buzzwords

 Concepts  Buzzwords
 Forward Contracts  settlement date, delivery,
 Forward Prices underlying asset
 spot rate, spot price, spot
 Forward Rates
market
 Information in Forward
 forward purchase, forward
Rates
sale, forward loan, forward
lending, forward borrowing,
synthetic forward
 expectation theory, term
premium

4
 Definition: Forward vs Spot
 To distinguish ordinary transactions from forward
transactions, we use the word “spot” (or sometimes,
“cash”).

 A spot transaction is for settlement immediately.

- Money and securities change hands today.
- The price for such a transaction is called the
“spot” price (or sometimes, “cash” price).

5
 Forward Contract: Definition
 Forward contract: a binding agreement to buy or sell a
fixed quantity of an asset at an agreed upon price (called
the forward price) at a specific time in the future.

 The terms of the contract are set today.

 No money exchanges hands today. Delivery and

settlement occur on the future date.

6
 Motivation
 Suppose today, time 0, you know you will need to do a
transaction at a future date, time t.

 One thing you can do is wait until time t and then do the
transaction at prevailing market prices
- i.e., do a spot transaction in the future.

 Alternatively, you can try to lock in the terms of the

transaction today
- i.e., arrange a forward transaction today.

7
 Forward Loan
 One way to think of a forward purchase of a zero is as a
forward loan.
 You contract today to lend $F at date t and be repaid $1
at date T.

𝑇
−𝐹𝑡 $1

0 t T

8
Pricing: No-Arbitrage/Replication
 This contract is equivalent to:
 Going long a T-period zero
 Financed by going short dT/dt t-period zeros

 Property:
 No money exchanges hands today (as true of all forward
contracts) since your short position in the t-year zero pays for
your current purchase of the T-year zero.

Vcontract at time 0 = 0

9
 Zero Cost Forward Price
 At t=0 the contract “costs” zero
 The forward price should take care of that
 What is such “F”?
$0 -$F +$1
|-----------------|-----------------|
0 t T
 Vcontract, 0= Vportfolio, 0 = -F x dt + 1 x dT
1) F= dT / dt
or
2) F=dT x (1+rt/2)2t = FtT
10
 Forward Rates
 Basic concept: a forward contract on a zero-coupon
bond is a binding agreement to make or take a loan on
a future date. You can describe the loan by its forward
price or by its promised rate of interest on the loan. This
rate is called the forward rate of interest.

 Definition: the forward rate of interest for the period t to

t+T is the rate of interest available today for a loan which
goes from date t (the expiration date of the forward
contract) to date T (the maturity date of the loan).

11
 Forward Rate
 People try to summarize the terms of the forward loan by
quoting the forward rate.

The annualized, semi-annually compounded forward rate

f is defined by:

𝟏
𝑭𝑻𝒕 = 𝟐 𝑻−𝒕
𝒇𝑻𝒕 ൗ
𝟏+ 𝟐

12
UNDERSTANDING
FORWARD RATES

13
Interpretation 1: From Definition

 Forward rate is the rate of return on a future loan.

 You pay FtT at time t in order to receive a dollar ($1) at time T.

(Clearly FtT < 1$)

14
 Forwards through Zeros
 Strips/Zero market Forward market

Prices of Zeros Prices of Forwards

Zero Rates Forwards Rates

15
Forwards Through Zeros

1
=
T 2(T-t)
(1+ f /2)
t T
F t

d
= t

d T

2T
(1+r /2)
= T

(1+rt /2) 2t

16
 Forward Rate

(1+ rt / 2) 2t (1+ 𝑓𝑡𝑇 / 2)2(T-t)

0 t T
2T
(1+ r / 2)
T

= (1 + r / 2) 2t
2T
T 2(T-t)
(1+ f / 2)
t
T

(1 + r / 2)
t

17
 Example…cont’d
 What is the semi-annual compounded forward rate for
a six-month loan starting in six months? (r0.5=5.54%,
r1=5.45%)
2×1
1 2(1-0.5)
= (1+r /2)
(1+ 𝑓0.5 /2) 1
2×0.5
(1+r /2)
0.5

2
(1+.0545/2)
(1+ 1
𝑓0.5 /2) =
(1+.0554/2)
1
⇒ 𝑓0.5 = 5.36%
18
 Interpretation 2

 The forward rate is the marginal rate for extending the

length of the loan.

 In the above example, the marginal rate from investing in 1-year

strips instead of 6-month strips is 5.36%, which is below the
current 5.54% 6-month rate.

19
 Question
 If the spot curve is upward sloping what does it say
about the size of the forward rates?
 A) Forward rates are upward sloping
 B) Forward rate are downward sloping
 C) Forward rate is higher than the short term spot rate
 D) Forward rate is lower than the short term spot rate

 If the spot curve is downward sloping what can you say

about the forward rates?

20
 Interpretation 3: Spot Rates as
Averages of Forward Rates
1 𝑡
𝑑𝑡 = 𝑑0.5 × 𝐹0.5 × 𝐹11.5 × ⋯ × 𝐹𝑡−0.5
1 𝑡
𝑟𝑡 2𝑡 𝑟0.5 𝑓0.5ൗ2) 𝑓𝑡−0.5ൗ2)
⇒ (1 + Τ2) = (1 + Τ2) × (1 + × ⋯ × (1 +

 The discount rate is the geometric average of all the

forward rates. In terms of our example, the 6-month spot
rate is 5.54%, and the forward rate is 5.36%. The
average is equal to the one-year rate of 5.45%.

21
 The Forward Curve

 Generally, when someone uses the term “forward curve”,

they are referring to the set of 1-period implied forward
rates today as a function of time.

 The T-year forward curve is composed of 2(T-1) forward

rates: the rate from year .5 to 1, the rate from year 1 to
1.5, ..., the rate from year T-.5 to T.

22
 The Forward Curve
8

7.5

6.5
Y Spot
i 6 Forward
e
l
d 5.5

4.5

4
0 5 10 15 20 25 30
Time to Maturity

US Spot and Forward Curve 23

 Practical Consideration
 One problem with the forward curve estimated via the
strip rates is that it is too jagged.
 errors in observable prices (bid/ask spread)
 only finite number of bonds
 liquidity of bonds

 Alternative method in practice is to use spline estimation,

which takes a limited number of bonds and fits a smooth
curve to estimate the discount function.

24
 The Forward Curve

7.5

Y6.5
i Spot
e 6 Forward
l
d5.5
5

4.5

4
0 5 10 15 20 25 30
Time to Maturity

US Spot and Forward Curve

25
 Outline
 Bond pricing basics

A. The discount function

B. Valuing fixed cash flows
C. Yields
D. Forward rates
E. Term structure theories

26
 Expectations Theory (EH)

 Expectations Theory: implied forward rates are

unbiased forecasts of future spot rates.

Note that nominal spot rates are a function of inflation

and real interest rates.

f = E[r ]
1,2 1,2

27
EH: Implications for the Yield Curve
 Under the expectations theory

 an upward sloping yield curve signals that interest rates are

expected to rise in the future

 a flat yield curve signals that they are expected to stay the same

 a downward sloping yield curve signals that interest rates are

expected to fall

28
 Empirical Evidence

 Historically, the yield curve has been upward sloping on

average.

 If the expectations theory is true, then the market is

forecasting an increase in interest rates most of the time.
This is not consistent with rational expectations.

29
 The Liquidity Preference
Hypothesis (LPH)

 Liquidity preference hypothesis:

For liquidity reasons, investors may have to sell a
bond before it reaches maturity. Thus, they face less
price risk (interest rate risk) if they invest in short-term
instruments.

30
 LPH: Risk Premia
 Under the liquidity preference theory, the expected
future spot rate and the forward rate differ by a
liquidity premium

f = E[r ] + L
1,2 1,2 1,2

31
 LPH: Implications for the Yield
Curve
 Under the liquidity preference theory

 an upward sloping yield curve is ambiguous

 a flat yield curve signals that interest rates are expected to fall

 a downward sloping yield curve signals that interest rates are

expected to fall substantially

32
 Empirical Evidence

 Average holding-period returns for bonds increase with

maturity. This supports the hypothesis that investors
have liquidity preferences.

 But premia appear to move substantially over time.

33
The Market Segmentation Theory
According to the Market Segmentation Theory, markets
are segmented and different clienteles trade different
maturity bonds.

This implies the yield curve can take any possible shape.
And there does not exist a defined correlation among the
yield movements of bonds with different maturities.

This Theory is Void! It cannot be tested!

34
 Questions
 Can we have negative nominal rates?
 Yes
 No

 Can we have negative real rates?

 Yes
 No

 Can we have negative inflation?

 Yes
 No

35
Real vs Nominal Rates

rReal = rNominal - Inflation

36
 Question
 What does inverted yield curve mean?

 One is that the market is not concerned about future inflation,

and therefore value longer bonds in higher price or lower yields.

 Another interpretation is that the market is afraid that we are

entering in a recession; therefore they forecast and price in
future reduction in the Fed Fund rates as a reaction of the FED
in order to fight recession.

37
 Questions/Summary
 What is the forward price? Do you pay it now?

 What is the forward rate? How do we compute it?

 Is it the same as the spot rate? If yes why? If not how do they differ?
 Do you have to pay now anything in order to get into a forward
agreement? What is the cost of this agreement today?

 How do we understand forward rates? Intuition?

 Term Structure Theories! What are their implications for the yiled
curve shapes?

 How inflation affects the term structure?