Chapter Overview

• Explore pattern of interest rates for different-term

Chapter Fifteen assets
• Identify factors that account for pattern and determine
what information may be gleaned from an analysis of

The Term Structure of the term structure of interest rates

• Demonstrate how prices of Treasury bonds may be
Interest Rates derived from prices and yields of stripped zero-
coupon Treasury securities
• Examine extent to which term structure reveals
market-consensus forecasts of future interest rates
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The Yield Curve Treasury Yield Curves

• Relationship between yield and maturity may

be shown graphically in a yield curve
• Yield curve is a plot of yield to maturity as a
function of time to maturity
• Key concern of fixed-income investors
• Central to bond valuation
• Allows investors to gauge their expectations for
future interest rates against those of the market

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Prices and Yields to Maturities on

Yield Curve: Bond Pricing
Zero-Coupon Bonds ($1,000 Face Value)
• Yields on different maturity bonds are not
equal
• Consider cash flow of each bond as a stand-
alone zero-coupon bond
• Bond stripping and bond reconstitution offer
opportunities for arbitrage
• The value of the bond should be the sum of
the values of its parts

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 Bond Pricing:
Valuing Coupon Bonds
Two Types of Yield Curves
• Value a 3-year, 10% coupon bond using Pure Yield Curve On-the-Run Yield Curve
discount rates from Table 15.1: • Refers to the curve for • Refers to the plot of
stripped, or zero- yield as a function of
$100 $100 $1100 coupon, Treasuries maturity for recently
Price   
1.05 1.06 2 1.07 3 – Spot curve issued coupon bonds
• May differ significantly selling at or near par
• Price = $1,082.17 and YTM = 6.88% from the on-the-run value
yield curve – Par curve
• 6.88% is less than the 3-year rate of 7%
• Typically published by
the financial press
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The Yield Curve under Certainty Two 2-Year Investment Programs

• Consider two 2-year bond strategies:

1. Buy the 2-year zero offering a 2-year YTM of 6%
and hold it until maturity
• Face value is $1,000, so it is purchased today for
$1,000/(1.06)2 = $890 and matures in two years to
$1,000
• Total 2-year growth factor is $1,000/$890 = 1.1236
2. Invest the same $890 in a 1-year zero-coupon
bond with a YTM of 5% and upon maturity
reinvest the proceeds in another 1-year bond
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Spot Rates and Short Rates Holding-Period Returns

• Spot rate • Multiyear cumulative returns on all competing
• The rate that prevails today for a time period bonds should be equal
corresponding to the zero’s maturity
• What about HPRs over shorter periods, such as
one year?
• Short rate
• Applies for a given time interval (e.g., one year)
• In a world of certainty, all bonds must offer
• Refers to the interest rate for that interval
available at different points in time identical returns, or investors will flock to the
• A spot rate is the geometric average of its higher-return securities, bidding up their
component short rates prices, and reducing their returns
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 Short Rates versus Spot Rates Forward Rates

(1 + 𝑦𝑛 )𝑛
(1 + 𝑟𝑛 ) =
(1 + 𝑦𝑛−1 )𝑛−1

• rn = short rate in year n

• yn = YTM of a zero-coupon bond with an n-period
maturity

(1 + 𝑦𝑛 )𝑛 = (1 + 𝑦𝑛−1 )𝑛−1 × (1 + 𝑟𝑛 )

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Interest Rate Uncertainty and

Forward Rates Continued
Forward Rates
• The forward interest rate is a forecast of a • The investor wants to invest for 1 year
future short rate • Buy the 2-year bond today and plan to sell it at
• Rate for 4-year maturity = 8% the end of the first year for $1000/1.06 = $943.40
or
• Rate for 3-year maturity = 7%
• Buy the 1-year bond today and hold to maturity

1 f4 
1  y4 4 
1.084
 1.1106
1  y3 3 1.07 3 • What if next year’s interest rate differs from
6%?
f 4  11.06% • The actual return on the 2-year bond is uncertain!
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Interest Rate Uncertainty and

Theories of Term Structure
Forward Rates Continued
• Investors require a risk premium to hold a Expectations Hypothesis Theory Liquidity Preference Theory
longer-term bond • Simplest theory of the term • Long-term bonds are more
structure risky
• States forward rate equals – f2 > E(r2)
• This liquidity premium compensates short- market consensus • The excess of f2 over E(r2) is
term investors for the uncertainty about expectation of future short the liquidity premium
interest rate – Predicted to be positive
future prices
• f2 = E(r2) and liquidity • Yield curve has an upward
premiums are zero bias built into the long-term
rates because of the
liquidity premium

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 Yield Curve Examples Yield Curve Examples
(1 of 2) (2 of 2)

Panel A: Panel C:
Constant Expected Short Rate. Declining Expected Short Rates.
Liquidity Premium of 1%. Constant Liquidity Premiums.

Panel B: Panel D:
Declining Expected Short Rates. Increasing Expected Short Rates.
Increasing Liquidity Premiums. Increasing Liquidity Premiums.

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Interpreting the Term Structure Interpreting the Term Structure

(1 of 2) (2 of 2)

• Yield curve reflects expectations of future • The yield curve is a good predictor of the
short rates, but also reflects other factors such business cycle
as liquidity premiums • Long-term rates tend to rise in anticipation of
economic expansion
• Inverted yield curve may indicate that interest
• An upward sloping curve could indicate:
rates are expected to fall and signal a recession
• Rates are expected to rise
and/or
• Investors require large liquidity premiums to hold
long term bonds
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Price Volatility of Long-Term Term Spread: Yields on 10-year

Treasury Bonds vs. 90-day Treasury Securities

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 Engineering a Synthetic Forward
Forward Rates as Forward Contracts
Loan
• Forward rates may be derived from the yield
curve

• In general, forward rates will not equal the

eventually realized short rate
• Still an important consideration when making
decisions, such as locking in loan rates

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