Fundamentals of Yield Curves

&
The Term Structure of Interest Rates
1
At any point in time an investor will have
access to a wide variety of bonds.
These will differ with respect to
Their yields, and
Their times to maturity
2
Investors and traders will be interested in
the relationship between the time to
maturity, and YTM
for bonds belonging to a given risk class.
A plot of yield versus time to maturity is
termed as the
Yield Curve
3
The Yield Curve
Is an important indicator of the state of the bond
market
And provides valuable information
4
While constructing the yield curve it is
important to ensure that
The bonds belong to the same risk class
And have a comparable degree of liquidity
For instance
We may construct a curve for government
securities
Or for AAA rated corporate bonds
But we cannot mix the data for the two categories
5
The primary yield curve in the domestic
capital market is
The Government or Treasury Bond Yield Curve
This is because
Such instruments are free of default risk
6
The Yield Curve
Is an indication of where the bond market is
trading currently
It also has implications for what the market
thinks will happen in the future
7
The curve sets the yield for all debt market
instruments
It fixes the price of money over the maturity
structure
Thus issuers of debt in the market use the
yield curve to price debt securities.
8
The yields of government bonds set the
benchmark for yields on other debt
securities.
For instance if the 5 year T-bond is trading at a
yield of 5%
All other bonds irrespective of the issuer will be
trading at yields in excess of 5%
The excess over the yield on a comparable T-bond is
called the Spread.
9
The yield curve acts as an indicator of future
yield levels.
It assumes certain shapes in response to
expectations of future interest rates.
Analysts study the current shape in order to
determine the direction of future interest rates.
10
The curve is analyzed by
Bond traders
Fund managers
Central bankers
Corporate finance personnel
11
Central bankers and government Treasury
departments analyze the curve for the
information it provides
Regarding forward rates
Future interest levels
This information is used to set rates for the economy
as a whole
12
Portfolio managers use the curve to assess
relative values of investments across the
maturity spectrum.
The curve indicates the returns that are available
at different points of time.
Consequently it helps determine which bonds are
cheap or costly.
13
Consider a bond that makes an annual
coupon of C on a semi-annual basis.
The face value is M, the price is P, and the
number of coupons remaining is N.

14
The YTM is the value of y that satisfies the
following equation.

15
The YTM is a solution to a non-linear
equation.
We generally require a financial
calculator or a computer to calculate it.
However it is fairly simple to compute the
YTM in the case of a coupon paying bond
with exactly two periods to maturity.
In such a case it is simply a solution to a
quadratic equation.
16
The YTM is also easy to compute in the case
of zero coupon bonds.
Consider a ZCB with a face value of $1,000,
maturing after 5 years.
The current price is $500.
The YTM is the solution to

17
The spot rate for a time period, is the YTM of
a zero coupon bond maturing at the end of
the period.
Assume that a six month zero coupon bond
with a face value of $1,000 is selling for
$961.54.
18
If we consider six months to be one period,
then the one period spot rate is given by:
961.54 = 1,000 s
1
= 0.04 4% for 6
---------
(1 + s
1
)
Months or 8% per annum.
19
If a one year bond is at $873.44, then the
two period spot rate is given by:
873.44 = 1,000 s
2
= .07 7.00%
______
(1 + s
2
)
2

For 6 months or 14% per annum
20
A Plain Vanilla bond is a series of cash flows
arising at six monthly intervals.
Each cash flow can be perceived as a ZCB
maturing at that point in time.
Thus a Plain Vanilla bond is essentially a
portfolio of zero coupon bonds.
21
The correct way to price a Plain Vanilla bond
is by discounting each cash flow
At the spot rate applicable for that period.
Take a bond with a face value of $1,000 and
one year to maturity
The coupon is 7% per annum, paid on a semi-
annual basis.
22
Using the spot rates calculated earlier the
price of the bond can be calculated to be:
P = 35 1,035 = 937.66
____ + _____
(1.04) (1.07)
2
23
What is the YTM of this bond?
It is obviously the solution to:
937.66 = 35 + 1,035
______ ______
(1+ y/2) (1 + y/2)
2

y/2 = 0.069454 6.9454%
24
The YTM is therefore a complex average of
the spot rates.
This per se need not pose any problems.
The problem is that the YTM is a function of the
coupon rate.
In other words, if we compare two bonds with the
same time to maturity, but with different coupons, the
YTMs for the two will differ.
25
Despite the fact that both have been priced
using the appropriate spot rates.
This is known as the Coupon Effect.
Consider a bond with a face value of $1,000
and one year to maturity, but with a coupon
of 12% per annum.
26
Its price can be calculated to be:
P = 60 + 1,060 = 983.54
____ ______
(1.04) (1.07)
2
The YTM is obviously given by:
983.54 = 60 + 1,060 y/2 = 0.069092
____ _____
(1+y/2) (1+y/2)
2
y/2 = 6.9092%

27
Thus the YTM, which is a complex average of
spot rates, varies with the coupon rate
When comparisons are sought to be made among
bonds with an identical maturity.
What is the reason why the 7% coupon bond
has a higher YTM than the 12% bond?
28
Take the 7% bond first.
It has a price of 937.66.
The present value of the first cash flow is
35
____ = 33.65
(1.04)
Thus 33.65 = 0.0359 3.59% of the value
_____ of the bond is tied up in one
937.66 period money.
29
The balance 96.41% is obviously tied up in
two period money.
In the second case the price is 983.54 while
the present value of the first cash flow is 60
_____ = 57.69, which is 5.87%
(1.04) of the value of the bond.
30
The one period spot rate is 4% while the two
period spot rate is 7%.
Thus one period money is cheaper than two
period money.
The second bond has a greater percentage of
its value tied up in one period money
So it is obvious that its yield to maturity will be
lower.
31
What is a Yield Curve?
It is a graph depicting the YTM, along the Y-
axis, versus time to maturity along the X-
axis.
It is imperative that the bonds being
compared belong to the same credit risk
class.
32
The expression `Term Structure of
Interest Rates refers to the relationship
between spot rates of interest and the
corresponding Time to Maturity
Once again the data should be applicable
to bonds of the same risk class.
The term structure is also referred to as
the Zero Coupon Yield Curve.
33
What is bootstrapping?
To calculate the spot rates and construct
the term structure, we need access to the
prices of ZCBs maturing at different
intervals.
However, in real life most of the data that
we have pertains to coupon paying bonds.
Bootstrapping is a technique for
calculating spot rates, using coupon
paying bonds.
34
Time to
Maturity
Price Coupon
1 Year 1,000 6%
2 Years 975 8%
3 Years 950 9%
4 Years 925 10%
35
Assume that we have the following data.

The one year bond is selling at par.
So the one year spot rate must be 6%, which
is the coupon rate on this bond.
The two year spot rate can be determined as
follows:
80 + 1080
975 = ____ ______ s
2
= 9.57%
(1.06) (1+s
2
)
2

36
Similarly the three year spot rate is given by:
90 90 1090
950 = ____ + ______ + ____
(1.06) (1.0957) (1+s
3
)
3
s
3
=11.32%
37
Using the same logic:
100 + 100 + 100 + 1100
925 = _____ ______ ______ ________
(1.06) (1.0957) (1.1132) (1+s
4
)
4


s
4
= 12.99%
38
A typical problem is that bonds may not exist
for certain maturities
Else, even if a bond were to exist it may not be
traded actively.
And in the absence of active trading, the
observed prices would be suspect.
39
Second a combination of par, premium and
discount bonds are likely to be used
This exposes us to the coupon effect
And the liquidity effect.
40
The Liquidity Effect:
For a given maturity on-the-run securities tend
to be more liquid than off-the-run securities.
T-Bill maturing on 16 May 19XX was trading at
6.31%, whereas an 8.125% T-Note maturing on
15 May 19XX was trading at 6.37%.
41
Off-the-run securities are less liquid
since most of them are in the hands of investors who
intend to hold until maturity.
The demand for on-the-run securities will be
relatively higher
And the yields will be lower, although both securities
are virtually identical.
42
Some of the earlier Treasury issues are
callable in nature.
It is not correct to compare bonds with
embedded options, with Plain Vanilla bonds
43
One problem with bootstrapping is that we
typically have data for bonds with different
coupons.
At times we may have data for bonds, all of
which have the same coupon.
The resulting yield curve is called the Coupon
Yield Curve.
44
It is an estimate obtained by using data for
bonds with different coupons, but all of
trading at par.
In this case, the coupon for each bond will be
equal to its YTM.
45
Time to
Maturity
Price in Dollars Coupon
1 Year 1,000 6%
2 Years 1,000 8%
3 Years 1,000 9%
4 Years 1,000 10%
46
The one year spot rate is 6%.
The 2 year spot rate can be determined as
follows.
80 1080
1000 = _____ + ______
(1.06) (1+s
2
)
2

S
2
= 8.08%
47
The 3 year rate can be calculated as 9.16%
and the 4 year rate as 10.30%.
The par bond yield curve is often used by
primary market analysts.
Since new bonds are always issued at par, such a
curve can be used to estimate the coupon
To be offered on a new bond whose issue is being
contemplated.
48
Without data on par bonds, the par bond
yield curve can still be derived.
Assume that we have the following vector of
spot rates.
49
Time to Maturity Spot Rate
1 Year 6%
2 Years 9.57%
3 Years 11.32%
4 Years 12.99%
50
The yield for a one year par bond is obviously
6%.
The yield or coupon for a two year par bond
may be calculated as:
C + 1000+C
1,000 = _____ ________
(1.06) (1.0957)
2

C = 94.0441 c = 9.4044%


51
Similarly:
C + C + 1000+C
1000 = _____ _____ ________
(1.06) (1.0957)
2
(1.1132)
3


C = 109.9837 c= 10.9984%
52
Having derived the spot rates, we can plot
them versus the time to maturity.
The graph may be upward sloping, or
inverted, or else may be humped.
53
54
55
56
Let
1
f
1
be the one period forward rate one
period from now.
It is the rate for a forward contract made
today, at time 0
To extend a one period loan next period, that is,
at time 1.
57
Consider an investor who wishes to making a
loan for two periods.
He will be indifferent between making a 2-
period loan at the 2-period spot rate
And a 1-period loan at the 1-period spot rate
with a forward contract to rollover the
proceeds for one period at
1
f
1
.
58
Thus the no-arbitrage condition requires
that:
(1+s
2
)
2
= (1+s
1
)(1+
1
f
1
)

1
f
1
is known as the one period implied
forward rate.
In general, if we have an m period spot
rate and an n period spot rate, where
m>n, then (1+s
m
)
m
= (1+s
n
)
n
(1+
n
f
m-n
)
m-n
59
Assume that the five year spot rate is 10%
and that the four year spot rate is 9%.
The one year forward rate four years from
now is given by:
1 +
4
f
1
= (1.10)
5
= 1.1409
4
f
1
= 14.09%
________
(1.09)
4
60
The first theory that we shall look at is
called the Expectations Hypothesis.
As per this theory, forward rates are
nothing but unbiased expectations of
future spot rates.
Thus
n
f
m-n
= E
0
[
n
s
m-n
]
In other words the (m-n) period forward
rate, n periods from now is the current
expectation
Of the (m-n) period spot rate that is expected
to prevail n periods from now.

61
The Expectations hypothesis can explain any
shape of the yield curve.
An expectation that future short term rates
will be above current levels would lead to an
upward sloping yield curve.
62
Assume that s
1
= 5.50%; E[
1
s
1
] = 6%;E[
2
s
1
] =
7.5%, and that E[
3
s
1
] = 8.5%
S
2
= [(1.055)(1.06)]
1/2
1 = 5.75%
S
3
= [(1.055)(1.06)(1.075)]
1/3
1 = 6.33%
S
4
= [(1.055)(1.06)(1.075)(1.085)]
1/4

= 6.87%
63
If the theory is true, then the yield curve is
an important forecasting tool
Since it is an indicator of the direction of future
short term interest rates.
According to the theory investors care only
about expected returns and not about risk.
It says that the term structure is based on
investors and issuers expectations about
future short-term rates
64
Participants choose maturities to maximize
outcomes over a known time horizon
Investors seek to maximize their expected rate of
return
Issuers seek to minimize their expected cost of
borrowed funds
The slope of the yield curve tells us what
buyers and sellers in general are expecting
about future market rates
65
Take the two period case.
An investor can buy a two year bond yielding a
rate of s
2
.
Or he can buy a one year bond yielding s
1
and
then roll over into another one period bond at
maturity.
According to the expectations hypothesis he will
be indifferent if the expected returns from the
two strategies are equal.
66
In other words the market will be in
equilibrium if:
(1+s
2
)
2
= E[(1+s
1
)(1+
1
s
1
)]
But if arbitrage is to be ruled out we require
that:
(1+s
2
)
2
= (1+s
1
)(1+
1
f
1
)
Thus if the expectations hypothesis is valid,
then
1
f
1
= E(
1
s
1
)
67
How can expectations of rising interest
rates lead to an upward sloping yield
curve?
If rates are expected to rise then
investors in long term bonds will indeed
be perturbed.
Rising interest rates imply falling bond
prices, and long term bonds are more
vulnerable to changing interest rates
68
Investors will start selling long term bonds
and buying short term bonds.
This will push up long term yields and lead to
a decline in short term yields
The overall effect will manifest itself as an
upward sloping yield curve.
69
The expectations theory has two critical
assumptions
Investors and issuers are risk neutral
They can buy or sell bonds at any point on the
yield curve
Agents move freely along the term structure
by buying or issuing at whatever maturity
they choose
70
Investors can ride the yield curve if it
maximizes their expected yield
Issuers will roll over short-term IOUs to
finance their capital expenditure if it
minimizes their expected cost of funds
71
This theory states that relative amounts
of long term and short term bonds will
not affect the shape of the yield curve
Unless investors expectations of the future
were to be affected.
For instance the central banks conduct
open market operations on a regular basis
by buying and selling Treasury securities.
72
As per the expectations hypothesis the
central banks cannot influence the shape of
the yield curve
By buying securities of one maturity and selling
another.
Because investors regard all securities,
irrespective of maturity as perfect
substitutes.
73
Long term bonds are more vulnerable to
interest changes than short term bonds.
Most investors prefer to lend short-term.
Take the case of an investor who intends
to invest for one period.
He can buy a one period bond and get a
rate of s
1
.
74
Or else he can buy a two period bond and
sell it after one period.
The rate of return is uncertain since the
terminal price will be uncertain.
Take the case of a zero coupon bond with a
face value of $1,000.
75
Its current price is:
1000
____________
(1+s
1
)(1+
1
f
1
)
The expected price after a period is:
E[ 1000] 1000
______ _________
(1+
1
s
1
) [1 + E(
1
s
1
)]
76
The rate of return from the two period
bond over the first year is:
E[ 1000] 1000 1000 1000
______ - __________ ________ - __________
(1 +
1
s
1
) (1+s
1
)(1+
1
f
1
) [1+E(
1
s
1
)] (1+s
1
)(1+
1
f
1
)
______________________ ______________________
1000 1000
________ ___________
(1+s
1
)(1+
1
f
1
) (1+s
1
)(1+
1
f
1
)
77


(1+s
1
)(1+
1
f
1
)
__________ - 1
1 + E(
1
s
1
)
A sufficient condition for this to be greater
than s
1
is
1
f
1
> E(
1
s
1
)
78
Thus an investor with a 1-period horizon
will hold a 2-period bond only if its
expected return is greater
Which implies that the forward rate must be
greater than the expected spot rate.
Thus the forward rate will embody a risk
or liquidity premium.
The forward rate will exceed the
expected future spot rate by the liquidity
premium.
79
We know that:
(1+s
2
)(1+s
2
) = (1+s
1
)(1+
1
f
1
)
According to the liquidity preference
theory:
(1+s
1
)(1+
1
f
1
) > (1+s
1
)[1+E(
1
s
1
)]
Therefore:
(1+s
2
)(1+s
2
) > (1+s
1
)[1+E(
1
s
1
)]

80
Consider a downward sloping term structure,
that is, s
1
> s
2
.
The inequality will hold only if E(
1
s
1
) is
substantially smaller than s
1
.
Thus a downward sloping curve will be
observed only if the market expects spot
rates to decline significantly.
81
Assume that s
1
= 7% and that s
2
= 6%.
The term structure is obviously downward
sloping.

1
f
1
= (1.06)(1.06)
______________ - 1 = 5.01%
(1.07)
If we assume that the liquidity premium is .41%,
then E(
1
s
1
) = 4.60%, which implies that the spot
rate is expected to decline significantly.
82
The expectations hypothesis would also say
that the rate is expected to decline
significantly.
However, according to it, E(
1
s
1
) = 5.01%
83
What about a flat term structure?
If s
1
= s
2
, then according to the liquidity
premium hypothesis, E(
1
s
1
) < s
1
.
Thus as per this hypothesis a flat term
structure implies that spot rates are likely
to decline.
In contrast a flat term structure would
imply no change in the one period spot
rate, if the expectations hypothesis were
to be valid.
84
If s
1
= s
2
= 7% and the liquidity premium is
.41%, the theory would imply that E(
1
s
1
) =
6.59%.
In contrast according to the expectations
hypothesis E(
1
s
1
) = 7%.
85
What about an upward sloping term
structure?
If s
1
< s
2
and the curve is slightly upward
sloping, then the liquidity premium theory
could be consistent with an expectation of
declining rates
However if the curve is steeply sloped
upward it would be consistent with the
expectation that rates are going to rise.
86
Assume that s
1
= 7% and s
2
= 7.1%.
Let the liquidity premium be .41%.
If so,
1
f
1
= 7.2% E(
1
s
1
) = 6.79%
However if s
2
= 7.3%, then
1
f
1
= 7.6% E(
1
s
1
)
= 7.19%.
In both cases the expectations hypothesis
would predict a rise in the spot rate.
87
The theory states that participants care
about both risk and return
Risk averse investors require extra
compensation for long maturity bonds
relative to short maturity bonds
Long term bonds are more vulnerable to rate
changes
Thus there is a premium paid for shorter term
bonds
Thus the forward rate is greater than the
expected future spot rate
88
The market segmentation or the hedging
pressure hypothesis argues that securities
are not perfect substitutes for each other.
Different investor groups have their own
maturity preferences.
A group will not stray from its desired
maturity range unless it is induced to do
so by higher yields or other favourable
terms.
89
It argues that banks, pension funds, and
mutual funds, often act like risk
minimizers
Rather than profit maximizers as assumed
by the expectations hypothesis.
They prefer to hedge against the risk of
fluctuations in prices and yields by
Balancing the maturity structures of their
assets with that of their liabilities.
90
For instance pension funds have stable and
predictable long term liabilities.
Thus they prefer long term assets.
Banks have relatively short term liabilities
And hence tend to prefer short term assets.
Thus financial markets are not one large pool
of loanable funds.
91
This theory goes to the other extreme as
compared to the expectations hypothesis
Investors and issuers are so risk averse that they
buy and sell only for maturities that match their
time horizon
For instance a CFO who has a planned outflow in
three months will invest only in a 3-month money
market security
Potential pensioners will invest only in long-term
bonds
92
The theory states that risk aversion is a
barrier to entry from other market segments
No matter how attractive interest rates may be
along other points on the yield curve
Thus the observed yield curve is a collection
of equilibrium rates in each segment
Based on the demand for and the supply of
money in that segment
Thus the implied forward rate is unrelated to
the expected future rates
93
Thus the debt market is essentially a
number of sub markets.
Demand and supply dynamics in each
group is the prime reason for the level
and structure of interest rates within that
maturity range.
However rates prevailing in a range are
relatively unaffected by rates prevailing
elsewhere.
94
If submarkets are isolated then
policymakers can alter the shape of the
curve by influencing supply-demand in
one or more segments.
If a positively sloped yield curve were to be
desired, the central bank can flood the market
with long term bonds.
It could simultaneously purchase short term
bonds.
95
This theory attempts to unify all the earlier
theories.
Investors have a preferred habitat along the
maturity scale that matches
their risk preferences
Tax exposure
Liquidity needs
Regulatory requirement
And planned holding periods.
96
An investor will not stray from his preferred
habitat
Unless the return on another segment is high
enough to overcome his preferences.
97
The yield curve is generally upward sloping
and levels off at long maturities
The liquidity preference theory would state that
investors require a higher rate of return from
long-term bonds for bearing greater risk
The segmented market theory would state that
demand for long term funds is strong relative
short-term funds and that supply of short term
funds is strong relative to long-term funds
Borrowers like to lock in rates for expected
periods
Lenders prefer the flexibility of short-term
investments
98
In practice short-term yields are more
volatile than long-term yields
Thus the term structure of volatility is
downward sloping
The expectations theory will argue that long-
term rates are an average of expected future
short-term rates
And averages are less volatile
The liquidity preference theory will come to the
same conclusion
99
The segmented market theory would say that
there is more shifting in the demand and
supply of short-term funds
And that there is greater stability in the
market for long-term funds
In practice we tend to observe this
Investors park funds in the money market while
doing asset reallocation
Long-maturity bonds attract buy and hold
investors
Life insurance companies
Pension Funds
100
Short-term and long-term yields usually
change in the same direction although not
always in a parallel fashion
Sometimes the curve may steepen or flatten
But most shifts in the curve are more or less
parallel
101
This may be explained as follows
Consider the factors that raise or lower
expected future rates
Expected inflation
Business cycles
Monetary policy
Trade balances
Foreign exchange rates
Tax rates
Fiscal policy
102
We would expect all these factors to
influence short-term and long-term rates in a
similar fashion
All the proposed theories are consistent with this
103
If the absence of risk long-term rates would
reflect the average of short-term rate
expectations over the maturity of the former
If the horizons of investors and borrowers were
evenly distributed across maturities then this
would be true
104
However what if most investors have a short-
term horizon
They will need an inducement to hold long-term
bonds
Because when they sell at the end of their
investment horizons they will be exposed to
market risk
In this case long-term yields will be higher
than the geometric average of expected
short-term rates
This is what the liquidity preference theory
predicts
105
But what if most traders have a long-term
horizon
They would need an inducement to hold short-
term bonds
For they face reinvestment risk
If so long-term rates will be lower than the
geometric average of expected short-term rates
So whether long-term rates are lower or
higher than the geometric average of
expected short-term rates
Would depend on how investors are distributed
across maturities
106
Assume there is a concentration of traders at
the short-end of the spectrum
If so long-term rates must be higher than the
average of expected short-term rates
The term risk in this context means that
expectations may not always be realized
The more volatile rates are
The greater the possibility of change from the
expected value
As well as the magnitude of change
107
If so investors who are considering a shift to
long term bonds despite their short horizons
would demand a higher premium
This would show up as greater yields
Thus the higher the volatility of interest rates,
the greater the steepness of the yield curve
Traders, speculators and dealers have no
fixed time horizon
Typically their horizons are short-term

108
Speculators on short-term yield changes face
greater risk from long-maturity instruments
Dealers too hold bonds for short periods
Hence they too face greater risk from long-term
securities
As compensation they demand higher yields
Thus such market participants impart a bias
towards short-term securities
This explains why on an average the yield curve
is usually upward sloping
109
Econometric models may be specified to
calculate the rate that best fits the market
prices of bonds in the sample
Using a technique like non-linear least squares.
110
It is a parametric approach for deriving
the zero-coupon yield curve.
According to this model, the m period
spot rate is given by:
s(m,) =
0
+
1
x [1 e
-m/
] +
________
m/

2
x 1 e
-m/

[________ e
-m/
]


m/

111
The parameters
0
,
1
,
2
and have to
be empirically estimated.
Advantages of the method:
It can handle a wide variety of term
structure shapes that are observed in the
market.
It avoids the need for interpolation to
determine the spot rates between
discrete points in time
112
Spot rates can be derived at any point in
time and not just at discrete points
The parameters can be interpreted as
follows.

0
must be positive and is the asymptotic
instantaneous forward rate.
It is a function of the term to maturity.
113
1 measures the deviation from the
asymptote.
It measures the speed with which the curve
tends towards its long term value.
If it is positive, the curve will have a
negative slope and vice-versa.
114
must be positive and is the position of the
hump or the u-shape on the curve.
2 measures the magnitude and direction of
the hump.
If it is positive there will be a hump.
Else there will be a u-shape.
115
The method of computation of forward rates
for money market products depends on
whether the market uses an add-on rate
approach or a discount rate approach
Consider CDs which typically use an add-on
approach
Assume the rate for an A-days CD is r
A
and
that for a B days CD is r
B
, where B > A
Assume that the year has 360 days
116
117
The forward rate can be derived from the
following expression:

118
Assume the 90-day rate is 4% while the
180day rate is 5%.
Now consider a discount instrument such as
commercial paper
The quoted rate is r
A
for paper with A days to
maturity and r
B
for paper with B days to
maturity where B > A.
119
Assume that the 90 day CP rate is 4% while
the 180 day rate is 5%.
The forward rate is given by
120