Investing

Chapter 3: The Term Structure of Interest Rates
Introduction
Spot Rates
Forward Rates
Theories of the Term Structure
Estimating the Term Structure
Swaps and Swap Rates
Bond Markets (FIN 601) - FSS 2015 - Prof. Dr. Erik Theissen - Chapter 3
The Term Structure

Introduction
Interest rates for different times to maturity are often different
Example (Frankfurter Allgemeine Zeitung, April 14, 2000)
Typical term structure
patterns:
flat (US)
normal (Germany)
inverse (UK)
Term structure described
by:
level
slope (long minus short)
curvature
The Term Structure

Introduction
How best to describe the term structure?
The term structure is typically derived for a homogeneous
(with respect to default risk and liquidity) class of bonds, e.g.
AAA-rated corporate bonds
Which interest rates to use to describe the term structure?
Using yield to maturity:
Yields to maturity of coupon bonds with the same time to
maturity may be different even when all bonds are fairly
priced (see below) which ones to use to describe the
term structure?
To avoid the ambiguity we use spot rates. Spot rates are
the yields to maturity of zero bonds
The Term Structure

Spot Rates
Spot rates:
Consider a zero bond (i.e. a bond which makes only one
payment at time T, there are no interest payments)
The yield to maturity on such a bond is called the T-period
spot rate and is given by
CT
PV
T
1 rT
Spot rates are the discount rates to use when valuing bonds
The Term Structure

Spot Rates
Spot rates:
Note: Every coupon bond can be interpreted (and valued) as
a portfolio of zero bonds
- Stripping of government bonds (STRIPS = Separate
Trading of Registered Interest and Principal of Securities)
This is essentially what we did in chapter 2
Advantage of spot rates: Because they are derived from
zero bonds, there are no problems with intermediate
payments that require reinvesting
The Term Structure

Spot Rates
Spot rates and yield to maturity:
Assume the following spot rates
year
spot rate
5%
7%
and two 2-year bonds, one with a 4% and one with a 8%

coupon and with PVs
4
104
94.6472
2
1, 05 1, 07
8
108
101, 9504
2
1, 05 1, 07
Assume further that the bonds are fairly priced (i.e., price =
PV)
The Term Structure

Spot Rates
The yields to maturity are
4
104
94.647
0 y A 0.06958
2
1 y A 1 y A
8
108
101.95
0 yB 0.06922
2
1 yB 1 yB
Both bonds are fairly priced. Why does the 8% bond have
lower yield to maturity?
The 8% bonds has shorter economic time to maturity. At
the same time the term structure is upward-sloping instruments with shorter maturity offer lower yield
Thus: Comparing yields to maturity may be misleading
The Term Structure

Spot Rates
Illustration of the coupon effect on yields to maturity:
Source: Elton et al. (2007), figures 21.5 and 21.6

The Term Structure

Forward Rates
Forward rates
Forward rate agreement: you agree today to lend money at
time t1 which is to be paid back at time t2
The interest rate is fixed today
Such an interest rate is called a forward rate and denoted
ft,T
rate f1,2
t0
terms of
contract fixed
t1
money
invested
t2
money
repaid
The Term Structure

Forward Rates
Forward and spot rates:
There are two ways to invest money for two periods:
1: Lend money for two periods today at the two-period spot
rate
2: Lend money today for one period at the one-year spot
rate and enter into a forward-rate agreement for period two
(1+r1)(1+f1,2)
t0
t1
t2
(1+r2)2
10
The Term Structure

Forward Rates
Forward and spot rates (contd.):
Absence of arbitrage requires
1 r2
1 r1 1 f1,2 f1,2
1 r2
1 r1
Similarly one can use the 2-year and 3-year spot rate to
calculate f2,3 etc.
In general:
T
1 rT
T
1
1 r0,T 1 r0, 1 f,T f,T T
1 r
There is thus a correspondence between spot and forward
rates
An open question: What is the relation between forward
rates and future (expected) spot rates?
11
The Term Structure

Forward Rates
Assume spot rates r1 = 5% and r2 = 6%. Two zero bonds
with one year and two years to maturity are traded at
100
100
PV1
95.2381 ; PV2
88.9996
2
1.05
1.06
Now assume the following investment:
t0
t1
t2
buy bond 1
-95.2381
+100
sell bond 2
+95.2381
-107.0095
sum
100
-107.0095
Note:
95.2381
100 107.0095
88.9996
12
The Term Structure

Forward Rates
The return on this (net) investment is 7,0095%
This is equivalent to the forward rate:
1.062
1 0.070095
1.05
Thus the forward rate is contractable by forming long-short
portfolios of traded bonds
13
The Term Structure

Forward Rates
There are various interest rate futures contracts
Futures contracts are standardized, exchange-traded
contracts
Fed Fund Futures
- underlying: the monthly average (!) of the effective
overnight fed funds rate
Eurodollar Futures
- underlying: the 3-months Libor (London Interbank Offered
Rate; an interbank rate for Eurodollar deposits)
Exchange-traded futures contracts on government bonds
(e.g. the Eurex Bund Futures Contracts)
- often physically settled which entails valuation problems
(the cheapest-to-deliver option)
14
The Term Structure

Approaches:
Expectations Hypothesis
Liquidity Preference Hypothesis
others (not covered)
- Preferred Habitat
- Market Segmentation Hypothesis
15
The Term Structure

Investment horizon and risk:
Consider an investor with a t-period investment horizon
She invests in a (default-free) zero bond
- Maturity = t: riskless
- Maturity < t: reinvestment risk
- Maturity > t: price risk
Risk-neutral investors dont care about the risk, they do not
require a risk premium
Risk-averse investors should require a risk premium
If the majority of investors has a short horizon (a preference
for liquidity), long-term bonds must offer a premium over
repeated short term investment
16
The Term Structure

The Expectations (or Risk-Neutrality) Hypothesis:
Forward rates are equal to expected future spot rates
Consequence: The expected return of a long-term investment and a repeated short-term investment are equal
1 r
0,T
t 2
t 2
1 r0,1 1 ft 1,t 1 r0,1 1 E0 rt 1,t

long-term
repeated short-term
Implication: There is no liquidity premium

This implies risk neutrality - there is no premium for bearing
the risk associated with a mismatch between investment
horizon and term to maturity of a bond
17
The Term Structure

The Expectations Hypothesis (contd.):
The term-structure is entirely driven by expectations on
future interest rates
These depend on expectations on a) real rates and b)
inflation
On average the term structure should be flat
18
The Term Structure

The Liquidity Preference (=Risk Aversion) Hypothesis:
Basic assumption: Investors (on average) have a preference
for liquidity (i.e. for investments with short term to maturity)
while issuers (on average) have a preference for long time
to maturity
f,T E0 r,T L ,T E0 r,T
Forward rates are larger than expected future spot rates
because they incorporate a liquidity premium
1 r
0,T
long-term
1 r0,1 1 E0 rt 1,t
t 2
repeated short-term
The expected return of a long-term investment is larger than

the expected return on repeated short-term investments
19
The Term Structure

The Liquidity Preference Hypothesis (contd.):
The term structure depends on
- expected future real rates
- expected inflation
- the liquidity premium
The liquidity premium may depend on the time to maturity
( term structure of liquidity premia), it may change over
time, and it is unobservable
We cannot derive expectations on future spot rates from
todays term structure
E.g. a normal term structure can be caused by a)
expectations of increasing spot rates and/or b) by an
increasing liquidity premium
20
The Term Structure

How to determine spot rates?
There are not too many zero bonds
Stripped coupon payments are difficult to use
- lower liquidity liquidity premium
- possibly different tax treatments (interest payments on a
coupon bond may be taxed differently than capital gains
from a zero bond)
- usually only available for government bonds
We thus often need to rely on coupon bonds to estimate the
spot rates
But remember: a coupon bond is a portfolio of zero bonds
21
The Term Structure

Illustration (Elton et al. 2007, p. 514)
Assume there are the following two bonds
Bond
t0 (price today)
t1
-100
106
-96.54
t2
106
Bond A is already a zero bond. We thus have r1 = 0.06

Now we construct a portfolio
Bond
t0 (price today)
t1
t2
-96.54
106
5.6604
-6
Portfolio
-90.8796
106
22
The Term Structure

Illustration (contd.)
The portfolio has the cash flow structure of a zero bond and
can be used to infer r2:
90.8796 1 r2 106 r2 0.08
In a similar way we can obtain r3 from a three-year coupon
bond and so on
This procedure is called bootstrapping
From the derived spot rates we can also derive prices of
hypothetical zero bonds (implied zeros)
Bootstrapping can be done more conveniently using matrix
notation (see Veronesi 2010, p. 66 and the end-of-chapter
problems)
2
23
The Term Structure

Problem of the approach:
Different two-year bonds may result in different estimates of
the two-year spot rate
Differences may occur because of differences in default risk,
liquidity risk, because of non-synchronous trading, because
of the bid-ask-spread and because of tax effects (different
taxation of interest income and capital gains; relevant when
comparing bonds with different coupons)
24
The Term Structure

A regression approach:
Define
Z 0,t
1 rt
where t may be a fraction. Z(0,t) is the discount factor, and is

also the price of a zero bond that pays 1 at maturity in t
Then we have
Pi Z 0;t Ci,t i
which can be estimated using OLS or more advanced
techniques (e.g. spline regressions)
Spot rates for maturities not covered by observations can be
obtained by interpolation
25
The Term Structure

Regression approach (contd.):
Note: Each discount factor (= each maturity date) is one
estimated parameter (one unknown)
We need more observations than we estimate parameters
Thus: the regression approach only works when there are
more bonds than maturity dates
This is typical for shorter maturities (e.g. up to 5 years)
see Veronesi (2010, p. 67)
26
The Term Structure

Estimating a continuous function:
The regression only gives us discrete points (those covered
by payment dates in the data set)
27
The Term Structure

Estimating a continuous function (contd.):
We can assume a functional form for the term structure, e.g.
a quadratic equation
Z 0,t 0 1t 2 t 2
We now rewrite our earlier regression as
Pi 0 1t 2 t 2 Ci,t i
and estimate the parameters 0, 1, 2
With these estimates we can estimate any spot rate via
Z 0, 0 1 2 2
28
The Term Structure

Estimating a continuous function (contd.):
A quadratic function is not able to accommodate all shapes
of the term structure observed in reality (e.g. it has no
inflection points)
We can use different, more complex functional forms (and
more advanced estimation techniques)
In general
r 0,t f t
where f(.) is a functional form that is flexible enough to

accommodate the shapes of the term structure observed in
reality
29
The Term Structure

Parametric approach: Nelson/Siegel (1987)
r 0,t 0 1 2
1 exp t /
t/
2 exp t /
0 : level, long-term interest rate (t )

0 1 : instantaneous interest rate (t 0)
1 : slope factor: short-term long-term interest rate
2 : shape factor, drives medium-term yields
Estimation: minimize sum of squared differences between
model prices and observed data points
30
The Term Structure

Parametric approach: Svensson (1994)
r 0;t 0 1 2
1 exp t / 1
t / 1
2 exp t / 1
1 exp t / 2
3
exp t / 2
t / 2
Extension of Nelson/Siegel (1987), allows for additional

turning point
Sufficiently flexible: monotonous, U-, inverse U- or S-shaped
Common approach of Deutsche Bundesbank and ECB; see
e.g. the technical note available at
https://www.ecb.europa.eu/stats/money/yc/html/technical_notes.pdf
31
The Term Structure

Parametric approach: Svensson (1994) (contd.)
32
The Term Structure

Definition of an interest rate swap:
A swap in general: Two parties exchange two cash flow
streams over a pre-specified period of time
Interest rate swap: One party pays a floating rate, the other
party (usually) pays a fixed rate
The floating rate is typically a benchmark rate such as Libor
or Euribor
The swap rate is the fixed interest rate which is equivalent
to the floating rate
Notional value = amount on which the interest is calculated
33
The Term Structure

A swap dealer with a matched book:
(rT: Treasury bond rate corresponding to the term of the swap)
Party A
3-months
Libor
rT+20 bps
Swap
Dealer
3-months
Libor
Party B
rT+30 bps
Source: Sundaresan (2010), p. 326
34
The Term Structure

Complications and extensions:
Caps and floors can be added to the floating rate leg of the
swap (a floor will increase and a cap decrease the fixed
rate)
Swaption: Option to enter into a swap at predetermined
conditions
35
The Term Structure

Valuation:
At the inception, the terms of the swap are usually fixed
such that its value is zero
When interest rates change the value of the swap will
change. Example:
- assume you pay Libor and receive a fixed rate of 5%
- now assume interest rates increase
- the floating rates you pay increase while the rate you
receive is fixed - your position now has a negative value
36
The Term Structure

The swap rate curve:
Swaps for different maturities are commonly traded
We can use the swap rates for different maturities to
estimate the term structure: swap (rate) curve or Libor curve
Advantages:
- Swap rates are observed for many maturities
- The swap market is very liquid
- There is no on the run / off the run problem
- Swap rate curves can be compared across countries
(country ratings differ, while the same banks offer swap
rates in different currencies)
37
The Term Structure

The swap rate curve (contd.):
Disadvantages:
- Swap rates are not default-free - they reflect the credit
risk of the contract parties
38
The Term Structure

Source: Brsenzeitung, 12.2.2015

39
Reading List
Required Reading:
Bodie, Z., A. Kane and A. Marcus (2009): Investments, 8th edition,

McGraw Hill, sections 15.3.-15.6.
Elton, E., M. Gruber, St. Brown and W. Goetzmann (2007): Modern
Portfolio Theory and Investment Analysis, 7th edition. Wiley, Chapter
20.
Please note: This chapter assumes bi-annual interest payments.
Fabozzi, F. (2010): Bond Markets, Analysis and Strategies, 7th edition,
Pearson, chapter 5.
Sundaresan, S. (2009): Fixed Income Markets and Their Derivatives,
3rd edition, Academic Press, chapter 8 and section 1 of chapter16.
Veronesi, P. (2010): Fixed Interest Securities, Wiley, chapter 2 (including
the appendix).
(please note: some of the contents of chapter 2 of the book has been
covered in chapter 2 of the lecture)
40
Study Questions
Question 1
Assume that the one-year spot rate is 5% and the two-year spot rate is 6%. Assume
further that the expectations hypothesis holds (i.e., the expected one-year spot rate
one year from now is the forward rate implied by today's term structure).
a) What is the price of a one-year zero bond and the price of a two-year zero bond
today?
b) What is the expected price of the two year zero-bond one year from now?
c) What is the expected return from holding the two-year zero bond in the first year?
Question 2
There are three bonds, a zero bond, a 4% coupon bond and a 6% coupon bond. All
bonds mature in exactly three years. The term structure in two scenarios is given in
the following table.
t
t
t
1
Scenario A
4.0%
5.0%
6.0%
Scenario B
6.0%
5.0%
4.0%
Assume that all bonds are fairly priced.

a) Calculate the YtM of the three bonds under scenario A and under scenario B.
b) Interpret your result.
41
Study Questions
Question 3
The prices and future cash flows of three coupon bonds are given as follows:
Bond
Price
Year 1
Year 2
99.50
105
101.25
106
100.25
Year 3
107
Use this information to obtain the one-, two- and three-year spot rates as well as the
one-period forward rates at time 1 and 2.
Question 4
Now consider the following bonds (see next slide). Use this information to obtain the
spot rates.
Note: You may want to reformulate the problem using matrix notation and then use
the matrix operators in Excel.
42
Study Questions
Price
Time to maturity
Coupon rate
(years)
100,976
3.5%
104,333
5.0%
102,866
4.0%
102,377
3.75%
112,668
6.0%
108,696
5.5%
109,626
5.25%
105,803
4.75%
103,642
4.50%
98,12
10
4.0%
43
Study Questions
Question 5
Consider the following investment alternatives shown below.
a) Calculate the YtM of all investments.
b) Calculate the weighted average yield to maturity of the components of the three
portfolios. Use the proportions invested in each bond as weights (for portfolio "A
and C" this would be 100/192 for bond A and 92/192 for bond C).
c) Compare your results from a and b.
Bond A
Bond B
Bond C
A and B
B and C
A and C
t=0
-100
-100
-92
-200
-192
-192
t=1
15
6
9
21
15
24
t=2
15
106
9
121
115
24
t=3
115
--109
115
109
224
44

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Chapter 3: The Term Structure of Interest Rates

The Term Structure

The Term Structure

The Term Structure

The Term Structure

The Term Structure

and two 2-year bonds, one with a 4% and one with a 8%

The Term Structure

The Term Structure

Source: Elton et al. (2007), figures 21.5 and 21.6

The Term Structure

The Term Structure

The Term Structure

The Term Structure

The Term Structure

The Term Structure

The Term Structure

The Term Structure

The Term Structure

1 r0,1 1 ft 1,t 1 r0,1 1 E0 rt 1,t

Implication: There is no liquidity premium

The Term Structure

The Term Structure

The expected return of a long-term investment is larger than

The Term Structure

The Term Structure

The Term Structure

Bond A is already a zero bond. We thus have r1 = 0.06

The Term Structure

The Term Structure

The Term Structure

where t may be a fraction. Z(0,t) is the discount factor, and is

The Term Structure

The Term Structure

The Term Structure

The Term Structure

where f(.) is a functional form that is flexible enough to

The Term Structure

0 : level, long-term interest rate (t )

The Term Structure

Extension of Nelson/Siegel (1987), allows for additional

The Term Structure

The Term Structure

The Term Structure

Source: Sundaresan (2010), p. 326

The Term Structure

The Term Structure

The Term Structure

The Term Structure

The Term Structure

Source: Brsenzeitung, 12.2.2015

Bodie, Z., A. Kane and A. Marcus (2009): Investments, 8th edition,

Assume that all bonds are fairly priced.

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