Lecture 2

The term structure of interest rates

Learning outcomes
By the end of this lecture you should:
Be familiar with the concept of the term structure
of interest rates and know what determines its
shape
Be able to back out the term structure from a set
of coupon bonds
Be able to profit from situations where different
bonds imply different term structures
Be able to deduce forward rates from the term
structure (and vice versa)

What is the term structure?

Suppose we can get a fixed interest rate for an
investment starting today and ending at time t
We call this interest rate the t spot rate and
denote it yt (or 0yt to emphasize that its the t
spot rate today, i.e. at time zero)
Note that the book denotes the short rates by yt
Thats not the standard notation and it blurs the
distinction between yields and spot rates

Together the spot rates make up the term

structure of interest rates or the (pure) yield curve

Here it is

What determines the term structure?

Think of interest rates as (sort of) prices of
future cash flows
Like other prices, they are set in equilibrium.
When the prices change, the yield curve shifts.
Typically (but not always) upwards sloping
Well discuss why the term structure looks like
it does, and what implications it has

Is it useful?
The spot rate for a given maturity constitutes
the alternative investment we used to set up
the arbitrage trades to motivate discounting in
lecture 1
The spot rates are the appropriate discount
rates for pricing (risk free) future cash flows
Take a three year bond with annual coupons:
FV + c )
(
c
c
P0 =
+
+
2
3
1
+
y
( 1 ) (1 + y2 ) (1 + y3 )

Inferring the term structure

We directly observe market bond prices.
These imply the term structure.
Zero coupon bonds have only one cash flow,
so backing out the implied spot rate is straight
forward:
=
P

1
t

FV

(1 + yt )

FV
=
yt
1
P

In practice, bonds with long maturities tend to

pay coupons

Inferring the term structure

Consider the pricing equation of a two year
bond at time 0:
FV + c )
(
c
=
+
P2
2
+
y
1
( 1 ) (1 + y2 )

We have one equation and two unknowns

We have to back out the spot rates in an
iterative manner. This method is called
bootstrapping.

Example
First find r1 from a one-year zero coupon bond:
FV
FV
=
P1
=
y1
1
1
y
P
+
( 1)
1

Then substitute into the equation for P2;0. We

now have one equation and one unknown:
FV + c )
(
c
P=
+
y=
2
2
2
(1 + y1 ) (1 + y2 )

( FV + c )

c
P2
1
(1 + y1 )

We can repeat this for any number of steps

Recap: What is an arbitrage?

An arbitrage is a (set of) trades that generate zero
cash flows in the future, but a positive and risk
free cash flow today
A straight forward example is a violation of the
law of one price
Our examples are based on the same principle
but (slightly) more complex
They typically rely on constructing some synthetic
instruments, i.e. portfolios that have the same CF
consequences as the real instruments

Recap: What is an arbitrage?

We often refer to these synthetic instruments as
replicating strategies or replicating portfolios
Once we have set up a replicating portfolio we
can exploit any mispricings as if it was the real
instrument
These trades, e.g. selling the real instrument and
buying the synthetic instrument, are the
arbitrage trades
Arbitrage traders will impose some structure on
the term structure of interest rates

A numerical example
Suppose that the following bonds trade in the
market:
A
-90.91

100

-79.72

100

-95.78

10

110

B
C

Get the arbitrage free price

Lets back out the implied term structure from
the pricing equations of bonds A and B:
=
PA 90.91
=
=
PB 79.72
=

100
100
=
y1
1 10%
1
90.91
+
y
( 1)
100

(1 + y2 )

=
y2

100
1 12%
79.72

Now use the term structure to calculate the

arbitrage free (or implied) price of bond C:
10
110
10 110
PCImplied =
+
=
+
96.78 > 95.78 =
PCObserved
2
2
(1 + y1 ) (1 + y2 ) 1.1 1.12

Set up the arbitrage trade

Bond C trades for less than the arbitrage free
price, i.e. it is too cheap
There is an arbitrage opportunity
Strategy: Construct a synthetic version of
Bond C from bonds A and B
Buy the underpriced real bond and sell the
overpriced synthetic bond

Construct the synthetic bond

A synthetic bond replicates the CFs of the C
bond so we want to achieve
CF1S = CF1C = 10
CF2S = CF2C = 110

Each A bond gives CF1 = 100

The synthetic bond contains XA A-bonds, so
that XA satisfies:
10
X ACF1 = CF X A100 = 10 X A =
= 0.1
100
A

C
1

Construct the synthetic bond

Similarly, the synthetic bond contains XB Bbonds so that XB satisfies
X ACF1A + X B CF1B = CF1C 0.1 100 + X B 0 = 10
110
XB =
= 1.1

A
B
C
100
X ACF2 + X B CF2 = CF2 0.1 0 + X B 100 = 110

We have now constructed a synthetic C bond.

Sell this synthetic bond and buy the real bond.

Exploit the mispricing

Our CFs will be
CF0 = ( X A PA + X B PB ) PC = (0.1 90.91 + 1.1 79.72 ) 95.78 96.78 95.78 = 1
CF1 = X ACF1A + CF1C = 0.1 100 + 10 = 0
CF2 = X B CF2B + CF2C = 1.1 100 + 110 = 0

We make a riskless profit at t = 0

We can scale these trades up
When doing so, the supply and demand our
trades create will push bond prices to their
arbitrage free values

Reinvestment risk
Suppose we have an investment horizon of two years
If we have a coupon bond we must reinvest it at t = 1
to get all cash flows at t = 2
Lets denote the spot rate valid at time 1 for an
investment maturing at time 2 by 1y2

The book somewhat unfortunately calls this the short rate

and denotes it r1

Our cash flows at t = 2 will be:

CF2 = FV + c + c(1 + 1y2)
Since 1y2 is unknown at t = 0, so is CF2

Holding period return

Our total CF at t = 2 will be:
CF2 = FV + c + c(1 + 1y2)
Since this is risky, so is the return we make on
this investment
To emphasize that we mean the (risky)
investment return, we sometimes refer to this
as the holding period return, HPR:
=
HPR

FV + c + c (1 + 1 y2 )
1
P0

Forward rates
Forward rates are interest rates for
investments we agree on today but that take
place in the future
The forward rate (determined today) for an
investment that starts at time s and ends at
time t is denoted sft
In the abscence of arbitrage opportunities, the
term structure determines all forward rates
(and vice verca)

Determining the forward rates

Suppose we want to determine the forward
rate between year 2 and 3, 2f3
The cash flow consequences of investing $1 at
this rate would be:
0

2
-$1

Set up a replicating strategy

3
$(1+2f3)

Set up a replicating strategy

We want to achieve a negative CF of $1 at t=2
1
Borrow (1 + y )
At t = 2 we must repay this with interest, i.e.
2

(1 + y2 )

1 + y2 ) =
1
2 (
2

If we invest the money we borrowed for three

years we achieve a CF at t = 3 of
1

(1 + y2 )

(1 + y3 )

Set up a replicating strategy

At t = 0 our CF is 0
At t = 1 our CF is -1
Since this replicates the CFs of the forward
rate, the t = 3 CF must also be the same:
1

(1 + y2 )

1 + y3 )
2 (

=
(1 +

f3 )

1 + y3 )
(
f3 =
1
2
(1 + y2 )
3

We can set up similar replicating strategies to

find any forward rate

Implied forward rates:

A numerical example
Suppose we want to determine the forward
rate between year 1 and 3, 1f3
Suppose the (relevant) term structure is this:
y1 = 10%
y3 = 12%

The cash flow consequences of investing $1 at

the forward rate, 1f3, would be:
0

1
-$1

3
$(1+1f3)2

Set up a replicating strategy

We want to achieve a negative CF of $1 at t=1
1
1
=
Borrow
(1 + y ) 1.1
At t = 1 we must repay this with interest, i.e.
1

1
1.1
CF1 =
(1 + y1 ) =

=
1
1.1
1.1

If we invest the money we borrowed for three

years we achieve a CF at t = 3 of
1
1.123
3
CF
=
(1 + y=
3
3)
1
+
y
1.1
( 1)

Set up a replicating strategy

By the no-arbitrage condition, this CF must be
equal to the CF of the replicated strategy (the
$1 investment at the forward rate, 1f3)
We can easily solve for the arbitrage free
forward rate:
1.123
1.123
2
= (1+1 f 3 ) 1 f 3 =
1 13%
1.1
1.1

Futures rates
In practice contracts like these are settled
every day
This avoids counterparty risk
The underlying logic is very similar

Liquidity risk
Suppose that we have an investment horizon
of one year
If we hold a coupon bond that matures a t = 2,
we must sell it at t = 1 to achieve our period 1
cash flow
The bond price at t = 1 will be:
P1 = (c + FV)/(1 + 1y2)
Our CF at t = 1 will be CF1 = c + P1

Liquidity risk
Our HPR will be
c + ( c + FV ) (1 + 1 y2 )
c + P1
HPR
=
=
1
1
P0
P0

Since 1y2 is unknown at t = 0, so is P1 and HPR

As for reinvestment risk, this risk arises
because our investment horizon is not
matched to our cash flows

Liquidity premium
In principle, we could pick a bond with a
maturity that matches our horizon
Bond issuers and investors may have different
horizons, or preferred habitats
Markets must clear. Somebody must carry
some risk. This risk will be priced.
The premium offered to induce investors to
hold bonds whose maturity does not match
their horizon is called the liquidity premium

Liquidity premium
If issuers typically have longer investment
horizons than investors, wed get an upwards
sloping term structure
In principle, the effect could go both ways
The theory that liquidity premia determine
the shape of the term structure is called the
liquidity preference theory or the preferred
habitat theory

Market expectations
Assume for now that all future interest rates are
known
Suppose further that the 1-year spot rate will be
higher in one year than today, i.e. that y1 < 1y2
If we invest $1 at for two years at y2 well get
(1+y2)2 at t = 2
Alternatively, we can invest our $1 for one year at
y1 and then for another year at 1y2. Well get
(1+y1)(1+1y2) at t = 2.

Market expectations
Since both cash flows are assumed to be risk
free and both cost $1 to achieve today, they
must be of equal size (or therell be arbitrage
opportunities): (1+y1)(1+1y2) = (1+y2)2
We can express the 2-year interest rate as the
geometric average of the two 1-year interest
rates: [(1+y1)(1+1y2)]1/2 = (1+y2)
Being an average, y2 must be y1 < y2 < 1y2

The expectations hypothesis

This would produce an upwards sloping term
structure
In reality 1y2 is not known at t = 0, but
expectations on 1y2 would work the same way
The theory that market expectations on future
interest rates shape of the term structure is
called the expectations hypothesis, EH
Since the term structure implies all forward
rates, a common way to phrase the EH is:
s

ft = E ( s yt )

So which is it?
We can check the EH in the data
It preforms poorly
Likely both theories are at work, so that
=
E ( s yt ) + L
s ft

L is the liquidity premium the market

demands to hold bonds of that maturity

So which is it?
Note that if there was no uncertainty about
future interest rates, there would be no
reinvestment or liquidity risk
L would be zero
The EH would be true (also by a trivial no
arbitrage argument)
The same goes if investors are risk neutral, i.e.
do not require compensation for taking on risk

Summing up
The term structure is the spot rates the
market sets in equilibrium
The outcome will depend on the believes
about future interest rates and (risk)
preferences of the market participants
We typically take this outcome as given, and
use it to find other prices, such as untraded
bonds or forward rates