1

END OF CHAPTER EXERCISES - ANSWERS

Chapter 21 : Term Structure of Interest Rates

Q1

What is the (spot) yield curve and why is it useful?

A1
The spot yield curve is a graph of the relationship between spot rates (on default free assets)
and their term to maturity. Forward rates which are used in pricing various financial assets
(e.g. Floating Rate Notes, interest rate swaps, futures and options contracts that depend on
interest rates) can be extracted from the spot yield curve.
Also the shape of the yield curve embodies the markets best guess of future inflation. Usually
the spot-rate curve is upward sloping and this implies that investors are expecting an increase
in price inflation in future years.

Q2

What are the two key features we require from a fitted yield curve?

A2
The yield curve should be smooth and continuous because we do not believe that spot rates
suddenly increase or suddenly fall at particular maturities. The curve should flatten out at
very long maturities because it seems unreasonable to assume for example that today,
investors think annual inflation in 25 years time will be radically different from what they think
it will be in 26 years time.

Q3

The 1-year spot rate is 9%. The 2-year spot rate (on US T-Bonds) is 9.5% p.a. and
the 3-year spot rate is 10% p.a.
(a.)
Calculate the implied one year ahead, 1-year forward rate, f12. Explain why a
1-year forward rate of 9.6% would not be expected to prevail in the market.
(b.)
Calculate the forward rates f23 and f13. Is there any link between f12, f23 and
f13?
(c.)
Very briefly, mention one practical use for spot rates and one practical use of
forward rates.

A3
The no-arbitrage condition determines the forward rate f12
(a.)

(1 + r2)2 = (1 + r1) (1 + f12)

(1 + 0.095)2 = (1 + 0.09) (1 + f12)
f12 = [(1.095)2/(1.09)] 1 = 0.1000 (or 10 %)
Also (approximately), we have f12 = 2 (r2) r1 = 10%

(b.)

f23 = 3(r3) - 2(r2) = 3 * 10% - 2 * 9.5% = 11%

f13 = (3/2) r3 - (1/2) r1 = 1.5 * 10% - 0.5 * 9% = 10.5%
The next bit is tricky and it requires a bit of algebra.
[1] (1 + r2)2 = (1 + r1) (1 + f12)
[2] (1 + r3)3 = (1 + r1) (1 + f13)2
[3] (1 + r3)3 = (1 + r2)2 (1 + f23)

K. Cuthbertson and D. Nitzsche (2008) Investments, J. Wiley, 2nd edition

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Now substitute equation [1] in equation [3] and note that equation [3] also equals
equation [2]
(1 + r3)3 = [(1 + r1)(1 + f12)] (1 + f23) = (1 + r1) (1 + f13)2
Canceling the term in (1+r1), expanding the brackets and ignoring cross product terms
like (f12 f23) because they are small, it follows (approximately) that
f12 + f23 = 2 (f13)
The above equation is exact if interest rates are continuously compounded, rather than
discretely compounded.
(c.)

By investing in a bond for two years with r2 = 9.5%, you are implicitly earning f12 = 10%
in the second year. Therefore, if someone offered you a forward contract today which
promised to pay 9.6% between years 1 and 2 you would not take it. This is because
buying a 1-year bond at r1 = 9% and simultaneously buying a forward contract paying
f12* = 9.6% (in the second year) would leave you worse off (by the end of the second
year), than buying the two-year bond at r2 = 9.5%.
In this example you have calculated the forward rate f12 = 10% and demonstrated that
riskless arbitrage will ensure this is the equilibrium price.
Forward rates provide a mechanism for pricing a forward rate agreement FRA, swaps
and options based on interest rates.
Spot rates are used in pricing coupon paying bonds and strips.

Q4

If the expectations hypothesis (EH) holds, why might the yield curve be:
(a.)
flat
(b.)
upward sloping
(c.)
downward sloping
What might cause a parallel shift in the yield curve?
The government implements a credible tight monetary policy by raising short-term
(e.g. 3-month) interest rates. Why might this result in a downward sloping yield
curve?

A4
If the EH is true then long-rates (e.g. r2) are a weight average of current (r1) and expected
future short-rates (Er1,2). The simplest 2-period case, is r2 = (1/2)r1 + (1/2)Er1,2 where the last
term is the one-year short-rate, expected to prevail between the end of year-1 and end of
year-2, hence:
(a.)

A flat yield curve (i.e. r2 = r1) implies that future short-term interest rates expected to
stay the same (i.e. Er1,2 = r1)

(b.)

An upward sloping yield curve implies future short-term interest rates are expected
to rise [i.e. Er1,2 > r1]

(c.)

A downward sloping yield curve implies future short-term interest rates are expected
to fall [i.e. Er1,2 < r1]

If all interest rates are expected to rise (say by 1% because inflation is expected to rise by
1%), in all future years, then we get a parallel shift in the yield curve.
Short rates rise. The latter reduces consumers expenditure etc. and hence inflation may be
expected to fall in the future (if the policy is credible). Hence the EH would predict that
todays forecasts of future short-rates (Er1,2) would be below the current short-rate (i.e. r1).
K. Cuthbertson and D. Nitzsche (2008) Investments, J. Wiley, 2nd edition

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Hence the EH would then predict that current long-rates r2 will be below current short rates
(i.e. r1) and the yield curve would be downward sloping.

Q5

(a.)

(b.)
(c.)

You can lend $100 to a bank at a forward interest rate f12 = 13% quoted
today but applicable to funds lent at the end of year-1 for a further year. The
spot rates for 1-year money and 2-year money are currently 10% p.a. and
12% p.a. respectively. Explain whether you would take the banks offer.
In principal, how can one calculate the forward rate f13 (i.e. the rate of interest
applicable between the end of year one and the end of year 3) and f23?
What are the practical uses of forward rates in finance ?

A5
Cash flows in Actual Forward Deal

113

100

Cash flows in Synthetic Forward Deal

114

90.909
0

90.909
100
Should you take the banks quoted offer of ate f12 = 13%?
First work out the implied (or synthetic) or no-arbitrage forward rate, sf12 given the two spot
rates:
(1+r1) (1+sf12) = (1+r2)2

(1 + r2 ) 2 (1.12) 2
(1+sf12) =
=
= 1.1404
(1 + r1 )
1.10
Hence:

sf12 = 14% p.a.

The no-arbitrage forward rate is sf12 = 14%.

You can mimic this forward rate by:
(i.)
Borrow 100/(1+r1) at t = 0 for 1-year (that is borrow $90.909 today)
(ii.)
Lend $90.909 at t = 0 for 2-years at r2
The 100/(1+r1) = 90.909 accrues to a debt of $100 after 1-year. This is equivalent to the cash
outflow if you lend money to the bank in one-years time.
The $90.909 invested at t = 0 for 2 years, accrues to a payment of 90.909 (1+r2)2 = 114 at t =
2.
K. Cuthbertson and D. Nitzsche (2008) Investments, J. Wiley, 2nd edition

Hence, the synthetic forward contract constructed from the two spot rates involves zero net
cash flows at t=0, an outflow of $100 at t=1 and receipt of $114 at t=2. The latter is more you
get from the bank if you lend it $100 after one year at a quoted forward rate of ate f12 = 13% ,
since you would only receive 113 at t=2.
Hence you would NOT take the banks offer construct you own synthetic forward contract
using the two spot rates.

(b)

(1 + r3)3 = (1 + r1) (1 + f13)2

(1 + r3)3 = (1 + r2)2 (1 + f23)
Solving the above equations for f13 and f23 gives the required forward rates.

(c)

Forward rates are used in pricing FRAs, futures, swaps, FRNs and interest rate
options.

Q6

Quoted spot (interest) rates are as follows:

(a.)
(b.)

(c.)

Year
1

Spot Rate, per cent

r1 = 5.00

r2 = 5.40

r3 = 5.70

r4 = 5.90

r5 = 6.00

What are the discount factors for each date - that is, the value today of $1
paid in year t)?
Calculate the PV and hence the fair price of the following Treasury Notes
(i.e. coupon bonds) all of which have a $1,000 par value.
(i)
5% coupon, 2-year Note
(ii)
5% coupon, 5-year Note
(iii)
10% coupon, 5-year Note
What are the one year forward rates applicable between (i.) year 1 and year
2, (ii.) year 2 and year 3?

A6
(a.)
Year
1
2
3
4
5
(b.)

Discount Factors
1/1.05
= 0.952
1/(1.054)2 = 0.900
1/(1.057)3 = 0.847
1/(1.059)4 = 0.795
1/(1.06)5
= 0.747

Forward Rates
(1.054)2/(1.05)-1
= 0.058 = f12
(1.057)3/(1.054)2-1
= 0.063 = f23
(1.059)4/(1.057)3-1
= 0.065 = f34
(1.06)5/(1.059)4-1
= 0.064 = f45
-

5%, 2 year note

PV = 50/1.05 + 1050/(1.054)2 = $992.79
5%, 5 year note
PV = 50/1.05 + 50/(1.054)2 + 50/(1.057)3 + 50/(1.059)4 + 1050/(1.06)5 = $959.3
10%, 5 year note

K. Cuthbertson and D. Nitzsche (2008) Investments, J. Wiley, 2nd edition

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PV = 100/1.05 + 100/(1.054)2 + 100/(1.057)3 + 100/(1.059)4 + 1100/(1.06)5 =
$1,171/43
(c.)

From the table above we have all the forward rates. Hence:
f12 = 5.8%p.a.,

f23 = 6.3% p.a.

K. Cuthbertson and D. Nitzsche (2008) Investments, J. Wiley, 2nd edition