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EC3314

Financial Economics
Spring Lecture 3
Forward Rates and Theories of Term
Structure

Outline
The Yield Curve
Theories of Term Structure
Engineering a synthetic forward loan
Readings: BKM Chapter 15

Spring Lecture 3 - Term Structure of Rates

Homogeneous bonds and heterogeneous interest rates


This issue is of great significance to both borrowers and lenders.
Should a lender invest in short-term bonds and have to worry about the

rates at which to reinvest when short-term bond matures? Or should


the lender buy long-term bonds and run the risk of an uncertain
liquidating value if selling is necessary before maturity?

Borrowers are faced with the choice of whether to borrow short-term or

long-term. Short-term borrowing runs the risk that refinancing may be


at higher rates. Long-term financing runs the risk that a high rate may
be locked in.

A study of the yield-curve and term-structure of interest rates can help

borrowers and lenders in making the right decision.

Spring Lecture 3 - Term Structure of Rates

What is a Yield Curve?


A graphical depiction of the relationship between the yield on bonds of

the same credit quality, but different maturities is known as the yield
curve.
Term structure of interest rates may be defined as the relation between

yield to maturity of zero coupon securities of the same credit quality and
maturities of those zero-coupon securities.
Yield-to-maturity on zero-coupon securities for different maturities is

also the spot rate for that maturity. Therefore, term structure of interest
rate may also be defined as the pattern of spot rates for different
maturities.

Spring Lecture 3 - Term Structure of Rates

How to Construct the Term Structure of Interest Rates?


The yield on Treasury securities is a benchmark for

determining the yield curve on non-Treasury


securities.
Consequently, all market participants are interested in
the relationship between yield and maturity for
Treasury securities.

Spring Lecture 3 - Term Structure of Rates

Yield Curve and Zeros


The graphical depiction of the relationship between

the yield on Treasury securities for different maturities


is known as the yield curve.
While a yield curve is typically constructed on the
basis of observed yields and maturities, the term
structure of interest rates is the relationship between
the yield on zero-coupon Treasury securities and
their maturities.
Therefore, to construct term structure of interest

rates, we need the yield on zero-coupon Treasury


securities for different maturities.
Spring Lecture 3 - Term Structure of Rates

Yield Curve and Zeros


Zero-coupon Treasuries are issued with maturities of

six-months and one-year, but there are no zerocoupon Treasury securities with maturity more than
one-year.
Thus, we cannot construct such term structure solely
from market observed yields.
Rather, it is essential to construct term structure from
theoretical consideration applied to yields of actually
traded Treasury debt securities.
Such a curve is called Theoretical Spot Rate Curve
Any non-callable security can be considered as a
portfolio of zero-coupon securities
Spring Lecture 3 - Term Structure of Rates

Theories of the Term Structure


Expectations Hypothesis
Or Unbiased Expectations Theory
Liquidity Premium
Market Segmentation Hypothesis

Spring Lecture 3 - Term Structure of Rates

Expectations Hypothesis
Irving Fisher (1896), Frederic Lutz (1940)
Unbiased expectations theory says that

expected future rates, on average, equals


implied forward rates if
Investors expectations of future one-period
rates are unbiased
And bonds of different maturity are perfect
substitutes for each other.

Spring Lecture 3 - Term Structure of Rates

Expectations Hypothesis
The forward rate equals the expectations of future

short interest rate

f2 = E(r2)

That is, liquidity premium = 0

Observed long-term rate is a function of todays

short-term rate and expected future short-term rates

Long-term and short-term securities are perfect


substitutes

Forward rates that are calculated from the yield on

long-term securities are market consensus expected


future short-term rates
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Liquidity Premium
Hicks (1946)
A liquidity premium exists because a given change in

interest rates will have a greater effect on the price of


long term bonds (as opposed to short term bonds)

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Liquidity Premium:
Bond price sensitivity wrt to change in interest rate
Bond Price = PV of coupons + PV of par value

Ct
Par Value T
P

t
T
(
1

r
)
(
1

r
)
t 1
T

Expanding:
C
C
C
C
PV
P

.....

1
2
T 1
T
(1 r ) (1 r )
(1 r )
(1 r )
(1 r )T

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Liquidity Premium:
Bond price sensitivity wrt to change in interest rate
Bond prices move inversely with yield movements:

P
C
2C
(T 1)C
TC
T ( PV )

.....

r
(1 r ) 2 (1 r ) 3
(1 r )T (1 r )T 1 (1 r )T 1
0
Malkiel (1962) Theorem 2:
For a given change in yield from the nominal yield, changes in

bond prices are greater, the longer is the term to maturity

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Liquidity Premium
Thus there is a greater risk of loss with long term

bonds

This also implies there is a greater chance of gains too!

Risk-averse investors therefore require a higher yield

in order to hold longer-term bonds.


This extra yield is the liquidity premium
Forward rates contain a liquidity premium and are
therefore not equal to expected future short-term
rates.

Spring Lecture 3 - Term Structure of Rates

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Liquidity Premium
When a liquidity premium exists, short term

investors will hold long term bonds (f2 > E(r2))

Long-term investors will hold short-term bonds


only if f2 < E(r2)

According to liquidity preference theory, the

number of short term investors dominate the


market so that generally f2 > E(r2)
Hence, the yield curve has an upward bias
built into the long-term rates because of the
risk premium.
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Liquidity Premium
Normally, liquidity premium increases for bonds with

longer maturity but at a decreasing rate.


Fama (1984b) investigated term premiums in bond
returns.
He found evidence that expected returns on longerterm bills exceed the return on 1-month bills
He also found that premium does not increase
monotonically with maturity, and that it peaked at
around 8 or 9 months

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Liquidity Premium
Empirical evidence suggesta that investors

have relatively short time horizons for bond


investments.

Thus, since they are risk averse, they will


require a premium to invest in longer term
bonds.

The Liquidity-Preference Hypothesis states

that longer term loans have a liquidity


premium built into their interest rates

Thus calculated forward rates will incorporate


the liquidity premium and will overstate the
expected future one-period spot rates.
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Theories of the Term Structure

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Theories of the Term Structure

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Market Segmentation Hypothesis


(MSH)
Culbertson (1957), Modigliani and Sutch (1966)
Assets of different maturities are not substitutes.

Some investors like short term bonds, others like long


term bonds.

Eg, if the demand for short term bonds increases, their


price increases, lowers their yields, and hence give an
upward sloping yield curve

Investors have preferred habitats (Preferred Habitat

Theorem, an offshoot of MSH)

Firms borrowing to undertake their investment


programs will tailor their debt payments to the
expected cash flows from the project.
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Market Segmentation Hypothesis


E.g. capital-intensive firms prefer to issue long-term

debt rather than rolling over short-term debts.


Insurance companies with long-term liabilities lend
long term
Less capital-intensive firms will prefer to borrow
short-term debts.
Thus, interest rates for a given maturity are explained
by the supply and demand for funds of that specific
maturity
Therefore, suppliers and users of funds have
preferred habitats

And they leave their habitats only if offered a premium


Spring Lecture 3 - Term Structure of Rates

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Interpretation of the Term Structure


A flat term structure means constant forward rates equal to

todays spot rates and thus


Expectations for the same future spot rates as today if you
believe in the Pure-Expectations Hypothesis
Expectations for declining future spot rates compared to
today if you believe in the Liquidity-Preference Hypothesis
A declining term structure means declining forward rates and
thus
Expectations for similarly declining future spot rates under
the Pure-Expectations Hypothesis
Expectations for more sharply declining future spot rates
under the Liquidity-Preference Hypothesis

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Interpretation of the Term Structure


An increasing term structure means

increasing forward rates and thus


Expectations for similarly increasing future
spot rates under the Pure-Expectations
Hypothesis
Expectations for future spot rates that increase
to a lesser degree or possibly remain flat or
decrease (depending on the size of the
Liquidity Premiums) under the LiquidityPreference Hypothesis

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Interpretation of the Term Structure


The spread between long term rates and short term rates

has been found to be a good predictor of future evolution


of interest rates, and of future economic activity
Harvey (1988) provides evidence that the expected real
term structure contains information that can be used to
forecast consumption growth.
Estrella and Hardouvelis (1991) for example, find that the
yield spread between the 10-year Treasury Bond rate and
the 3-month Treasury Bill rate contains information about
future growth in output, consumption, and investment, and
the probability of a recession in the United States
Typically, a positive slope means that consumption and
GDP will increase in the future. A negative slope is a good
predictor of a recession.
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Interpretation of the Term Structure


Estrella and Hardouvelis (1991)
Spread = slope of yield curve
Spread predicts the private sector

components of GNP:

Consumption, consumer durables and


investment

It can predict real output up to one and a half

years in the future

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Synthetic forward loan


In general, if you borrow 1,000 now for one

year, you will have to return $1,000 * (1 + r)


next year
What if you plan to borrow 1,000 NEXT
YEAR for one year. Then what rates are you
going to be charged over that period?
yields on, 1-yr and 2-yr zeros

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Synthetic forward loan


If you plan to borrow 1,000 next year, you

will have to return 1,000 * (1 + f2) in two


years time from today.

f2 of course, is the forward rate between year 1


and year 2.

The forward rate f2 should be the same as the

implied forward rate given the prices of, and

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Synthetic forward loan


E.g. suppose we have a 1-yr zero that sells at

$952.38 and a 2-yr zero that sells at $890


YTM on 1-yr zero = 1,000/952.38 1 = 0.05
YTM on 2-yr zero = (1,000/890)0.5 1 = 0.06
Therefore the forward rate between year 1
and year 2, f2:

(1 y )
1.06
f
1
1 0.0701
(1 y )
1.05
2

Or 7.01%

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Synthetic forward loan


Thus if you buy a 1-yr zero now
Cash Flow = - $952.80
In order to create an offsetting cash flow
Sell 1.0701 2-yr zeros
Cash Flow = 1.0701 x $890 = + $952.80
This is a synthetic forward loan.
You borrow $1,000 a year from now (on redemption

of the 1-yr zero)


And repay $1,070.10 a year later (when you redeem
the 2-yr zeros you sold)
The rate on the forward loan is exactly the same as
the forward rate between year 1 and year 2.
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