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Term Structure

The document discusses the term structure of interest rates. It defines the term structure as the relationship between borrowing term and interest rate. Different interest rates apply for different time horizons. The term structure can be expressed through yield curves derived from instruments like treasury securities. Spot rates, forward rates, and short rates are introduced as ways to represent the term structure. Expectations theory and other theories are outlined to explain the typical shapes of the term structure.

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48 views

Term Structure

The document discusses the term structure of interest rates. It defines the term structure as the relationship between borrowing term and interest rate. Different interest rates apply for different time horizons. The term structure can be expressed through yield curves derived from instruments like treasury securities. Spot rates, forward rates, and short rates are introduced as ways to represent the term structure. Expectations theory and other theories are outlined to explain the typical shapes of the term structure.

Uploaded by

osiccor
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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TheTermStructureofInterest Rates

TermStructureofInterestRates
Dierentinterestratesprevailinthemarket forborrowingoverdierent=mehorizons. Thetermstructureofinterestratesdescribes therela=onshipbetweenthetermof borrowingandtherateforborrowing. Itcanbeexpressedinmanydierentways.

TermStructureofInterestRates
Adierenttermstructurecanbederivedfor each(typeof)instrument. Wewillfocusonthemarketbenchmarkterm structurederivedfromthetreasurymarket.
Treasurysecuri=esaredefaultfree,sothis representsatermstructurethatisfreefrom considera=onsofcreditworthiness Thetreasurymarketisthemostliquidmarket,so therearenoilliquidityconcerns

TypesofInterestRates
YieldtoMaturity SpotRate ForwardRate ShortRate

YieldtoMaturity
Widelyusedforbonds Givenbytheconstantinterestratethat equatesthediscountedvalueofthefuture cashowsunderthebondanditscurrent marketprice. Alsocalledtheinternalrateofreturn.

YieldtoMaturity
Forabulletbondwithcouponpaymentc,n couponpayments,facevalueFandpriceP,the yield(y)isthesolu=onoftheequa=on:
1 (1 + y ) n P = cF + F (1 + y ) n y

Theyieldcurvegivestheyieldasafunc=onof bondmaturity.

YieldtoMaturity
OQenusedtocomparebondswithdierent maturi=es,issuers,etc. Canbemisleading:
Theyieldonathreeyearbonddependsonthe borrowingrateatthreeyears,aswellasatall previouscoupondates. Thecurvedoesnotrevealyearbyyear informa=onaboutborrowingcosts.

SpotRates
LetP(t,t+k)denotetheprice(at=met)ofa zerocouponbondwithfacevalue1,withk periodsun=lmaturity. Lett=0.Thespotrateforkperiodstomaturity istheyieldtomaturityofazerocouponbond withkperiodstomaturity.Itisthesolu=onsk oftheequa=on:

P (0, k ) = (1 + sk )

Spotratecurvefordierentmaturi=esofCanadianTreasuries. Source:www.bandofcanada.ca

SpotRates
Wecanalsopriceabulletbondbasedon observedspotrates:
n

P = cF (1 + sk ) k + F (1 + sn ) n
k =1

Moregenerally,ifaninstrumentpaysthe (determinis=c)cashowC atthe=mek k periodsinthefuture,k=1,,n,itspriceis:


n

P = Ck (1 + sk ) k
k =1

ForwardRates
Ratesforcontractsmadetodayforborrowing infutureperiods. fj,kisthenota=onfortheforwardratecovering periodjtok Forexample,f3,5istheinterestratefor agreeingtodaytoborrowmoney3yearsfrom nowandrepayit5yearsfromnow.

ForwardRatesandArbitrage
Arbitrageistheopportunitytoearnariskless protbytakingadvantageofmispricinginone ormoremarkets. Innancialtheory,wegenerallyassumethat themarketdoesnotpermitarbitrage opportuni=es.
Otherwise,investorswouldimmediatelyinvestin arbitrageopportuni=esinhugeamounts.
Supplyanddemandwouldalterpricesun=lthe arbitrageopportuni=esnolongerexisted.

ForwardRatesandSpotRates
Topreventarbitrage,wemusthavethe followingrela=onshipbetweenforwardand spotrates:
(1 + f j ,k )
k j

(1 + sk ) k = (1 + s j ) j

Intermsofbondprices:

(1 + f j ,k )
k j

P (0, j ) = P (0, k )

ForwardRatesandSpotRates
Oneperiodforwardratesfk,k+1aresimply denotedbyfk. Itiseasytoseethat: Spotratesaregeometricaveragesofforward rates. Thereisaonetoonerela=onshipbetween thespotcurveandtheforwardcurve.
Spotratesuniquelydetermineforwardratesand viceversa

1 + sk = ((1 + f 0 )(1 + f1 ) (1 + f k 1 ))

1/ k

ShortRates
Oneperiodinterestratesthatapplyfor borrowingatfuture=mes. rkistherateforborrowingbetween=mekand =mek+1thatprevailsinthemarketat=mek. fkrateforborrowingbetween=mekandk+1 agreeduponat-mezero. rkrateforborrowingbetween=mekandk+1 agreeduponat-mek(itisthespotratethat prevailsinthefuture). Viewedfromtoday,rkisrandom.

Bootstrapping
Themostusefulrepresenta=onoftheterm structureofinterestratesisaspotratecurve. Wedontobservespotratesdirectlyinthe market.
Bondprices(oQenforcouponbearingbonds)are observed.

Theprocessofinferringspotratesfrom observedpricesofbondsiscalled bootstrapping.

ShapeoftheTermStructure
Normal sT sT Inverted

T Flat sT

TheoriesoftheTermStructure
Expecta=onTheory(Forwardratesrepresent marketfutureexpecta=onsofinterestrates).
Pure/UnbiasedExpecta=onsTheory LiquidityPreferenceTheory PreferredHabitatTheory

MarketSegmenta=onTheory

Pure/UnbiasedExpecta=onsTheory
Forwardratesrepresentexpectedfuturespot rates:

f k = E [ rk ]

Theslopeofthecurverepresentsexpecta=ons offuturerates:
Upwardslopingmeansthemarketexpectsrates togoup. Downwardslopingmeansthemarketexpects ratestogodown.

LiquidityPreferenceTheory
Investorsfavourliquidity. Forwardratesareexpectedfuturespotratesplus aliquiditypremium. TheliquiditypremiumLkincreaseswithk.

f k = E [ rk ] + Lk , Lk > 0

Reectsthefactthatlendersprefertolendforshort horizons(borrowersprefertoborrowforlong horizons).

Anupwardslopingcurvemayreectonly increasingliquiditypremiums(notnecessarilyan expectedincreaseinrates).

PreferredHabitatTheory
SameasLiquidityPreferenceTheory,exceptthat itallowsforLktobeposi=ve,nega=ve,orzero. Borrowersandinvestorshavepreferredmaturity ranges. Ifsupply/demandforagivenmaturitysector doesnotmatch,borrowers/investorsmaybe drivenoutsidetheirpreferredhabitatiftheyare compensatedbyanappropriateriskpremium/ discount.

f k = E [ rk ] + Lk

MarketSegmenta=onTheory
Neitherinvestorsnorborrowersarewillingto shiQfromonematuritysectortotheotherto takeadvantageofopportuni=esarising betweenexpecta=onsandforwardrates. Theshapeoftheyieldcurveisdeterminedby supplyanddemandforsecuri=eswithineach maturitysector,andindependentlyfromother maturi=es.
Eachsector(orsegment)isaseparatemarket

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