APS 502

The Term Structure

of Interest Rates
Sept. 29, 2020

1
 The yield curve

Spot and forward rates

The Term Structure of
Interest Rates Term structure explanations

Expectation dynamics

2
 The yield curve

Fact: In general, yields on bonds of different maturities

are different. (i.e. interest rates are a function of
time.)

If we plot yield vs. time to maturity for bonds, we call

the resulting curve the yield curve.
yield

time to maturity

3
Plot of yield curve from yahoo.com (9/12/2004)

4
Plot of yield curve from yahoo.com (10/4/2005)

5
 The yield curve
The yield curve is not exactly what we want since
there may be coupons, etc.

We would really like to know the interest rate on a cash

flow at time t, with no intermediate cash flows.

0 t

6
 The yield curve

Spot and forward rates

The Term Structure of
Interest Rates Term structure explanations

Expectation dynamics

7
 Spot Rates
Interest rates for a specific time are known as spot rates, st.
These spot rates can be quoted as being compounded
(i) yearly
(ii) m periods per year
(iii) continuously
When we plot the spot rates vs. time, this is known as the
spot rate curve.
spot
rate

time
Also known as the term structure of interest rates.
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 Present Value and Spot Rates
When computing present value, the spot rate corresponding
to the time of each cash flow must be used for discounting
Example: Consider the following cash flow stream

2
1 1

-1
-2

The spot rate 7% x x

6% x
curve is 5% x

1 2 3 4 9
 Example
We can 2
1 1
compute the
present value
as follows:
-1
-2

Time 0 1 2 3 4
Cash Flow -1 2 1 -2 1

Spot Rate 5% 6% 7% 7%

2 1 −2 1
PV = −1 + + 2
+ 3
+ 4
= 0.925
1.05 1.06 1.07 1.07
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 Determining Spot Rates
One approach:
If you know the price of a zero coupon bond,
its yield will be the spot rate.
−s t
F
P = Fe t

(continuous compounding)

0 t

Given the price, P, and face value, F, we can solve

for the spot rate at time t, st.

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 Determining Spot Rates
One approach:
If you know the price of a zero coupon bond,
its yield will be the spot rate.

Problem:
What if there are no zeros?

Solution:
Construct a zero coupon bond from coupon bonds.

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 Constructing Zeros
C1
F1


Bond 1
C1 C1 C1 C1

0 maturity

P1 C2
F2
Bond 2

0
C2 C2 C2 C2
 maturity

P2

Form a portfolio of x of bond 1 and y of bond 2.

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Constructing a Zero Coupon Bond

Face
Portfolio Value Coupon
Bond 1 3 100 10%
Bond 2 -2.5 100 12%

Cash Flow Table

Portfolio of Bonds
Time 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Bond 1 120 10 10 10 10 10 10 10 10 10 110
Bond 1 Bond 2 Portfolio
Bond 2 12 12 12 12 12 12 12 12 12 112
100
Portfolio 0 0 0 0 0 0 0 0 0 50
Cash Flow

80

60

40

20

0
0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Time

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 Portfolio of bonds
Price: xP1 + yP2 = P0
Three equations for
the portfolio: Coupon: xC1 + yC2 = C0

Face: xF1 + yF2 = F0

To construct a zero coupon bond, set C0=0, and F0=$100

Solve for x and y. Price is computed by xP1+yP2.

Spot rate is computed from that.

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 Example
Bond 1: 10 year, 10% coupon, P1=$98.72
Bond 2: 10 year, 8% coupon, P2=$85.89
Portfolio: x – Bond 1, y – Bond 2.
Coupon: x(10) + y(8) = 0
Create a zero:
Face: x(100) + y(100) = 100

x = -4, y = 5

So price of zero: xP1+yP2=$34.57

100
Spot Rate: 34.57 = s10=0.112
(1 + s10 )10
(discrete compounding)
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 Forward Rates

Forward rate: Interest rates for money to be borrowed

between two dates in the future, but under terms agreed
upon today.

Notation: f t1 ,t2 represents the forward rate between

t1 and t2.

Question: How can you compute forward rates from

the spot rate curve?

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 Example

Given spot rates s1 and s2, what is the forward rate

f1,2 between time 1 and time 2.
1+f1,2
1

1 2

If we start with $1 at time 1 and move it to time 2,

we should have 1+f1,2 by the definition of the
forward rate.

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 Example
1+f1,2
1 1

1 2 1 2

Spot rates tell us how to

1/(1+s1)
move money to and from
time zero.
0 1 2
To move money from time 1 (1+s2)2 /(1+s1)
to time 2, we can use the
spot rates and go through
time 0. 1 2

(1 + s2 ) 2 (1 + s2 ) 2
Hence, 1 + f1, 2 = f1, 2 = −1
(1 + s1 ) (1 + s1 )
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 Example

Suppose the spot rates for 1 and 2 years are 7% and 8%.

What is the implied forward rate f1,2?

(1 + 0.08) 2
f1, 2 = − 1 = 0.0901
(1 + 0.07)

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 Formula for Forward Rates
1 1

0 i j 0 i j

(1+si)i

i j
(1+si)i (1+fi,j)j-i (1+sj)j

i j i j

(1 + si )i (1 + f i , j ) j −i = (1 + s j ) j
Note: This calculation must be consistent with the type of compounding.

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 Example

Suppose the spot rates for 2 and 6 years are 3% and 5%.

What is the implied forward rate f2,6?

(1 + s2 ) (1 + f 2,6 ) = (1 + s6 )
2 4 6

1/ 4
 (1 + s6 ) 
6
f 2, 6 =  
2 
−1
 (1 + s2 ) 
= 6.01%
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 Terminology

When we consider rates that span only 1 period, we refer

to these as short rates.

Example:
For yearly compounding
s1, f1,2, f2,3, etc.

Note: Short rates can be determined from the spot rate

curve and vice-versa.

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 The yield curve

Spot and forward rates

The Term Structure of
Interest Rates Term structure explanations

Expectation dynamics

24
 Term Structure Explanations

Q: Why isn’t the term structure flat?

Three Explanations
(1) Expectations Theory

(2) Liquidity Preference

(3) Market Segmentation

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 Expectations Theory

Spot rates are determined by the expectations of what

interest rates will be.

Ex: If the spot rate curve slopes upward, that is because

people expect interest rates to increase in the future.

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 Liquidity Preference

Investors prefer short term securities over long term

securities because long term securities “tie-up” capital
that may be needed before maturity.

However, there are well developed markets for short and

long term securities. Hence investors can easily get out.

More likely, long term investments are more sensitive

to interest rates. To lessen risk, investors would prefer
short term securities.

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 Market Segmentation

Fixed income market is segmented by maturity dates.

The rate for each maturity date is determined by the group

of investors interested in that maturity date. Hence,
simple supply and demand among those investors
determines the interest rate.

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 The yield curve

Spot and forward rates

The Term Structure of
Interest Rates Term structure explanations

Expectation dynamics

29
 Expectation Dynamics

Forward rates are rates in the future that are agreed upon now.

We don’t know what the actual future rates will be when the
future time arrives.

When we use the forward rates as a prediction of the actual

future rates, we call this forecast Expectation Dynamics.

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 The Invariance Theorem
If interest rates evolve according to expectation dynamics,
then a sum of money invested in the interest rate market for
n years will grow by a factor of (1+sn)n regardless of the
investment and reinvestment strategy.
1 Even if I reinvest here (1+sn)n

Why?: Implied forward rates were computed to satisfy this

relationship.
Even if you don’t lock in a future interest rate now, you can
still use forward rates for discounting, as long as you assume
expectation dynamics.

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