Chapter 4

Term Structure of Interest Rates

Chapter 4
Section 1

Spot Rates

Chapter 4
Yields of U.S. Treasury Securities

Yield rates of US treasury securities

(published by http://www.treasury.gov/resource-center/data-
chart-center/interest-rates/Pages/TextView.aspx?data=yield)

Date 1mo 3mo 6mo 1yr 2yr 5yr 10yr 20yr 30yr
09/20/11 0.00 0.01 0.03 0.09 0.18 0.85 1.95 2.82 3.20
09/21/11 0.01 0.01 0.04 0.11 0.21 0.88 1.88 2.69 3.03
09/22/11 0.00 0.00 0.03 0.10 0.20 0.79 1.72 2.48 2.78
09/23/11 0.00 0.01 0.02 0.10 0.23 0.89 1.84 2.59 2.89

Chapter 4
Yield Curve

Yields change all the time

Reason for different yields:
Quality ratings
Time to maturity: (In general, the longer time to maturity, the
higher the yield)
Yield vs (external) interest rate
Yield is the generalized “return rate” of an individual security
Interest rate can be regarded as the “return rate” of risk-free
investment
U.S. Treasury securities are “risk-free” and their yields often
serve as the interest rate
“ Yield = Interest rate + risk compensation rate”
Same credit grades, similar maturities =⇒ similar yields

Chapter 4
Term Structure Theory

Term structure theory focuses on pure interest rates

Key observation: Your local bank is likely to offer you a
higher rate of interest if you promise to keep your money
longer in an account ⇒ Interest rate depends on the length of
time the money is held

Chapter 4
Spot Rates

Spot rates st : the (nominal annual) rate of interest in the

time interval [0, t]
s1 is the 1-year interest rate
s2 represents the rate that is paid for money held two years.
The growth factor of your deposit will be (1 + s2 )2 at the end
of 2 years
st represents the rate that is paid for money held t years. The
growth factor of your deposit will be (1 + st )t at the end of t
years

Chapter 4
Compounding Periods

Yearly compounding: Vt = (1 + st )t (t is an integer)

st mt
Frequent compounding (m periods a year): Vt = (1 + m)
(mt should be an integer)
Continuous compounding: Vt = est t

Chapter 4
Present Value

Discount factor dt : To calculate the present value of a

payment at time t
With various compounding conventions, dt are different
Yearly compounding : dk = (1+s1 k )k
1
Frequent compounding (m periods a year): dk = (1+sk /m)mk
Continuous compounding: dt = e−st t
Present value of a cash flow (x0 , x1 , · · · , xn )

PV = x0 + d1 x1 + · · · + dn xn

Chapter 4
Example: A 10-year Bond

A 10-year bond with coupon rate 8% and face value $100 pays
coupon annually. Calculate the PV with the spot rates indicated in
the table below. For simplicity, assume the coupons are paid only
at the end of each year, starting a year from now
Year 1 2 3 4 5 6 7 8 9 10 Total PV
Spot Rate 5.571 6.088 6.555 6.978 7.361 7.707 8.020 8.304 8.561 8.793
Discount 0.947 0.889 0.827 0.764 0.701 0.641 0.583 0.528 0.477 0.431
Cash Flow 8 8 8 8 8 8 8 8 8 108
PV 7.58 7.11 6.61 6.11 5.61 5.12 4.66 4.22 3.82 46.50 97.34

Chapter 4
Determining Spot Rates

If zero-coupon bonds are available, it is easy

However, most long term bonds bear coupons
Determine the spot rates by coupon bonds - A recursive
method
(i) Calculate the shorter term (typically 1-year) spot rate by the
yield of corresponding bonds
(ii) Calculate the spot rate for the next longer term by the price of
the corresponding coupon bond and the shorter term spot rate
determined in the last step
(iii) repeat (ii)

Chapter 4
Illustration

To determine the spot rates s1 , s2 , · · · by the prices of coupon

bonds (assume coupons are paid annually). Suppose the an i-year
bond pays a coupon amount Ci every year, with a face value Fi
and the current price Pi
F1 +C1
Calculate s1 by 1-year bond: s1 = P1 −1
C2 F2 +C2
Calculate s2 by 2-year bond: P2 = 1+s 1
+ (1+s 2)
2

C3 C3 F3 +C3
Calculate s3 by 3-year bond: P3 = 1+s 1
+ (1+s 2)
2 + (1+s3 )3
···

Chapter 4
Short Sell

Short sell: To borrow a share of stock or bond from a broker

and sell it
Short seller also must pay coupons to the broker
Cover the short position: Short seller must later purchase a
share of the same stock/bond in the market in order to return
the share that was borrowed
Short selling allows investors to profit from a decline in a
security’s price

Chapter 4
Example: Construction of a Zero
Bond A is a 10-year bond with a 10% coupon and price
PA = 98.72. Bond B is a 10-year bond with an 8% coupon and
price PB = 85.89. Both bonds pay coupons annually and have face
value 100
Question: What is the 10-year spot rate?
Solution: Consider a portfolio with -0.8 unit of bond A and 1 unit
of bond B. This portfolio has a face value 20 and price

P = −0.8PA + PB = 6.914.

The coupon payment is zero, so it is a zero-coupon portfolio. The

10-year spot rate s10 must satisfy

(1 + s10 )10 P = 20

so S10 = 11.2%
Chapter 4
Section 2

Forward Rates

Chapter 4
Forward Rates

Interest rate on [0, t] is different for different t

Interest rate on [t1 , t] should be different for different starting
time t1
Forward rate: The interest rate between two future dates,
but under terms agreed upon today
Specifically, forward rate ft1 ,t2 for two times t1 < t2 : The rate
of interest charged for borrowing money at time t1 which is to
be repaid (with interest) at time t2
Forward rate is different from the spot rate in the future
Forward rate is implied by the spot rate structure

Chapter 4
Example: Tom’s Headache

Tom will graduate one year later. He estimates that the cost for
job hunting will be $10,000 after graduation. He plans to borrow
this money from Hang Seng bank for one year. Of course, Tom
can borrow this money one year later. But he worries that the
interest rate might increase at that time. So he wants to fix the
borrowing interest rate now
Question: Suppose s1 = 4%, s2 = 6%, and the interest
compounded annually. What is the interest rate charged if Hang
Seng agrees to lend him the money one year later for one year?

Chapter 4
Analysis: Tom’s Headache

If you have $1 to invest now, then you have two options:

Option 1: Put it in a 2-year account, and get $(1 + s2 )2 after
two years
Option 1: Put it in a 1-year account and simultaneously
arrange that the proceeds be lent for 1 year (with interest rate
f ) starting a year from now. The final amount of money
received after two years is $(1 + s1 )(1 + f )
Comparison principle: (1 + s2 )2 = (1 + s1 )(1 + f ) or

(1 + s2 )2
f= −1
1 + s1
In Tom’s case, f = 8.04%

Chapter 4
Arbitrage Argument

We now use the arbitrage argument, instead of comparison

principle
Assume that lending and saving bear the same interest rate
and there is no transaction cost
If (1 + s1 )(1 + f ) < (1 + s2 )2 , then
Borrow $1 for the first year with interest rate s1
Make arrangement now to borrow $(1 + s1 ) for the second
year with a forward rate f
Save $1 now for two years with interest rate s2

Chapter 4
Arbitrage Argument (Cont’d)

Cash flows
Now: 1 − 1 = 0
One year later: (1 + s1 ) − (1 + s1 ) = 0
Two years later: (1 + s2 )2 − (1 + s1 )(1 + f ) > 0
Hence, one gets a positive profit without costing anything
If (1 + s1 )(1 + f ) > (1 + s2 )2 , similar argument applies

Chapter 4
Implied Forward Rate

The (implied) forward rate, ft1 ,t2 , between two times t1 < t2
is the rate of interest between those times that is consistent
with a given spot rate curve
These rates are expressed on an annualised basis, unless
specified otherwise

Chapter 4
Forward Rate Formulas

Yearly compounding (j > i): (1 + si )i (1 + fi,j )j−i = (1 + sj )j

or 1/(j−i)
(1 + sj )j

fi,j = −1
(1 + si )i
m periods a year (fi,j denotes the forward rate from year i to
year j): (1 + si /m)im (1 + fi,j /m)(j−i)m = (1 + sj /m)jm or
1/(j−i)
(1 + sj /m)j

fi,j =m −m
(1 + si /m)i

Continuous compounding (t2 > t1 ): est1 t1 eft1 ,t2 (t2 −t1 ) = est2 t2
or
st t2 − st1 t1
ft1 ,t2 = 2
t2 − t1

Chapter 4
Section 3

Expectations Dynamics

Chapter 4
Term Structure Explanations

Typical term structure: longer maturity, higher interest rate

Why is the curve not flat?
Three “theories”

Chapter 4
Theory 1: Expectation Theory

Expectation Theory: People expect that the spot rate will increase
in the future
People expect that interest rate will increase due to inflation
etc.
This expectation is reflected in forward rates
(1 + s2 )2 = (1 + s1 )(1 + f1,2 ): s2 is larger than s1 if and only
if f1,2 is larger than s1

Chapter 4
Theory 2: Liquidity Preference

Liquidity Preference: People prefer the liquidity

Short term bonds have higher liquidity
Long term bonds are more sensitive to interest rate risk
To induce investors into long-term instruments, better rates
must be offered for long bonds

Chapter 4
Theory 3: Market Segmentation

Market Segmentation: Market is segmented by maturity dates, and

each is determined by the demand and supply of the capital
The market segments: Short term demand and supply, long
term demand and supply
Different segments are “independent”: Different competition
⇒ different interest rate
Investors may shift to adjunct segment with more attractive
interest rate

Chapter 4
Fed’s Operation Twist

Quantitative easing: Over the last three years the Fed has
acquired over $1.65 trillion of US government bonds
Operation twist: the Fed trades in some of its shorter-term
bonds for more of the longer-term ones
This drives up prices of long-term bonds, which depresses
long-term yields or interest rates
Lower long-term interest rates lead to lower mortgage rates,
car loans and other bank lending rates

Chapter 4
Expectations Dynamics

Forecast of future interest rates

Basis: the expectation implied by the current spot rate curve
will actually be fulfilled
Predict next year’s spot rate curve from the forward rates
implied by the current spot rate curve
This new curve implies yet another set of expectations
(forward rates) for the following year
Repeating these steps, an entire future of spot rate curves can
be predicted

Chapter 4
Expectation Dynamics Analysis

Given the current spot rates s1 , · · · , sn , what will be the spot

(1) (1)
rates one year later, s1 , · · · , sn−1 ?
A reasonable expectation: forward rates f1,2 , f1,3 , · · · , f1,n
Specifically,
1/(j−1)
(1 + sj )j

(1)
sj−1 = f1,j = − 1, j = 2, · · · , n
1 + s1
(i)
Expectation dynamics: fi,j estimates the spot rates sj−i ,
j = i + 1, · · · , n, for the ith year
Year s1 s2 s3 s4 s5 s6 s7
Current 6.00 6.45 6.80 7.10 7.36 7.56 7.77
Next Year 6.90 7.20 7.47 7.70 7.88 8.06

Chapter 4
Expectation Dynamics Analysis (Cont’d)

All future spot rate curves implied by an initial spot rate can be
displayed by listing all of the forward rates associated with the initial
spot rate curve:
f0,1 f0,2 f0,3 . . . f0,n−2 f0,n−1 f0,n
f1,2 f1,3 f1,4 . . . f1,n−1 f1,n
f2,3 f2,4 f2,5 . . . f2,n
... ...
fn−2,n−1 fn−2,n
fn−1,n
The discount factor to discount cash received at time j back to
time i (i < j) is
 j−i
1
di,j =
1 + fi,j
(annual compounding)
Compounding formulation di,j = di,k dk,j , i < k < j

Chapter 4
Short Rates

Short rates are the forward rates spanning a single time period:

rk := fk,k+1, k = 0, 1, 2, · · ·

Short rate is convenient for the calculation

Annual compounding:
(1 + sk )k = (1 + r0 )(1 + r1 ) · · · (1 + rk−1 )
(1 + fi,j )j−i = (1 + ri ) · · · (1 + rj−1 )
di,j = (1 + ri )−1 · · · (1 + rj−1 )−1
Given current short rates r0 , r1 , · · · , rn , the short rates one
year later are estimated to be r1 , · · · , rn

Chapter 4
Forward rates
Year s1 s2 s3 s4 s5 s6 s7
1 6.00 6.45 6.80 7.10 7.36 7.56 7.77
2 6.90 7.20 7.47 7.70 7.88 8.06
3 7.50 7.75 7.97 8.12 8.30
4 8.00 8.20 8.33 8.50
5 8.40 8.50 8.67
6 8.60 8.80
7 9.00

Short rates
Year r1 r2 r3 r4 r5 r6 r7
1 6.00 6.90 7.50 8.00 8.40 8.60 9.00
2 6.90 7.50 8.00 8.40 8.60 9.00
3 7.50 8.00 8.40 8.60 9.00
4 8.00 8.40 8.60 9.00
5 8.40 8.60 9.00
6 8.60 9.00
7 9.00

Chapter 4
Invariance Theorem

Need to invest in the U.S. Treasury fixed-income securities for

n years
There are many choices, e.g. long term bonds/short term
bonds/coupon bonds/zero-coupon bonds, fully invested and
reinvested
Invariance Theorem: Suppose that the interest rates evolve
according to the expectation dynamics. Then a sum of money
invested in the market for n years will grow by a factor of Rn ,
which is independent of the investment and reinvestment strategy.
If the interest is compounded annually, then Rn = (1 + sn )n .

Chapter 4
Section 4

Duration via Term Structure

Chapter 4
Fisher-Weil Duration
In the last chapter, duration was defined to be a measure of
interest rate (yield) sensitivity
Now consider sensitivity with respect to parallel shifts in spot
rate curve
(s1 , · · · , sn ) =⇒ (s1 + λ, · · · , sn + λ)
A stream (xt0 , xt1 , · · · , xtn ) under continuous compounding
and spot rate curve st , t0 ≤ t ≤ tn , the present value is
n
X
PV = xti e−sti ti
i=0

Fisher-Weil duration:
n
1 X
DF W = ti xti e−sti ti
PV
i=0

Chapter 4
Fisher-Weil Duration (Cont’d)

Price (present value) with respect to a parallel shift λ

n
X
P (λ) = xti e−(sti +λ)ti
i=0

Sensitivity of the price

n
dP (0) dP (λ)  X
≡ = − ti xti e−sti ti
dλ dλ λ=0

i=0

Hence
1 dP (0)
DF W = −
P (0) dλ

Chapter 4
Quasi-Modified Duration
Frequent compounding is m times a year; The spot rate in
period k is sk (expressed as a yearly rate) and cash flow
stream is (x0 , x1 , · · · , xn )
Price with respect to a parallel shift λ
n  
X sk + λ −k
P (λ) = xk 1 +
m
k=0
Sensitivity of the price
n
dP (0) X
=− (k/m)xk (1 + sk /m)−(k+1)
dλ
k=1
Define the quasi-modified duration
Pn
1 dP (0) (k/m)xk (1 + sk /m)−(k+1)
DQ = − = k=1Pn
P (0) dλ k=0 xk (1 + sk /m)
−k

It is no longer the average of the cash flow times!

Chapter 4
Functions of Duration

Duration is used extensively by investors and bond portfolio

managers
It serves as a convenient and accurate proxy for interest rate
risk
Investment institutions usually have guidelines about the level
of duration

Chapter 4
Immunization (Again)

Immunization: the procedure to protect against interest rate

risk
More robust method for portfolio immunization
It does not depend on selecting bonds with a common yield
In fact yield does not even enter the calculation

Chapter 4
Example: A $1M Obligation

We have a $1M obligation to meet at the end of 5 years. The

current spot curve is shown in the next slide. Assume a yearly
compounding convention. We decide to invest in two bonds: B1 is
a 12-year 6% bond with price 65.95, and B2 is a 5-year 10% bond
with price 101.66.

Chapter 4
Worksheet for Immunization Problem

Year Spot d B1 P V1 −P V1′ B2 P V2 −P V2′

1 7.67 0.929 6 5.57 5.18 10 9.29 8.63
2 8.27 0.853 6 5.12 9.45 10 8.53 15.76
3 8.81 0.776 6 4.66 12.84 10 7.76 21.40
4 9.31 0.700 6 4.20 15.38 10 7.00 25.63
5 9.75 0.628 6 3.77 17.17 110 69.08 314.73
6 10.16 0.560 6 3.36 18.29
7 10.52 0.496 6 2.98 18.87
8 10.85 0.439 6 2.63 18.99
9 11.15 0.386 6 2.32 18.76
10 11.42 0.339 6 2.03 18.26
11 11.67 0.297 6 1.78 17.55
12 11.89 0.260 106 27.53 295.26
Total 65.95 466.00 101.66 386.15
Duration 7.07 3.80

Chapter 4
Immunization Procedure

PV of the obligation is PV = 1M/1.09755 = $627, 903.01

Quasi-modified duration is D = 5/(1 + s5 ) = 4.56
Denote by V1 and V2 the present values of the investment on
bonds 1 and 2 respectively
Then we have equations

V1 + V2 = PV
D1 V1 + D2 V2 = D × PV

We obtain V1 = $145, 628.81, V2 = $482, 278.09

Let x1 and x2 be the number of shares of bonds 1 and 2,
respectively (each share has a face value $100)
Then x1 = V1 /P1 = 2208.17, x2 = V2 /P2 = 4744.03

Chapter 4
Immunization Results

λ=0 λ = 1% λ = −1%
Bond 1
Shares 2,208.00 2,208.00 2,208.00
Price 65.95 51.00 70.84
Value 145,602.14 135,805.94 156,420.00
Bond 2
Shares 4,744.00 4,744.00 4,744.00
Price 101.66 97.89 105.62
Value 482,248.51 464,392.47 501,042.18
Obligation value 627,903.01 600,063.63 657,306.77
Bonds minus obligation -$52.37 $134.78 $155.40

Chapter 4