S 1-2

Term Structure of Interest Rates

B.B.Chakrabarti
Professor of Finance
 Yield
Yield (y) is the IRR at which PV of the
promised future cash flows is equal to the
price of the security.
Current yield
= Dollar coupon / Security price
= c*100/P
where c = coupon rate and P = Security
price
B.B.Chakrabarti: [email protected]
 Yield
• Yield is not rate of return.
• Rate of return = Yield,
if intermediate cash flows are reinvested at
the yield rate.
• Rate of return will be lower if reinvestment
rate is lower and higher otherwise.

B.B.Chakrabarti: [email protected]
 Yield
• High yield does not mean high return.
• Yields are not additive.
• YTM is yield when all cash flows till
maturity are considered.
• Cash flow yield for MBS and ABS –
assumes a prepayment rate
• Other yields are yield-to-call, yield-to-put,
yield-to-best and yield-to-worst.
B.B.Chakrabarti: [email protected]
Yield and Price Relationship
If C= annual coupon=c*100, c= coupon
rate, y= yield=YTM, T= maturity period
and N= no. of coupons = 2T for semi-
annual coupons, then

P = C/y + (100-C/y)/(1+y/2)^N

B.B.Chakrabarti: [email protected]
 Yield and Price Relationship
• If coupon rate=YTM, a security sells at
par.

• If coupon rate>YTM, a security sells at a

premium.

• If coupon rate<YTM, a security sells at a

discount.
B.B.Chakrabarti: [email protected]
 Day Count Conventions
• The day count defines the ways in which interest
accrues over time.
• The day count convention is usually expressed
as X/Y, where,
– X is the way in which the no. of dates between two
dates is calculated
– Y is the way in which the total no. of days in the
reference period is measured
• Hence, interest earned between two dates
= (X/Y)*( Interest earned in reference period)
B.B.Chakrabarti: [email protected]
 Day Count Conventions
• Three day count conventions that are
commonly used are:
– Actual/Actual
Example: Treasury Bonds
– 30/360
Example: Corporate Bonds
– Actual/360
Example: Money Market Instruments

B.B.Chakrabarti: [email protected]
Price of Money Market Instrument
The prices of money market instruments (e.g. 91-day T-
bill) are quoted using discount rate.
If T-bill discount rate is denoted as d (in %), cash price
as P and n = remaining life of T-bill measured in
calendar days, then

360
d= (100 - P)
n

B.B.Chakrabarti: [email protected]
 Bond Equivalent Yield
Discount rate cannot be taken as the rate
of return on the investment in T-Bills due
to two shortcomings –
1) assumes 360 days in a year and
2) measures return not on the invested
amount but on 100.

Bond Equivalent Yield is used to measure

rate of return.
B.B.Chakrabarti: [email protected]
 Bond Equivalent Yield

365 (100 - P)
BEY = *
n P
365d
or, BEY =
360 - nd
when d is expressed in decimals.

B.B.Chakrabarti: [email protected]
 Price of Money Market Instrument
Problem:
Face value of an 182-day T-Bill is $1
million with discount yield of 9.25%.

a) What is the cost of purchase?

b) What is the BEY?
c) What is the BEY if maturity period
is 275 days?
B.B.Chakrabarti: [email protected]
 Price of Money Market Instrument
Solution:
d = (360/n)*(100-P)
or, P = 100 – n*d/360
= 100 – 182*9.25/360
= 95.324 per 100
So, Cost of purchase = $953,240.
BEY = (100-P)/P * 365/n
= 4.676/95.324*365/182 = 9.838%
B.B.Chakrabarti: [email protected]
 Price of Money Market Instrument
Solution:
When n > 182 days, industry convention is to
assume semi-annual interest and
reinvestment of the same to scale down the
annualized yield to make it comparable with
the Bond market.
Hence,
P*(1+y/2)*{1+y/365*(n-365/2)}=100

B.B.Chakrabarti: [email protected]
 Price of Money Market Instrument
Solution:
Using P=95.324 and n=275 days,

BEY = y = 6.409%

B.B.Chakrabarti: [email protected]
 Par Yield
Par yield is the coupon rate that causes the
bond price to equal its par value.
Suppose, d1, d2,----, dN are discount factors of
a coupon bond.

N
Pr ice of n - period bond =
åi =1
d i * s / a coupon + d N *100

B.B.Chakrabarti: [email protected]
 Par Yield
For Par yield, Price = 100

(1 - d N )
Par Yield = 2 * s/a coupon = 2 *100 *
N
å di
i =1

B.B.Chakrabarti: [email protected]
 Discount Factor
Discount factor for Nth. period,

dN = 1/(1+yN/2)^N

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 Zero or Spot Rate
The n-year zero or spot rate is the rate of
interest earned on an investment that
starts today and lasts for n years.
- All the interest and principal are realized
at the end of n years.
- There are no intermediate payments.

B.B.Chakrabarti: [email protected]
 Forward Rate
Forward interest rates are the rates of interest
implied by current zero rates for periods of time
in the future.
f0,1,2 = forward rate from the end of
year 1 to end of year 2, as
known at time 0
This will be denoted as f1 in a term structure of
forward rates assuming uniform intervals.

B.B.Chakrabarti: [email protected]
 Forward Rate with Semi-annual
Compounding
0 1 2 N-1 N

f0 f1 fN-1

100 100
PN = =
N (1 + f /2)(1 + f /2) - - - - - -(1 + f
(1 + y N / 2) 0 1 N -1/2)
or, 1 + f N /2 = PN /PN +1
Hence, f N = 2 * (PN - PN +1 ) / PN +1 = 2 * (d N - d N +1 ) / d N +1
B.B.Chakrabarti: [email protected]
 Exercise
• Problem
• Given the following Spot rates, calculate the Discount factor, STRIP
price, Forward rate and Par yield for all the maturities.
Maturity (Years) Spot rate (%)
0.5 5.00
1.0 6.00
1.5 7.00
2.0 8.00
 Exercise
• Solution
• Maturity = 0.5 year
Spot rate = 5%
Discount factor = 1/(1+0.05/2) = 0.9756
Strip price = 100*0.9756 = 97.56
Forward rate = 5.00%
Par yield = 5.00%
• Maturity = 1.0 year
Spot rate = 6%
Discount factor = 1/(1+0.06/2)^2 = 0.9426
Strip price = 100*0.9426 = 94.26
Forward rate = 2*(0.9756-0.9426)/0.9426 = 7.002%
Par yield = 2*100*(1-0.9426)/(0.9756+0.9426) = 5.985%
 Exercise
• Maturity = 1.5 year
Spot rate = 7%
Discount factor = 1/(1+0.07/2)^3 = 0.9019
Strip price = 100*0.9019 = 90.19
Forward rate = 2*(0.9426-0.9019)/0.9019 = 9.025%
Par yield = 2*100*(1-0.9019)/(0.9756+0.9426+0.9019) =6.957%
• Maturity = 2.0 year
Spot rate = 8%
Discount factor = 1/(1+0.08/2)^4 = 0.8548
Strip price = 100*0.8548 = 85.48
Forward rate = 2*(0.9019-0.8548)/0.8548 = 11.02%
Par yield = 2*100*(1-0.8548)/(0.9756+0.9426+0.9019+0.8548)
= 7.902%
 Yield Curve
• A yield curve is a line that plots yields (interest rates) of bonds
having equal credit quality but differing maturity dates. The slope
of the yield curve gives an idea of future interest rate changes and
economic activity.
• How a Yield Curve Works?
• This yield curve is used as a benchmark for other debt in the
market, such as valuation of bonds, setting mortgage rates or bank
lending rates, and it is used to predict changes in economic output
and growth.
• The most frequently reported yield curve compares the 3-month, 6-
month, 1-year, 2-year, 5-year, 10-year, and 30-year Treasury rates.
• In India, CCIL (Clearing Corporation of India Ltd.) publishes Zero
Coupon Sovereign Rupee Yield Curve on a daily basis.
• https://www.ccilindia.com/RiskManagement/SecuritiesSegment/P
ages/ZCYC.aspx
 Modelling Yield Curve
• The Process (apart from Interpolation technique)
• Do ZCBs span the maturity spectrum?
• If yes – Use discounting technique.
• If no – Do Coupon bonds span the maturity spectrum?
• If yes - Use Boot-strapping.
• If no – Use Yield curve fitting.
• Yield curve fitting
• 1) Objective – Smoothness - Fit functional forms to describe
the spot or forward rate
• Methods – Nelson Siegel (NS) or Nelson Siegel Svensson
(NSS)
• 2) Objective - Accuracy – Segment the curve and fit a
separate function for each segment.
• Methods – Polynomial , Exponential, Basis, Cubic Basis
and Smoothing Splines
Discounting Technique for Yield Curve
Given,
Period Coupon Price
0.5 yr 0 99
1.0 yr 0 97
1.5 yr 0 95
2.0 yr 0 93

To determine ZCYC for 2 years.

Discounting Technique for Yield Curve
The equations are,
99 = 100/(1+ r0.5 /2)
97 = 100/(1+ r1.0 /2)^2
95 = 100 /(1+ r1.5 /2)^3
93 = 100/(1+ r2.0 /2)^4

Solving the equations we get,

r0.5 = 2.02%
r1.0 = 3.07%
r1.5 = 3.45%
r2.0 = 3.67%
 Bootstrapping for ZCYC
Given,
Period Coupon Price
0.5 yr 0 99
1.0 yr 0 97
1.5 yr 4 100
2.0 yr 5 100.5
To determine ZCYC for 2 years.

B.B.Chakrabarti: [email protected]
 Bootstrapping for ZCYC
The equations are,
99 = 100/(1+r0.5/2)
97 = 100/(1+r1.0/2)^2
100 = 2 /(1+r0.5/2)+2/(1+r1.0/2)^2+102 /(1+r1.5/2)^3
100.5 = 2.5/(1+r0.5/2)+2.5/(1+r1.0/2)^2
+2.5/(1+r1.5/2)^3 +102.5/(1+r2.0/2)^4
Solving the equations we get,
r0.5 = 2.02%
r1.0 = 3.07%
r1.5 = 4.03%
r2.0 = 4.79%
B.B.Chakrabarti: [email protected]
CCIL and Zero Coupon Sovereign Rupee Yield Curve
• CCIL uses the Nelson-Siegel-Svensson equation as under:
• Spot Rate = ß0 + (ß1+ß2) *(1-e (-m/ t1)) / (m/ t 1) – ß2*e (-m/ t 1)
+ ß3*(1- e (-m/ t 2)) / (m/ t 2) - ß3*e (-m/ t 2)
where,
• m = maturity
• β0 = Positive parameter is the long term Zero Rate
• β1 = This parameter along with β0 determines the short term Zero
Rate (the vertical intercept)
• τ1 = Positive parameter positions the first hump
• β2 = Parameter determining the magnitude and direction of the
hump occurring at τ1.
• τ2 = Positive parameter positions the second hump on the curve.
• β3 = Parameter, analogous to β2, determines the magnitude and
direction of the second hump.
CCIL and Zero Coupon Sovereign Rupee Yield Curve
• The basic process of determining the optimal parameters for the
Zero Rate function that best fits the traded data is as follows:
• i. A vector of starting parameters [β0, β1, β2, β3, τ1, τ2] is selected.
• ii. The zero rates are determined, using these starting parameters.
• iii. The present value of the various bond cash flows and a vector of
theoretical bond prices is determined.
• iv. Price errors are calculated by taking the difference between the
theoretical and traded prices.
• Steps i through iv are repeated through an optimization process
until the sum of the squares of the Price Errors weighted by the
inverse of the respective bond’s duration (which is the Objective
Function) is minimized.
• Trade data is subjected to a filtering process for removal of market
outliers and small value trades, trades in special securities are also
excluded.
CCIL and Zero Coupon Sovereign Rupee Yield Curve