Spot vs.

Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Advanced Debt Instruments

1. The Term Structure and Interest Rate Dynamics

Jung-Hyun Ahn

2024
Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Roadmap

1 Spot vs. Forward Rates

2 Swap Rates

3 Spread Measures

4 Term Structure Theory

5 Yield Curve Volatilities

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Spot Rates

Spot rates, st

Yield-to-maturity on zero-coupon bonds for maturity t.

The term structure of spot rates

the graph of the spot rate st versus the maturity t;

also known as spot yield curve or spot curve;
changes continuously with the market price of bonds.

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

US Treasury Spot Yield Curve as of Jan. 5, 2021

(Source: Bloomberg)

CRVF <go> ← Bloomberg yield curve find function

Historical US Spot yield Curves Euro Area Spot yield curves

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Forward Rates

Forward rates, f (j, k)

Annualized interest rate applicable on a k-year zero-coupon bond starting in j years.

The term structure of forward rates

the graph of the forward rates for zero-coupon bonds of different maturities
with the same future start date versus the maturity;
also known as forward curve.
Forward curves and spot curves are mathematically related.

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Compute YTM of coupon bonds from spot curve

The price of a coupon bond can be computed using YTM.

Alternatively, the price can be calculated using the spot rates considering a coupon
bond as a portfolio of zero coupon bonds.
This is more fundamental approach given the term structure of interest rates.
The price determined using the spot rates is referred to as the bond’s "no-arbitrage
value".

Given price and spot curve, we can derive the YTM

For an annual coupon bond with the maturity T years

CPN CPN CPN FV

P = + + ... + +
1 + s1 (1 + s2 )2 (1 + sT )T (1 + sT )T
CPN CPN CPN FV
= + + ... + +
1 + Y TM (1 + Y T M )2 (1 + Y T M )T (1 + Y T M )T

where st (t ∈ 1, ..., T ) is spot rate for the maturity t years.

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Ex.1.1. Compute YTM based on spot rates

Calculate the yield to maturity of a three-year bond that makes a 5% annual coupon
payment and $1,000 face value given the following relevant spot rate curve:
Time-to-Maturity Spot Rate
1 year 2%
2 years 3%
3 years 4%

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Sol.

50 50 50 1000
P = + + + = 1029.60
1.02 (1.03)2 (1.04)3 (1.04)3

50 50 50 1000
+ + + = 1029.60
1 + Y TM (1 + Y T M )2 (1 + Y T M )3 (1 + Y T M )3
,→ YTM:
Excel: RAT E(3, 50, −1029.60, 1000)
Calculator: N = 3, P V = −1029.60, F V = 1000, CP T I/Y
→ 3.94%

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

The Forward Rate Model

Consider two investors who are considering investment on zero-coupon bond for 5-year
horizon.
Investor A: investing in 5-year zero-coupon bond;
Investor B: investing in 2-year zero-coupon bond and reinvesting them in 3-year
zero-coupon bonds in 2 years.
Under no profitable arbitrage, the return on both investment should be same:

(1 + s5 )5 = (1 + s2 )2 (1 + f (2, 3))3

Forward rate f (2, 3) can be derived from the above relationship. Forward rates and
spot rates are related.
Generalizing, k-year (implicit) forward rate for zero-coupon bond starting j years from
now, f (j, k), can be computed by

(1 + sj+k )j+k = (1 + sj )j (1 + f (j, k))k

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Ex.1.2. Forward rates

Suppose that the two-year and five-year spot rates are s2 = 4% and S5 = 6%.
Calculate the implied three-year forward rate for a loan starting two years from
now, i.e., f (2, 3).

Sol.

(1 + s5 )5 = (1 + s2 )2 (1 + f (2, 3))3
(1 + 0.06)5 = (1 + 0.04)2 (1 + f (2, 3))3
=⇒
(1 + 0.06)5
(1 + f (2, 3))3 =
(1 + 0.04)2
=⇒

f (2, 3) = 7.35%

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Forward Pricing Model

Valuing forward contracts based on arbitrage-free pricing.

Consider two investors:
Investor A purchases a $1 face value, zero-coupon bond maturing in j + k years at a price of Pj+k ;
Investor B enters into a j-year forward contract to purchase a $1 face value, k-year zero-coupon
bond at a price of F (j, k). Investor B’s cost today is the present value of the price that you will
pay in j years, i.e., P V [F (j, k)].
Because both investors will receive the $1 cash flows at j + k, these two investments should incur same
cost today:

Pj+k = P V [F (j, k)]

1 F (j, k)
=
(1 + sj+k )j+k (1 + sj )j

=⇒
 j+k
1/ 1+s DFj+k
j+k
F (j, k) = j
=
1/(1+s DFj
j)

where DFt is discount factor for t years from now.

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Alternative interpretation:
1/(1+s
j+k)j+k 1
F (j, k) = =
1/(1+s )j
j (1+sj+k )j+k/(1+sj )j
1
=
(1 + f (j, k))k
The forward price of a k-year zero-coupon bond in j years is the value of future cash
flow that occurs in j + k years discounted at j.

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Ex.1.3. Forward pricing

Calculate the forward price two years from now for a $1 par, zero-coupon, three-year
bond given the following spot rates.

The two-year spot rate, s2 = 4%.

The five-year spot rate, s5 = 6%.

Sol.
DF2 = 1/(1 + 0.04)2 = 0.9246
DF5 = 1/(1 + 0.06)5 = 0.7473
=⇒
F (2, 3) = DF5 /DF2 = 0.7473/0.9246 = 0.8082

$0.8082 is the price agreed to today, to pay in two years, for a three-year bond that
will pay $1 at maturity (in 5 years).

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Relationship between Spot and Forward rate

For an upward-sloping spot curve:
the forward curves lie above the spot curve;
forward rate f (j, k) rises as forward period j increases.
Spot vs Forward curves, 31, July 2013
Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

For an downward-sloping spot curve:

the forward curves lie below the spot curve;
forward rate f (j, k) falls as forward period j increases.

Spot vs Forward curves, 31 December 2006

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Relevance of the forward curve to active bond investors

If a trader expects the future spot rate to be below what is predicted by the
prevailing forward rate,
the price of the bond is expected to increase because the cash-flow of bonds
will be discounted by lower rates than current ones.
The trader estimates that the bond is currently undervalued.

If the trader expects the future spot rate to be above that predicted by the
existing forward rate,
the price of the bond is expected to decrease because the cash-flow of bonds
will be discounted by higher rates than current ones.
The trader estimates that the bond is currently overvalued.

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Par rates

Par rates

the YTM for a coupon paying bond trading at par −→ Par rate = coupon rate

Par curve

the graph of the YTM on coupon-paying government or benchmark bond versus

maturity.
In practice, recently issued (“on the run”) bonds are most often used to create
the par curve, becasue these securities are most liquid and typically priced at
or close to par;
Par curves are used to generate spot curve by bootstrapping.

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Bootstrapping

Ex.1.4. Bootstrapping Spot Rates

Given the following (annual-pay) par curve, compute the corresponding spot rate-
curve:
Time-to-Maturity Par Rate
1 year 1.00%
2 years 1.25%
3 years 1.50%

Sol.

s1 =1-year par rate (by definition) = 1%

1.25 101.25  
s2 : 100 = + → s2 = 1.252% 
1.01 (1 + s2 )2
1.50 1.50 101.50  
s3 : 100 = + 2 + 3 → 
s3 = 1.51% 
1.01 (1.01252) (1 + s3 )

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Riding (Rolling down) the Yield Curve

If the yield curve is upward-sloping, investors can potentially achieve superior

returns by purchasing bonds with longer maturities than those matching their
investment horizon

As time passes and maturity shortens, bond cash flows are discounted at
successively lower yields, resulting in a higher present value, i.e., the price. (known
as ‘riding’ or ‘rolling down the yield curve.’)
=⇒ Investor can make (additional) capital gain.

This strategy works only when the yield curve remains stable over the investment
horizon.

Disadvantage: exposed to interest rate risk (increase in interest rate)

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Ex.1.5. Riding the yield curve

Consider an investment on bonds of 1-year horizon.

Purchasing 1-year 3%, Annual coupon bond (A) and hold till the maturity.
Purchasing 2-year 3%, annual coupon bond (B) and sell in 1 year.
Face value of both bonds is 100. Spot curve is the following and it is expected
to remain unchanged over 1 year. Compute annualized return on both strategy.
Which strategy yields higher return?
Time-to-Maturity Spot rate
1 year 3.00%
2 years 4.00%

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Sol.

In both cases, investor receives 2 coupons of 3%

103
Price of A today: PA0 = = 100
1.03
3 103
Price of B today: PB0 = + = 98.14
1.03 (1.04)2
103
Price of B in 1 year (if spot curve remains constant): PB1 = = 100
1.03
(3 + 100 − 100) 
Annual return on A: = 3%

100
(3 + 100 − 98.14)  
Annual return on B: = 4.95%
> 3% → B is better.

98.14
,→ Investment in bonds with longer maturities yields higher return due to capital
gain.

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Plain vanilla Interest rate swap

Agreement between two parties to exchange a series of cash flow at regular dates
till the maturity based on an notional amount.

One party makes payments based on a fixed rate while the counterparty makes
payments based on a floating rate.

The fixed rate in an interest rate swap is called the swap fixed rate orswap rate.

Swap rates reflects the credit risk of commercial banks

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Swap rate curve

the curve which show how swap rates vary for various maturities.

Advantage compared to government bond yield curve

more comparable in different countries
Not regulated by any governement

Treasury bond yield curve: relfect sovereign risk specific to each country

Quote at more maturities

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Interest rate swap pricing

Although benchmark swap rates are quoted for specific maturities, swap contracts
may be customized by two parties in the over-the-counter market.

Basic principle of swap pricing given spot rate curve

The present value of fixed-leg payments equals to the present value of floating-leg
payments over the life of the swap.
,→ No profit for any parties. ⇒ The value of the swap at origination is 0.

,→ Given a notional principal $1, the swap fixed rate for maturity T , SF RT , satisfies
T
X SF RT 1
t + =1
t=1
(1 + st ) (1 + sT )T

where st is the spot rate for the maturity t.

SFR can be thought of as the coupon rate of $1 par value bond given the
underlying spot rate curve.

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Ex.1.6. Swap rate curve

Given the following spot rate curve, compute the swap fixed rate for a tenor of 1,
2, and 3 years (i.e., compute the swap rate curve).
Time-to-Maturity Spot Rate
1 year 3.00%
2 years 4.00%
3 years 5.00%

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Sol.

SF R1 1
SF R1 : + =1
(1 + s1 ) (1 + s1 )
SF R1 1  
+ =1→ SF R1 = 3.00% 
(1.03) (1.03)
SF R2 SF R2 1
SF R2 : + + =1
(1 + s1 ) (1 + s2 )2 (1 + s2 )2
SF R2 SF R2 1  
+ 2 + 2 = 1 = 1 →  SF R2 = 3.98% 
(1.03) (1.04) (1.04)
SF R3 SF R3 SF R3 1
SF R3 : + + + =1
(1 + s1 ) (1 + s2 )2 (1 + s3 )3 (1 + s3 )3
SF R3 SF R3 SF R3 1  
+ + + = 1 = 1 → SF R3 = 4.93% 
(1.03) (1.04)2 (1.05)3 (1.05)3

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Spread measures

G-spread

I-spread

Z-spread

Swap spread

TED spread

MRR-OIS spread

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Yield Spread

A yield spread or benchmark spread is the difference in yield between a (corporate)

bond and a benchmark bond.

The most used benchmark bond: Government bond satisfying the following:
The same or nearest maturity, the same denominated currency
On the run, as these are more actively traded and liquid

What if a benchmark bond with the same maturity does not exist?
,→ Linear interpolation using two benchmark bonds’ yields with nearest maturity

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Yield-to-Maturity Components

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

G-spread

G-spreadt = bond’s yieldt - (benchmark) government bond’s yieldt

Government bond yield may have to be interpolated

I-spread

a.k.a. Interpolated spread

I-spreadt = bond’s yieldt - swap fixed ratet
Swap fixed rate may have to be interpolated.
reflects credit risk relative to MRR(Market reference rate).

Which benchmark? Swap rate or Government bond’s yield?

It depends on multiple factors: relative liquidity between two markets, Interest rate
exposure profile. (Large banks-swap rate, small banks-government bond yields)

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Ex.1.7. G-spread

Consider a 3-year, 8% coupon, semi-annual coupon bond priced at 103.165. The

1-year and 4-year U.S. Treasury yields are 3% and 5% respectively. Calculate the
G-spread.

Sol.

YTM of the bond: RAT E(3 ∗ 2, 0.08/2 ∗ 100, −103.165, 100) ∗ 2 = 6.82%
3−1
3-year Treasury yield (interpolation) = 3% + (5% − 3%) × = 4.33%
4−1
 
G-spread: 6.82% − 4.33% = 2.49% = 249 bps
 

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Ex.1.8. I-spread

6% Zinni, Inc., bonds are currently yielding 2.35% and mature in 1.6 years. From
the provided swap curve, compute the I-spread.
Tenor Swap Rate
0.5 1.00%
1 1.25%
1.5 1.35%
2 1.50%

Sol.

1.6 − 1.5
Interpolated swap rate = 0.0135 + (0.015 − 0.0135) × = 1.38%
2.0 − 1.5
 
I-spread = 2.35 − 1.38 = 0.97% or 97 bps
 

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Z-spread

a.k.a. zero-volatility spread.

the spread that, when added to each spot rate on the default-free spot curve,
makes the present value of a bond’s cash flows equal to the bond’s market
price.
Constant spread added to default-free spot curve
a spread over the entire spot rate curve
reflects compensation for credit and liquidity risk for option-free risky bonds.

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Ex.1.9. Z-spread

One-year spot rate is 4% and the two-year spot rate is 5%.The market price of a
two-year bond with annual coupon payments of 8% is 104.12. Compute the Z-
spread of the bond.

Sol.

8 108
104.12 = +
1.04 + Z (1.05 + Z)2
 
Using Excel Goal Seek (Valeur Cible in French version). ⇒ Z = 0.008 or 80 bps .
 

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Swap spread

swap spreadt = swap fixed ratet - treasury yieldt

almost always positive, reflecting the lower credit risk of governments compared to
the credit risk of surveyed banks that determines the swap rate.

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

TED spread

TED: T-bill and ED (Eurodollar futures contract ticker)

TED spread = MRR - rate on T-bills
is seen as an indication of the level of credit risk in economy
T-bills are considered to be risk-free
MRR reflects the risk of lending to banks
An increase in TED spread suggests an increase in credit risk or/and liquidity
risk in economy

MRR-OIS spreard

MRR-OIS spread= MRR- Overnight indexed swap (OIS) rate

OIS: interest rate swap between unsecured overnight rate (Federal funds rate,
EONIA) or overnight rate index and a fixed rate for a pre-set period.
Useful as a measure of credit risk and an indication of well-being of banking
system.

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

New Market Reference Rates (MRR)

Currency Former New Secured / Overnight

USD USD LIBOR Secured Overnight Financing Rate (SOFR) Secured / Overnight
GBP GBP LIBOR Sterling Overnight Index Average (SONIA) Unsecured / Overnight
CHF CHF LIBOR Swiss Average Rate Overnight (SARON) Secured / Overnight
JPY JPY LIBOR Tokyo Overnight Average Rate (TONAR) Unsecured / Overnight
EUR EONIA, EUR LIBOR Euro Short-Term Rate (€STR) Unsecured / Overnight

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Term structure theory

Unbiased expectations theory

Local expectations theory

Liquidity preference theory

Segmented markets theory

Preferred habitat theordy

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Unbiased expectations theory

a.k.a. pure expectations theory

“Investors’ expectations determine the shape of the interest rate term

structure.”

Forward rates= expected future spot rates

Long-term interest rates equal the mean of future expected short-term rates.

If the yield curve is upward sloping, short-term rates are expected to rise.

Advanced Debt Instruments, J. Ahn

Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Liquidity preference theory

Forward rates reflect investors’ expectations of future spot rates, plus a

liquidity premium for interest rate risk.

Interest rate risk: longer dated cash flows more sensitive to rate changes
Premium is positively related to maturity

Forward rates are biased estimates of future rates because of the liquidity
premium

A positive-sloping yield curve may be due to future expectations or/and

liquidity premium

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Yield Curve Shift

Yield curve shifts can be either simple parallel shifts, or more complex nonparallel
shifts.

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Maturity Structure of Yield Curve Volatilities

Short term interest rates are more volatile than are long-term rates.

Interest rate volatility will drive price volatility in a fixed-income portfolio.

especially important when securities have embedded options (sensitive to volatility)

Long-maturity volatility is associated with uncertainty of the real economy and

inflation.

Short-maturity volatility reflects risk regarding monetary policy.

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Spot vs. Forward Rates Swap Rates Spread Measures Term Structure Theory Yield Curve Volatilities

Monetary Policy and other factors affecting yield curve

Monetary policy

During economic expansions, monetary authorities raise benchmark

(short-term) rates to help control inflation.
−→ often consistent with bearish flattening (short-term bond yields rise more
than long-term bond yields)
During economic recessions or anticipated recessions, the monetary authority
cuts benchmark rates to help stimulate economic activity.
associated with bullish steepening (short-term rates fall by more than
long-term yields)

Others

Fiscal policy: Expansionary policy causes increase in yield

(↗ Supply of bonds ⇒ ↘ Price ⇒ ↗ Yield)
Investor demand: Flight to quality during times of crisis often leads to a
bullish flattening (long-term rate falls more than short-term yields)
Advanced Debt Instruments, J. Ahn