1 TERM STRUCTURE OF INTEREST RATES

The the interest rate offered on investments does usually vary according to the term of the
investment. In investigating this variation we make use of unit zero-coupon bond prices. A
unit zero-coupon bond of term n, say, is an agreement to pay $1 at the end of n years. No
coupon payments are paid. We denote the price at issue of a unit zero-coupon bond maturing
in n years by Pn
Discrete-time spot rates
The yield on a unit zero-coupon bond with term n years, yn , is called the ’n-year spot rate of
interest’. Using the equation of value for the zero-coupon bond we find the yield on the bond,
yn , from
1 −n1
Pn = ⇒ (1 + y n ) = P n
(1 + yn )n
Example
The prices for $100 nominal of zero-coupon bonds of various terms are as follows
1 year = $94 5 years = $70 10 years = $47 15 years = $30
Calculate the spot rates for these terms and sketch a graph of these rates as a function of the
term.
Solution
The spot rates for the various terms can be found from the equations of value

5 years: 100(1 + y5 )−5 = 70 ⇒ y5 = 7.4%

Since rates of interest differ according to the term of the investment, in general ys 6= yt for
s 6= t. Every fixed-interest investment may be regarded as a combination of (perhaps notional)
zero-coupon bonds. For example, a bond paying coupons of D every year for n years, with
a final redemption payment of R at time n may be regarded as a combined investment of
n zero-coupon bonds with maturity value D, with terms of 1 year, 2 years,..,n years, plus a
zero-coupon bond of nominal value R with term n years.
Let vyt = (1 + yt )−1 , then we have

A = D(P1 + P2 + ... + Pn ) + RPn

= D(vy1 + vy22 + ... + vynn ) + Rvynn

This is actually a consequence of ’no arbitrage’; the portfolio of zero-coupon bonds has the same
payouts as the fixed-interest bond, and the prices must therefore be the same. The variation

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by term of interest rates is often referred to as the term structure of interest rates. The curve
of spot rates {yt } is an example of a yield curve.
Example
The current annual term structure of interest rates is

(7%, 7.25%, 7.5%, 7.75%, 8%)

A five-year fixed-interest security has just been issued. It pays coupons of 6% annually in
arrears and is redeemable at par. Calculate the following

a) the price per $100 nominal of the security

b) the gross redemption yield of the security

Solution

a) The price per $100 nominal is given by

2 3 4 5 5
P = 6(v7% + v7.25% + v7.5% + v7.75% + v8% ) + 100v8% = $92.25

b) The gross redemption yield is the value of i that solves the equation

92.25 = 6a 5 + 100v 5

Use approximation techniques to solve for i

Discrete Time Forward Rates

The discrete-time forward rate, ft,r , is the annual interest rate agreed at time 0 for an invest-
ment made at time t > 0 for a period of r years, i.e. if an investor agrees at time 0 to invest
$100 at time t for r years, the accumulated investment at time t + r is 100(1 + ft,r )r
The following is the connection between forward rates, spot rates and zero-coupon bond
prices

t r t+r −1 r (1 + yt+r )t+r Pt

(1 + yt ) (1 + ft,r ) = (1 + yt+r ) = Pt+r ⇒ (1 + ft,r ) = =
(1 + yt )t Pt+r
One-period forward rates are of particular interest. The one-period forward rate at time
t (agreed at time 0) is denoted ft = ft,1 . We define f0 = y1 . Comparing an amount of
$1 invested for t years at the spot rate yt , and the same investment invested 1 year at a
time with proceeds reinvested at the appropriate one-year forward rate, we have (1 + yt )t =
(1 + f0 )(1 + f1 )(1 + f2 )...(1 + ft−1 ). The one-year forward rate, ft , is therefore the rate of
(1 + yt+1 )t+1
interest from time t to time t + 1 i.e. (1 + ft ) =
(1 + yt )t

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 Example
The 3, 5 and 7-year spot rates are 6%, 5.7% and 5% pa respectively. The 3-year forward rate
from time 4 is 5.2% pa. Calculate: i) f3 , ii) f5,2 , iii) y4 and iv) f3,4
Continuous-time spot rates
Let Pt be the price of a unit zero-coupon bond of term t. Then the t-year spot force of interest
is Yt where
1
Pt = e−Yt ⇒ Yt = − log Pt
t
This is also called the continuously compounded spot rate of interest or the continuous-time
spot rate. Note that yt = eYt − 1
Continuous-time forward rates
The continuous-time forward rate Ft,r is the force of interest equivalent to the annual forward
rate of interest ft,r . A $1 investment of duration r years, starting at time t, agreed at time
0 ≤ t accumulates using the annual forward rate of interest to (1 + ft,r )r at time t + r. Using
the equivalent forward force of interest the same investment accumulates to eFt,r r . Hence the
annual rate and continuous-time rate are related as ft,r = eFt,r − 1. Note that

(t + r)Yt+r − tY t
etY t erFt,r = e(t+r)Yt+r ⇒ Ft,r =
r
 
1 1 Pt
Further, since Yt = − log Pt ⇒ Ft,r = log
t r Pt+r
Example
The prices for $100 nominal of zero-coupon bonds of various terms are as follows:1 year = $94
5 years = $70 10 years = $47 15 years = $30. Calculate Y10 and F5,10
Instantaneous forward rates
The instantaneous forward rate Ft is defined as

1 d
Ft = lim Ft,r = − Pt
r→0 Pt dt

Remark
In practice the term structure varies rapidly over time, and the 5-year spot rate tomorrow
may be quite different from the 5-year spot rate today. In more sophisticated treatments we
model the change in term structure over time. In this case all the variables used need another
argument, v, say, to give the ’starting point’. For example, yv,t would be the t-year discrete
spot rate of interest applying at time v, Fv,t,r would be the force of interest agreed at time v,
applying to an amount invested at time v + t for the r-year period to time v + t + r.
Example

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Suppose that y0,5 = 6%, y5,5 = 7.5%, F0,5,5 = 7% and F5,5,5 = 8.25%. Calculate the price for
$100 nominal of a ten-year zero-coupon bond issued at time 0 and time 5

1.1 Theories of the term structure of interest rates

Factors affecting variation of Interest Rates

The factors include:

a) Supply and demand-Interest rates are determined by market forces, ie the interaction
between borrowers and lenders. If cheap finance is easy to obtain or if there is little
demand for finance, this will push interest rates down.

b) Base rates-In many countries there is a central bank that sets a base rate of interest.
This provides a reference point for other interest rates e.g the Central Bank Rate (CBR)
was raised to 7.50% on May 30th, 2022, click the following hyperlink for more information:
CBK raises the CBR rate

c) Interest rates in other countries-The interest rates in a particular country will also
be influenced by the cost of borrowing in other countries because major investment insti-
tutions have the alternative of borrowing from abroad.

d) Other factors include expected future inflation, the tax rate and Risk associated with
changes in interest rates

Theories for variation of Interest Rates

The three most popular explanations for the fact that interest rates vary according to the term
of the investment are:

1) Expectations theory-The relative attraction of short and longer-term investments will

vary according to expectations of future movements in interest rates. An expectation of
a fall in interest rates will make short-term investments less attractive and longer-term
investments more attractive. An expectation of a rise in interest rates will have the
converse effect.

2) Liquidity preference-Longer-dated bonds are more sensitive to interest rate movements

than short-dated bonds. It is assumed that risk averse investors will require compensation
(in the form of higher yields) for the greater risk of loss on longer bonds.

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3) Market segmentation-Bonds of different terms are attractive to different investors,
who will choose assets that are similar in term to their liabilities. The liabilities of
banks, for example, are very short-term (investors may withdraw a large proportion of the
funds at very short notice); hence banks invest in very short-term bonds. Many pension
funds have liabilities that are very long-term, so pension funds are more interested in the
longest-dated bonds. The demand for bonds will therefore differ for different terms. The
supply of bonds will also vary by term, as governments and companies’ strategies may
not correspond to the investors’ requirements.

Exercise

1) In a particular bond market, the two-year par yield at time t = 0 is 5.65% and the issue
price at time t = 0 of a two-year fixed-interest stock, paying coupons of 7% annually in
arrears and redeemed at 101, is $103.40 per$100 nominal. Calculate the one-year spot
rate and the two-year spot rate

2) The n-year spot rate is estimated using the function yn = 0.09 − 0.03e−0.1n . Calculate
the one-year forward rate at time 10.

3) Explain what is meant by the following theories of the shape of the yield curve: market
segmentation theory, liquidity preference theory.

4) A 5-year 6% semiannual coupon bond with face value $100 currently sells for $98. A
5-year 2% semiannual coupon bond with face value $100 currently sells for $90. What is
the current 5-year spot rate?

5) Consider the accumulation function a(t) = 1 + 0.05t

a) Compute the spot rates of interest for investments of 1, 2 and 2.5 years

b) Derive the accumulation function for payments due at time 2, assuming the payments
earn the forward rates of interest

c) Calculate the forward rates of interest for a payment due at time 2 with time to
maturity of 1, 2 and 2.5 years

6) Suppose the spot rates of interest for investment horizons of 1, 2 and 3 years are, respec-
tively, 4.0%, 4.2% and 4.3%, and the 1-year forward rates of interest for payments due at
time 1 and 2 are, respectively, 4.4% and 4.6%.

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a) Do the above rates violate the no-arbitrage relationship concerning spot and forward
rates of interest?

b) If so, describe an arbitrageur’s strategy to make riskless profits.