THE TERM STRUCTURE AND INTEREST RATE DYNAMICS

Spot Rates and Forward Rates

The price of a risk-free single-unit payment (e.g., $1, €1, or £1) after N periods is called the discount
factor with maturity N, denoted by PVN. The yield-to-maturity of the payment is called a spot rate,
denoted by ZN. That is

DFN= 1/(1+ZN)N

The N-period discount factor, DFN, and the N-period spot rate, ZN, for a range of maturities in years
N> 0 are called the discount function and the spot yield curve (or, more simply, spot curve),
respectively.

This spot curve represents the term structure of interest rates. Note that the discount function
completely identifies the spot curve and vice versa, because both contain the same set of
information about the time value of money.

The spot curve shows, for various maturities, the annualized return on an option-free and default-
risk-free zero-coupon bond (zero for short) with a single payment at maturity. For this reason, spot
rates are also referred to as zero-coupon yields or zero rates.

A forward rate is an interest rate determined today for a loan that will be initiated in a future period.
The set of forward rates for loans of different maturities with the same future start date is called the
forward curve.

Forward rates and forward curves can be mathematically derived from the current spot curve.

The forward pricing model describes the valuation of forward contracts. The no-arbitrage principle,
which simply states that tradable securities with identical cash flow payments must have the same
price, may be used to derive the model as shown

DFB = DFA × FA,B−A

The spot rates for three hypothetical zero-coupon bonds (zeros) with maturities of one, two, and
three years are given in the following table.

The spot rates for three hypothetical zero-coupon bonds (zeros) with maturities of one, two, and
three years are given in the following table

Maturity (T) 1 2 3
Spot Rate Z1= 9% Z2=10% Z3=11%
1. Calculate the forward rate for a one-year zero issued one year from today, f1,1.
2. Calculate the forward rate for a one-year zero issued two years from today, f2,1.
3. Calculate the forward rate for a two-year zero issued one year from today, f1,2.
4. Based on your answers to 1 and 2, describe the relationship between the spot rates and the
implied one-year forward rates.
f1,1is calculated as

(1 + Z2)2 = (1 + Z1)1 (1 + f1,1)1

(1+0.10)^2 = (1+0.09)^1(1 + f1,1)1
1.21 =1.09*(1 + f1,1)1
f1,1 = (1.21/1.09)-1= 0.11009
= 11.01%

f2,1 is calculated as

Breakdown of the Concept:

1. Zero-Coupon Bond: This type of bond does not pay periodic interest (coupons). Instead, it is
issued at a discount to its face value and pays the face value at maturity. For example, a zero-
coupon bond with a face value of $1,000 maturing in 2 years might be issued for $800 today.
2. Forward Rate: The forward rate is the agreed-upon interest rate for a transaction that will
occur at a future date. In this case, it is the rate that will be applied to the 2-year bond that
will be purchased one year from now.
3. Issuing 1 Year from Today: This indicates that the bond will be issued (or bought) at a future
date (1 year from now), and it will have a total maturity of 2 years from that point. Therefore,
if you buy the bond one year from now, it will pay back its face value in 2 years from that
purchase date (i.e., 3 years from today).

Relationship between Spot Rates and Implied One-Year Forward Rates

Based on the calculated forward rates:
 f1,1=11.01%
 f2,1=13.12%
 f1,2=12.00%
The relationship can be summarized as follows:
 The forward rate f1,1 is lower than the subsequent spot rate Z2(10%), indicating that the
market anticipates a higher rate in the future, as seen in f2,1.
 The forward rate f2,1 is higher than both Z2 and Z1, suggesting an increasing trend in interest
rates.
 This indicates that the market expects interest rates to rise in the future, as reflected in the
upward movement of the implied forward rates compared to the current spot rates.
In general, when forward rates are higher than current spot rates, it can imply expectations of rising
rates, while lower forward rates may indicate expectations of falling rates.

The relationship between spot rates and one-period forward rates is fundamental in fixed-income
finance and can be expressed using mathematical equations that connect these rates over different
time horizons. Here's a detailed breakdown of this relationship:
Definitions:
1. Spot Rate (Z): The interest rate for a security (like a bond) that is purchased today and
matures at a specific future date. Spot rates are usually denoted as ZT for a maturity of T
years.
2. Forward Rate (f): The interest rate agreed upon today for a loan or investment that will start
at a future date. For example, fT,1 refers to the forward rate for a period starting in year T
and lasting for one year
The relationship between spot rates and one-period forward rates may be demonstrated using the
forward rate model and successive substitution, resulting in Equations 5a and 5b:

(1 + ZT)T = (1 + z1)(1 + f2,1)(1 + f3,1)…(1 + fT−1,1) (5a)

This equation states that the value of an investment with maturity T can be constructed by
multiplying the returns from a series of shorter-term investments.

ZT = {(1 + Z1)(1 + f2,1)(1 + f3,1)…(1 + fT−1,1)} 1/ T − 1 (5b)

Equation 5b shows that the spot rate for a security with a maturity of T > 1 can be expressed as a
geometric mean of the spot rate for a security with a maturity of T = 1 and a series of T ‒ 1 forward
rates.

Implications of the Relationship:

1. Geometric Mean: The spot rate ZT is effectively a geometric average of the one-year spot
rate and the forward rates. This means that if the future forward rates are higher than the
current spot rates, the longer-term spot rates will be higher as well.
2. Interest Rate Expectations: The relationship implies that current spot rates can provide
insights into market expectations of future interest rates. For instance, if the forward rates
are rising, it indicates that the market expects future interest rates to increase.
3. Arbitrage Opportunities: The relationship helps identify arbitrage opportunities. If the spot
and forward rates do not align according to these equations, investors could exploit the price
discrepancies in the bond market.

Given the data and conclusions for Z 1, f1,1, and f2,1 from Example 2: Z1 = 9% f1,1 = 11.01% f2,1 = 13.03%
Show that the two-year spot rate of Z2 = 10% and the three-year spot rate of Z3 = 11% are geometric
averages of the one-year spot rate and the forward rates

Using Equation 5a,

(1 + Z2)2 = (1 + Z1)(1 + f1,1)

Z2 = 2 √(1 + 0.09)(1 + 0.1101) − 1 ≈ 10%

(1+ Z3) 3 = (1 + z1)(1 + f1,1)(1 + f2,1)

The spot rate for a given maturity can be expressed as a geometric average of the short-term rate
and a series of forward rates.

Forward rates are above (below) spot rates when the spot curve is upward (downward) sloping,
whereas forward rates are equal to spot rates when the spot curve is flat.

If forward rates are realized, then all bonds, regardless of maturity, will have the same one period
realized return, which is the first-period spot rate.
fundamental relationship between spot rates and forward rates. This relationship arises from the
way forward rates are mathematically derived from spot rates and reflects expectations about
future interest rates.

1. Upward-Sloping Spot Curve:

o When the spot curve slopes upward (indicating that longer-term spot rates are
higher than short-term spot rates), the forward rates will generally lie above the
spot curve.
o This is because the forward rate between periods effectively represents the rate that
equates the average of current and future spot rates for different maturities.
o As spot rates increase with each maturity, each marginal forward rate has to be
higher to account for this upward movement, thus pushing the forward curve above
the spot curve.
2. Downward-Sloping Spot Curve:
o When the spot curve slopes downward (indicating lower long-term spot rates than
short-term ones), the forward rates will lie below the spot curve.
o In this case, each forward rate reflects a marginal decrease, resulting in forward
rates that are lower than the average spot rate over the period.
3. Mathematical Basis:
o The spot rate for any period is an average rate that reflects the return required
over that entire period.
o Forward rates, however, represent the incremental rate needed between specific
periods to maintain this average. Thus, they act as marginal rates: if the spot rates
are rising (or falling), these marginal rates will be positioned higher (or lower) than
the average.
In essence, this relationship between the spot and forward curves highlights how market
expectations for future rates shape the yield curve. An upward-sloping yield curve typically signals
expectations of rising interest rates, while a downward-sloping yield curve indicates the opposite

YIELD-TO-MATURITY IN RELATION TO SPOT AND FORWARD RATES

From the previous example the spot rates z1= 9%, z2 = 10%, and z3 = 11%. Let YT be the YTM.

1. Calculate the price of a two-year annual coupon bond using the spot rates. Assume the coupon
rate is 6% and the face value is $1,000. Next, state the formula for determining the price of the bond
in terms of its YTM. Is Z2 greater than or less than Y2? Why?

2. Calculate the price of a three-year annual coupon-paying bond using the spot rates. Assume the
coupon rate is 5% and the face value is £100. Next, write a formula for determining the price of the
bond using the YTM. Is Z3 greater or less than Y3? Why?

Price = 60/(1.09)^1 + 1060/(1.10)^2

Note that y2 is used to discount both the first- and second-year cash flows. Because the bond can
have only one price, it follows that z1 < y2 < z2 because y2 is a weighted average of z1 and z2 and the
yield curve is upward sloping. Using a calculator, one can calculate the YTM as y2 = 9.97%, which is
less than z2 = 10% and greater than z1 = 9%, just as we would expect. Note that y2 is much closer to
z2 than to z1 because the bond’s largest cash flow occurs in Year 2, thereby giving z2 a greater weight
than z1 in the determination of y2

Note that y3 is used to discount all three cash flows. Because the bond can have only one price, y3
must be a weighted average of z1, z2, and z3. Given that the yield curve is upward sloping in this
example, y3 < z3. Using a calculator to compute YTM, y3 = 10.93%, which is less than z3 = 11% and
greater than z1 = 9%—just as we would expect, because the weighted YTM must lie between the
highest and lowest spot rates. Note that y3 is much closer to z3 than it is to z2 or z1 because the
bond’s largest cash flow occurs in Year 3, thereby giving z3 a greater weight than z1 and z2 in the
determination of y3

Investors can expect to earn the yield-to-maturity on a bond only under extremely restrictive
assumptions.
The YTM is the expected rate of return for a bond held to maturity, assuming that all promised
coupon and principal payments are made in full when due and that coupons are reinvested at the
original YTM.

As interest rates change, the reinvestment of coupons at the original YTM is unlikely. The YTM can
provide a poor estimate of expected return if (1) interest rates are volatile, (2) the yield curve is
sloped either upward or downward, (3) there is significant risk of default, or (4) the bond has one or
more embedded options (e.g., put, call, or conversion).

If either (1) or (2) is the case, reinvestment of coupons would not be expected to be at the assumed
rate (YTM)

Case 3 implies that actual cash flows may differ from those assumed in the YTM calculation, and in
Case 4, the exercise of an embedded option would result in a holding period shorter than the bond’s
original maturity.

The realized return is the actual bond return during an investor’s holding period. It is based on
actual reinvestment rates and the yield curve at the end of the holding period. If we had perfect
foresight, the expected bond return would equal the realized bond return

To illustrate these concepts, assume that z1 = 5%, z2 = 6%, z3 = 7%, z4 = 8%, and z5 = 9%. Consider a
five-year annual coupon bond with a coupon rate of 10%. The forward rates extrapolated from the
spot rates are f1,1 = 7.0%, f2,1 = 9.0%, f3,1 = 11.1%, and f4,1 = 13.1%. The price, determined as a
percentage of par, is 105.43.

YTM= 105.43= 10/(1+y5)^1+………………………110/(1+y5)^5

The yield-to-maturity of 8.62% is the bond’s expected return assuming no default, a holding period
of five years, and a reinvestment rate of 8.62%. But what if the forward rates are assumed to be the
future spot rates?
Using the forward rates as the expected reinvestment rates results in the following expected cash
flow at the end of Year 5:

10(1 + 0.07)(1 + 0.09)(1 + 0.111)(1 + 0.131) + 10(1 + 0.09)(1 + 0.011)(1 + 0.131) + 10(1 + 0.111)(1 +
0.131) + 10(1 + 0.131) + 110 ≈ 162.22

Therefore, the expected bond return is (162.22 – 105.43)/105.43 = 53.87% and the expected
annualized rate of return is 9.00% [solve (1 + x) 5 = 1 + 0.5387]

From this example, we can see that the expected rate of return is not equal to the YTM even if we
make the generally unrealistic assumption that the forward rates are the future spot rates. The YTM
is generally a realistic estimate of expected return only if the yield curve is flat. Note that in the
foregoing formula, all cash flows were discounted at 8.62% regardless of maturity

Yield Curve Movement and the Forward Curve

The forward contract price remains unchanged as long as future spot rates evolve as predicted by
today’s forward curve.

If a trader expects the future spot rate to be below what is predicted by the prevailing forward rate,
the forward contract value is expected to increase and the trader would buy the forward contract.

Conversely, if the trader expects the future spot rate to be above that predicted by the existing
forward rate, then the forward contract value is expected to decrease and the trader would sell the
forward contract.

If the spot rate curve is upward sloping and is unchanged, then each bond “rolls down” the curve and
earns the forward rate that rolls out of its pricing (i.e., an N-period zero-coupon bond earns the N-
period forward rate as it rolls down to be an N – 1 period security). This dynamic implies an expected
return in excess of short-maturity bonds (i.e., a term premium) for longer-maturity bonds if the yield
curve is upward sloping.

Forward Contracts and Expectations

1. Forward Contract Price:
o This is the price agreed upon today for a transaction that will occur at a future date.
The price is determined based on the current forward rate curve, which reflects
market expectations about future spot rates.
2. Spot Rate:
o The spot rate is the current price at which an asset can be bought or sold for
immediate delivery. It reflects the market value of the asset at the moment.
3. Forward Rate Curve:
 o The forward rate curve represents the market’s expectations of future spot rates
over different maturities. Traders analyze this curve to make informed decisions
about buying or selling forward contracts.
Trader Expectations
 Buying Forward Contracts:
o If a trader believes that the future spot rate will be lower than the rate predicted by
the forward curve, they expect to benefit from the forward contract. Since the
contract price remains unchanged, if the actual spot rate is lower at expiration, the
trader can buy the asset at a lower price and potentially sell it at a higher market
rate, increasing the value of their position. Therefore, they would buy the forward
contract to lock in the favorable price.
 Selling Forward Contracts:
o Conversely, if a trader anticipates that the future spot rate will be higher than what
the forward curve predicts, they expect the value of the forward contract to
decrease. In this case, if they enter into a forward contract and the spot price at
maturity is higher than the forward price, they would have to pay more to acquire
the asset than they would receive if they sold it in the market. Thus, the trader
would sell the forward contract to avoid potential losses.

The roll-down effect refers to the phenomenon where the price of a bond increases as it approaches
its maturity date, assuming a stable yield curve. This effect arises from the nature of how bond yields
and prices interact over time, particularly in a market where interest rates are constant or where the
yield curve is positively sloped.
Key Concepts of the Roll-Down Effect
1. Yield Curve:
o The yield curve represents the relationship between interest rates (or yields) and the
maturity of debt securities. Typically, a positively sloped yield curve indicates higher
yields for longer maturities, reflecting increased risk over time.
2. Bond Pricing:
o A bond's price is inversely related to its yield. As yields decrease, bond prices
increase. When a bond approaches maturity, it gradually "rolls down" the yield
curve, moving from a longer maturity to a shorter maturity.
3. Mechanism:
o As a bond ages, it shifts from one point on the yield curve to another. For instance, a
bond that initially had a five-year maturity will become a four-year bond after one
year. If the yield curve is upward sloping, the yield for a four-year bond is typically
lower than that of a five-year bond, which increases the price of the bond.
4. Expected Returns:
o If the yield curve is stable (i.e., interest rates do not change significantly), the roll-
down effect can lead to capital gains on the bond. This means that the investor may
benefit not just from the coupon payments but also from the appreciation in the
bond's price as it rolls down the curve.
Example
 Assume you purchase a 5-year bond with a yield of 6%.
 After one year, it becomes a 4-year bond. If the yield curve remains stable, the yield for a 4-
year bond might be 5.5%.
 The bond's price will increase as it is now valued at the lower yield for a shorter maturity.
ACTIVE BOND PORTFOLIO MANAGEMENT

One way that active bond portfolio managers attempt to outperform the bond market’s return is by
anticipating changes in interest rates relative to the projected evolution of spot rates reflected in
today’s forward curves.

Forward and Spot Yield Curves: The forward price for a contract is stable if future spot rates evolve
in line with the current forward curve, reflecting the market's expectations. The forward curve is a
valuable reference because it allows investors to gauge the anticipated trajectory of spot rates.
Trading Strategy Based on Rate Expectations:
 If an investor anticipates that the future spot rate will be lower than the current forward rate
suggests, the forward contract's value is expected to rise. In this case, the investor might
want to buy the forward contract.
 Conversely, if the investor expects the future spot rate to be higher than the forward rate,
the forward contract's value may decrease, prompting a sell position.
Calculating Forward Contract Price:
 Using a forward pricing model (Equation 2), we can express the forward price for a bond with
a maturity of B−A years, starting at time A, as FA, B−A
 Equation 7, derived from solving Equation 2, specifies that: FA, B−A=DFB/ DFA
Here, DFB and DFA represent the discount factors for periods B and A, respectively, and they
determine the forward price needed to deliver the bond with the designated maturity at the
specified future time.

Active bond portfolio management is consistent with the expectation that today’s forward curve
does not accurately reflect future spot rates.

WHEN SPOT RATES EVOLVE AS IMPLIED BY THE CURRENT FORWARD CURVE

Calculating Initial Discount Factors with a Flat Yield Curve

With a flat 4% yield curve, the discount factors (using Equation 1) for each term are:
 One-year discount factor DF1 DF1: 1/ (1+0.04)=0.9615
 Two-year discount factor DF2: DF2=1/(1+0.04)^2 =0.9246
 Three-year discount factor DF3: DF3=1/(1+0.04)^3=0.8890
2. Forward Contract Price Using Equation 7
To find the forward contract price for a one-year bond starting in Year 2, we apply Equation 7:
F2,1= DF3/ DF2=0.8890/ 0.9246 =0.9615
This result aligns with the one-year discount factor, indicating that the forward price reflects the yield
curve's stability under a flat rate environment.
3. Adjusting for the Time Lapse Using Equation 8
Suppose that, after a year passes (when t=1), the future discount function is still aligned with the
forward discount function derived from the initial spot curve. Then, the adjusted discount factors
one year from now become:
 One-year discount factor (from Year 1 to Year 2)
DF1new= DF2/DF1=0.9246/0.9615=0.9616

 Two-year discount factor (from Year 1 to Year 3)

DF2new=DF3/DF1=0.8890/ 0.9615=0.9246
4. Forward Contract Price After One Year Using Equation 9
Using Equation 9, we calculate the forward contract price for the one-year bond starting in Year 2,
one year from today:
F2,1new= DF1new=0.9246/ 0.9616=0.9616
The nearly unchanged price confirms that, as long as the spot rate curve remains flat, the forward
price remains stable, showing that forward rates reliably predict future discount factors under stable
spot rate conditions.
5. Rolling Down the Yield Curve
 With the flat yield curve, each bond effectively “rolls down” the curve, earning the current
one-period spot rate.
 For example, after one year, a three-year bond will yield: (0.9246−0.8890)/0.8890=4%
 If another year passes, a bond with an initial two-year maturity returns: (0.9615−0.9246)/
0.9246=4%

Key Concepts in Simple Terms

1. Discount Factor:
o The discount factor is a way to express today’s value of money that will be received
in the future. A 4% interest rate means the discount factor for one year is about
0.9615, meaning $1 a year from now is worth about $0.9615 today.
2. Forward Price:
o The forward price of a contract is like a “locked-in” price for a future bond, based on
today’s interest rate expectations. It’s calculated by using today’s discount factors for
the relevant future years.
3. Equations Involved:
o Equation 7 gives the forward price. If you want to “lock in” the price today for a
bond that starts in the future (e.g., a one-year bond starting in Year 2), you can
calculate it by dividing the discount factor for the future year by the discount factor
for the year before.
o Equation 8 shows that if you check again later (like a year from now), the discount
factors for the new years should still match those predicted by today’s rates,
assuming the yield curve stays the same.

This illustrates that under a flat yield curve, bonds consistently earn returns matching the spot and
forward rates, affirming the yield curve's predictive reliability for forward prices and discount factors
in a stable interest rate environment.

As in earlier examples, assume the following: z1 = 9% z2 = 10% z3 = 11% f1,1 = 11.01% f1,2 = 12.01%
If the spot curve one year from today reflects the current forward curve, the return on a zero-coupon
bond for the one-year holding period is 9%, regardless of the bond’s maturity.

The following computations assume a par amount of 100 and represent the percentage change in
price. Given the rounding of price and the forward rates to the nearest hundredth, the returns all
approximate 9%. With no rounding, however, all answers would be precisely 9%.

The return of the one-year zero-coupon bond over the one-year holding period is 9%. The bond is
purchased at a price of 91.74 and is worth the par amount of 100 at maturity.

[100/(100/(1+z1))]-1
The return of the two-year zero-coupon bond over the one-year holding period is 9%. The bond is
purchased at a price of 82.64. One year from today, the two-year bond has a remaining maturity of
one year. Its price one year from today is 90.08, determined as the par amount divided by 1 plus the
forward rate for a one-year bond issued one year from today.
[(100/(1 + f1,1))÷( 100/(1 + z2)^2) ]− 1 = [((100/(1 + 0.1101))/100/(1 + 0.10)^2)]-1=

The return of the three-year zero-coupon bond over the one-year holding period is 9%. The bond is
purchased at a price of 73.12. One year from today, the three-year bond has a remaining maturity of
two years. Its price one year from today of 79.71 reflects the forward rate for a two-year bond issued
one year from today

This numerical example shows that the return of a bond over a one-year period is always the one-
year rate (the risk-free rate over the one period) if the spot rates evolve as implied by the current
forward curve.

But if the spot curve one year from today differs from today’s forward curve, the returns on each
bond for the one-year holding period will not all be 9%.

To show that the returns on the two-year and three-year bonds over the one-year holding period are
not 9%, we assume that the spot rate curve at Year 1 is flat with yields of 10% for all maturities. The
return on a one-year zero-coupon bond over the one-year holding period is

The return on a two-year zero-coupon bond over the one-year holding period is

The return on a two-year zero-coupon bond over the one-year holding period is

The bond returns are 9%, 10%, and 13.03%. The returns on the two-year and threeyear bonds differ
from the one-year risk-free interest rate. 9%

If any of the investor’s expected future spot rates is below a quoted forward rate for the same
maturity, then (all else being equal) the investor would perceive the bond to be undervalued, in the
sense that the market is effectively
discounting the bond’s payments at a higher rate than the investor and the bond’s market price is
below the intrinsic value perceived by the investor

Another example will reinforce the point that if a portfolio manager’s projected spot curve is above
(below) the forward curve and his expectation turns out to be true, the return will be less (more)
than the one-period risk-free interest rate.
 For the sake of simplicity, assume a flat yield curve of 8% and that a trader holds a three year bond
paying an 8% annual coupon. Assuming a par value of 100, the current market price is also 100. If
today’s forward curve turns out to be the spot curve one year from today, the trader will earn an 8%
return.
If the trader projects that the spot curve one year from today is above today’s forward curve—for
example, a flat yield curve of 9%—the trader’s expected rate of return is 6.24%, which is less than
8%:

Swap Rate Curve

Interest rate swaps are an integral part of the fixed-income market. These derivative contracts
usually involve the net exchange, or swap, of fixed-rate for floating-rate interest payments, and these
contracts are an essential tool for investors who use them to hedge, speculate on, or otherwise
modify risk.

The rate for the fixed leg of an interest rate swap is known as the swap rate.

The swap curve provides another measure of the time value of money.

Swaps are an essential tool frequently used by investors to hedge, take a position in, or otherwise
modify interest rate risk.

The key difference between the swap rate and the government bond rate is that the swap rate is
derived using short-term lending rates rather than default risk-free rates

The yield curve of swap rates is called the swap rate curve or, more simply, the swap curve. Because
it is based on so-called par swaps, in which the fixed rate is set so that no money is exchanged at
contract initiation—the present values of the fixed-rate and benchmark floating-rate legs being equal
—the swap curve is a type of par curve.

The swap market is a highly liquid market for two reasons. First, unlike bonds, a swap does not have
multiple borrowers or lenders, only counterparties who exchange cash flows. Such arrangements
offer significant flexibility and customization in the swap contract’s design. Second, swaps provide
one of the most efficient ways to hedge interest rate risk. The Bank for International Settlements
(BIS) estimates that the notional amount outstanding on interest rate swaps was nearly $350 trillion
as of June 2020.

Many countries do not have a liquid government bond market with maturities longer than one year.
The swap curve is a necessary market benchmark for interest rates in these countries. In countries
where the private sector is much bigger than the public sector, the swap curve is a far more relevant
measure of the time value of money than is the government’s cost of borrowing.

Swaps are frequently used as a benchmark in Europe, whereas in Asia, the swap markets and the
government bond markets have developed in parallel, and both are used in valuation in credit and
loan markets
Why Do Market Participants Use Swap Rates When Valuing Bonds?

Government spot curves and swap rate curves are the chief reference curves in
fixed-income valuation.

The choice between them can depend on multiple factors, including the
relative liquidity of these two markets. In the United States, where there is
both an active Treasury security market and a swap market, the choice of a
benchmark for the time value of money often depends on the interest rate
exposure profile of the institution using the benchmark. On one hand,
wholesale banks frequently use the swap curve to value assets and liabilities
because they hedge their balance sheet with swaps. On the other hand, retail
banks with little exposure to the swap market are more likely to use the
government spot curve as their benchmark.

Let us illustrate how a financial institution uses the swap market for its internal
operations.

Consider the case of a bank raising funds using a certificate of deposit (CD)
Assume the bank can borrow $10 million in the form of a CD that bears interest
of 1.5% for a two-year term. Another $10 million CD offers 1.70% for a three-
year term.

The bank can arrange two swaps: (1) The bank receives 1.50% fixed and pays
Market Reference Rate (MRR) minus 10 bps with a two-year term and a
notional amount of $10 million, and (2) the bank receives 1.70% fixed and pays
MRR minus 15 bps with a three-year term and a notional amount of $10
million.

After issuing the two CDs and committing to the two swaps, the bank has
raised $20 million with an annual funding cost for the first two years of MRR
minus 12.5 bps applied to the total notional amount of $20 million.
The fixed interest payments received from the counterparty to the swap are
paid to the CD investors; in effect, fixed-rate liabilities have been converted to
floating-rate liabilities. The margins on the floating rates become the standard
by which value is measured in assessing the bank’s total funding cost.

By using the swap curve as a benchmark for the time value of money, the
investor can adjust the swap spread so that the swap will be fairly priced given
the spread. Conversely, given a swap spread, the investor can determine a fair
price for the bond

THE SWAP SPREAD AND SPREADS AS A PRICE QUOTATION CONVENTION

The swap spread is a popular way to indicate credit spreads in a market. The
swap spread is defined as the spread paid by the fixed-rate payer of an interest
rate swap over the rate of the “on-the-run” (most recently issued) government
security with the same maturity as the swap.

The spread captures the yield premium required for credit relative to the
benchmark government bond. Because swap rates are built from market rates
for short-term risky debt, this spread is a barometer of the market’s perceived
credit risk relative to default-risk-free rates.

This spread typically widens countercyclically, exhibiting greater values during

recessions and lower values during economic expansions.

The term “swap spread” is sometimes also used as a reference to a bond’s basis
point spread over the interest rate swap curve and is a measure of the credit
and/or liquidity risk of a bond.

Here, a swap spread is an excess yield of swap rates over the yields on
government bonds, and we use the terms I-spread, ISPRD, or interpolated
spread to refer to bond yields net of the swap rates of the same maturities.

In its simplest form, the I-spread can be measured as the difference between
the yield-to-maturity of the bond and the swap rate given by a straight-line
interpolation of the swap curve.

Often, fixed-income prices will be quoted as a swap rate plus (or minus) a
spread, for which the yield is simply the yield on an equal-maturity government
bond plus the swap spread.
For example, if the fixed rate of a five-year fixed-for-float MRR swap is 2.00%
and the five-year Treasury is yielding 1.70%, the swap spread is 2.00% ‒ 1.70%
= 0.30%, or 30 bps.

The swap spread helps an investor to identify the time value, credit, and
liquidity components of a bond’s YTM. If the bond is default free, then the
swap spread could provide an indication of the bond’s liquidity, or it could
provide evidence of market mispricing. The higher the swap spread, the higher
the return that investors require for credit and/or liquidity risks.

Spreads as a Price Quotation Convention

Treasury curves and swap curves represent different benchmarks for fixed-
income valuation. It is therefore important to distinguish between a bond price
quote that uses the bond yield net of a benchmark Treasury yield and one that
uses a swap rate

The Treasury rate can differ from the swap rate for the same term for several
reasons.

Unlike the cash flows from US Treasury bonds, the cash flows from swaps are
subject to greater default risk. Market liquidity for specific maturities may
differ.

For example, some parts of the term structure of interest rates may be more
actively traded with swaps than with Treasury bonds. Finally, arbitrage
between these two markets cannot be perfectly executed.

Swap spreads to the Treasury rate (as opposed to I-spreads, which are bond rates net of the swap
rates of the same maturities) are simply the differences between swap rates and government bond
yields of a particular maturity. One problem in defining swap spreads is that, for example, a 10-year
swap matures in exactly 10 years, whereas this condition is true for a 10-year government bond only
at the time of issuance. By convention, therefore, the 10-year swap spread is defined as the
difference between the 10-year swap rate and the 10-year on-therun government bond. Swap
spreads of other maturities are defined simila
TRADITIONAL THEORIES OF THE TERM STRUCTURE OF INTEREST RATES

Expectations Theory

One branch of traditional term structure theory focuses on interpreting term

structure shape in terms of investors’ expectations. Historically, the first such
theory is known as the unbiased expectations theory, also called pure
expectations theory.

It says that the forward rate is an unbiased predictor of the future spot rate;
its broadest interpretation is that bonds of any maturity are perfect substitutes
for one another.

For example, buying a bond with a maturity of five years and holding it for
three years has the same expected return as buying a three-year bond or
buying a series of three one-year bonds.

The predictions of the unbiased expectations theory are consistent with the
assumption of risk neutrality. In a risk-neutral world, investors are unaffected
by uncertainty and risk premiums do not exist. Every security is risk free and
yields the risk-free rate for that particular maturity. Although such an
assumption leads to interesting results, it clearly is in conflict with the large
body of evidence showing that investors are risk averse

A theory that is similar but more rigorous than the unbiased expectations
theory is the local expectations theory. Rather than asserting that every
maturity strategy has the same expected return over a given investment
horizon, this theory instead contends that the expected return for every bond
over short periods is the risk-free rate. This conclusion results from an assumed
no-arbitrage condition in which bond pricing does not allow for traders to earn
arbitrage profits.

The primary way that the local expectations theory differs from the unbiased
expectations theory is that it can be extended to a world characterized by risk.

Although the theory requires that risk premiums be nonexistent for very short
holding periods, no such restrictions are placed on longer-term investments.
Thus, the theory is applicable to both risk-free as well as risky bonds.

Although the local expectations theory is economically appealing, it is often

observed that short-holding-period returns on long-dated bonds in fact exceed
those on short-dated bonds.

The need for liquidity and the ability to hedge risk essentially ensure that the
demand for short-term securities will exceed that for long-term securities.
Thus, both the yields and the actual returns for short-dated securities are
typically lower than those for long-dated securities.

Liquidity Preference Theory

Whereas expectations theories leave no room for risk aversion, liquidity

preference theory attempts to account for it.

Liquidity preference theory asserts that liquidity premiums exist to

compensate investors for the added interest rate risk they face when lending
long term and that these premiums increase with maturity.

Thus, given an expectation of unchanging short term spot rates, liquidity

preference theory predicts an upward-sloping yield curve. The forward rate
provides an estimate of the expected spot rate that is biased upward by the
amount of the liquidity premium, which invalidates the unbiased expectations
theory. The liquidity premium for each consecutive future period should be no
smaller than that for the prior period.