Chapter 15

The Term Structure of

Interest Rates

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 Chapter Overview
• The yield curve
• Interest rates under certainty
• Interest rates under uncertainty
• Theories of the term structure
– The expectation hypothesis
– Liquidity preference
• Interpreting the term structure
• Forward rates and contracts

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 The Yield Curve
• The yield curve displays the relationship
between YTM and time to maturity
• Information on expected future short-term
rates can be implied from the yield curve

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 Treasury Yield Curves (1 of 4)
Treasury Yield Curve Yields as of 4:30 P.M.
Eastern time

A. (January 2006) Flat Yield Curve

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 Treasury Yield Curves (2 of 4)
Treasury Yield Curve Yields as of 4:30 P.M.
Eastern time

B. (December 2012) Rising Yield Curve

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 Treasury Yield Curves (3 of 4)
Treasury Yield Curve Yields as of 4:30 P.M.
Eastern time

C. (September 11, 2000) Inverted Yield Curve

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 Treasury Yield Curves (4 of 4)
Treasury Yield Curve Yields as of 4:30 P.M.
Eastern time

D. (October 4, 1989) Hump-Shaped Yield Curve

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 Yield Curve: Bond Pricing
• Yields on different maturity bonds are not all
equal
• Consider each bond cash flow as a stand-alone
zero-coupon bond
• Bond stripping and bond reconstitution offer
opportunities for arbitrage
• The value of the bond should be the sum of the
values of its parts

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Prices and Yields to Maturities on
Zero-Coupon Bonds ($1,000 Face
Value)
Maturity (years) Yield to Maturity (%) Price
1 5% $952.38  $1,000/1.0 5
2 6 $890.00  $1,000/1.0 6 2
3 7 $816.30  $1,000/1.0 73
4 8 $735.03  $1,000/1.0 8 4

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 Valuing Coupon Bonds
• Value a 3 year, 10% coupon bond
using discount rates from Table 15.1:

$100 $100 $1100

Price   
1.05 1.06 2
1.073

• Price = $1082.17 and YTM = 6.88%

• 6.88% is less than the 3-year rate of 7%

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 Bond Pricing:
Two Types of Yield Curves
Pure Yield Curve On-the-Run Yield Curve

• Uses stripped or zero coupon • Uses recently-issued coupon

Treasuries bonds selling at or near par

• May differ significantly from the • The one typically published by

on-the-run yield curve the financial press

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 The Yield Curve and
Future Interest Rates (1 of 5)
• Yield Curve Under Certainty
– Suppose you want to invest for 2 years
 Buy and hold a 2-year zero
or
 Rollover a series of 1-year bonds
– Equilibrium requires that both strategies provide
the same return

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 The Yield Curve and
Future Interest Rates (2 of 5)
• Yield Curve Under Certainty
– Buy and hold vs. rollover:

1  y 2
2
 1  r1   1  r2 
1  y 2   1  r1 1  r2  
.5

• (r2) is just enough to make rolling over a series of

1-year bonds equal to investing in the 2-year bond

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 The Yield Curve and
Future Interest Rates (3 of 5)
• Yield Curve Under Certainty
– Spot rate
 The rate that prevails today for a given maturity
– Short rate
 The rate for a given maturity (e.g., one year) at
different points in time
– A spot rate is the geometric average of its
component short rates

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 The Yield Curve and
Future Interest Rates (4 of 5)
Short Rates and Yield Curve Slope
• When next year’s short rate, r2 > • When next year’s short rate, r2 <
r1, the yield curve slopes up r1, the yield curve slopes down

• May indicate rates are expected to • May indicate rates are expected to
rise fall

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 The Yield Curve and
Future Interest Rates (5 of 5)
• Forward rates

1  f  1 y  n
n

n
1  y  n- 1
n 1

– fn = One-year forward rate for period n

– yn = Yield for a security with a maturity of n

1  y 
n
n
 1  y n 1 
n 1
 1  f n 

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Two 2-Year Investment Programs
(1 of 2)

Time Line

Alternative 1: Buy and hold

2-year zero

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Two 2-Year Investment Programs
(2 of 2)

Alternative 2: Buy a 1-year

zero, and reinvest proceeds in
another 1-year zero

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Short Rates versus Spot Rates

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 Forward Rates
• The forward interest rate is a forecast of a
future short rate
• Rate for 4-year maturity = 8%
• Rate for 3-year maturity = 7%

1  f4 
1  y 
4
4


1.08 4
 1.1106
1  y 
3
3
1.07 3

f 4  11.06%

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 Interest Rate Uncertainty and
Forward Rates (1 of 3)
• Suppose that today’s rate is 5% and the
expected short rate for the following year is
E(r2) = 6%. The value of a 2-year zero is:
$1,000
 $898.47
1.05  1.06

• The value of a 1-year zero is:

$1,000
 $952.38
1.05

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 Interest Rate Uncertainty and
Forward Rates (2 of 3)
• The investor wants to invest for 1 year
– Buy the 2-year bond today and plan to sell it at
the end of the first year for $1000/1.06 =
$943.40
or
– Buy the 1-year bond today and hold to maturity
• What if next year’s interest rate differs from
6%?
– The actual return on the 2-year bond is
uncertain!

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 Interest Rate Uncertainty and
Forward Rates (3 of 3)
• Investors require a risk premium to hold a
longer-term bond
• This liquidity premium compensates short-term
investors for the uncertainty about future prices

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 Theories of Term Structure
(1 of 2)
• The Expectations Hypothesis Theory
– Observed long-term rate is a function of
today’s short-term rate and expected future
short-term rates
– fn = E(rn) and liquidity premiums are zero

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 Theories of Term Structure
(2 of 2)
• Liquidity Preference Theory
– Long-term bonds are more risky fn > E(rn)
– The excess of fn over E(rn) is the liquidity
premium
– The yield curve has an upward bias built into
the long-term rates because of the liquidity
premium

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 Yield Curve Examples
(1 of 4)
Panel A:
• Constant Expected Short Rate
• Constant Liquidity Premium

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 Yield Curve Examples
(2 of 4)
Panel B:
• Declining Expected Short Rate
• Increasing Liquidity Premiums

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 Yield Curve Examples
(3 of 4)
Panel C:
• Declining Expected Short Rate
• Constant Liquidity Premiums

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 Yield Curve Examples
(4 of 4)
Panel D:
• Increasing Expected Short Rates
• Increasing Liquidity Premiums

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 Interpreting the Term Structure
(1 of 2)
• The yield curve reflects expectations of future
interest rates
• The forecasts are clouded by liquidity
premiums
• An upward sloping curve could indicate:
– Rates are expected to rise
and/or
– Investors require large liquidity premiums to
hold long term bonds

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 Interpreting the Term Structure
(2 of 2)
• The yield curve is a good predictor of the
business cycle
– Long term rates tend to rise in anticipation of
economic expansion
– Inverted yield curve may indicate that interest
rates are expected to fall and signal a
recession

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Price Volatility of Long-Term
Treasury Bonds

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Term Spread: Yields on 10-year
vs. 90-day Treasury Securities

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Forward Rates as Forward Contracts
• In general, forward rates will not equal the
eventually realized short rate
– Still an important consideration when trying to
make decisions
 Locking in loan rates

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 Engineering a Synthetic Forward
Loan (1 of 2)
A: Forward Rate: 7.01%

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 Engineering a Synthetic Forward
Loan (2 of 2)
B. For a General Forward Rate. The short rates in the
two periods are r1 (which is observable today) and
r2 (which is not). The rate that can be locked in for
a one-period-ahead loan is f2.

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 End of Presentation

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