Bond Yields and the Term

Structure

7
Learning

Objectives
To evaluate the return of a bond, measures such as current yield
and nominal yield were often used. The popularity of these measures, however, was mainly due to their simplicity in calculation
rather than theoretical rigor. We discuss the use of yield to maturity in measuring bond returns, which properly takes account of
the time value of money and reflects the cash-flow pattern. When
this method is applied to a callable bond assuming a known call
date, the result is the yield to call. To measure the return of
a bond ex post, we can use the realized compound yield, which
is also called the holding-period yield. Applying the realized
compound yield over specific investment horizons with different
interest-rate scenarios will provide useful information for bond
management.
The par yield is often used as a summary measure of the spotrate curve. While the yield curve is very important in evaluating
financial assets, it is not directly observable. Indeed, it has to be
estimated using bond prices observed in the market. We discuss
the use of the bootstrap method and the least squares method
for the estimation of the spot rates of interest with discrete compounding (usually semiammally). An alternative method is to
estimate the instantaneous forward rate of interest under the continuous compounding assumption. This method can be applied
to bonds with irregularly spaced coupon payments and maturity dates. Using the estimated forward-rate ftmction, we can
compute the spot-rate curve.
We discuss models of the determination of the term structure, including the expectations hypotheses, liquidity premium
hypothesis, market segmentation hypothesis and preferred habitat hypothesis.

Yield to matuTity, yield to

call and pal' yield
Realized compound yield
and hOTiz011analysis
Estimation

of the yield

CUTve:bootstrap method
and least squaTes method
Estimation of the
instantaneous forward
Tate and the term
Models of the
deteTmination of the term
Str"uctuTe

7.1

Some Simple Measures of Bond Yield

Bond dealers often quote the potential return of a bond. A simple quote is the current

yield, which is the annual dollar amount of coupon payment(s) divided by the quoted
(clean) price of the bond. In other words, it is the annual coupon rate of interest
divided by the quoted price of the bond per unit face value. For example, if a bond has
a face value of $1,000 and pays a $22 coupon every 6 months with a current quoted
price in the secondary market of $980, then the bond's current yield is 44/980 =
4.49%.
The current yield does not adequately reflect the potential gain of the bond
investment. First, it does not take account of the time value of money. Second, it
does not take into consideration the capital gain or loss when the bond is held until
maturity when the redemption payment is made. For example, if the bond is bought
at a discount, there is a capital gain when the bond is redeemed. On the other hand,
if the bond is bought at a premium, there is a capital loss when the bond is redeemed.
Third, the computation of the current yield is based on the quoted price, while the
actual investment is the purchase (dirty) price.
Another simple measure of bond yield is the nominal yield, which is the annual
amount of coupon payment(s) divided by the face value, or simply the coupon rate of
interest per annum. Like the current yield, the nominal yield is not a good measure
of the potential return of the bond. These measures are used due to their simplicity
in computation rather than good theoretical justification.

7.2

Yield to Maturity

Given the yield rate applicable under the prevailing market conditions, we can compute the bond price using one of the pricing formulas in Chapter 6. The computed
price reflects the fair value of the bond based on the prevailing rate of interest. This
is especially important if an investor has to price a new issue of bonds. The pricing
formula can be extended to the case of a general term structure with given spot rates
if, forward rates if or accumulation function a(t). The bond price is then computed
using (6.10) (for an annual coupon bond) or (6.11) (for a semiannual coupon bond).
In practice, however, the yield rate and the term structure are not observable,
while the transaction price of the bond can be observed from the market. 1 Given the
transaction price, we can solve for the rate of interest that equates the discounted
future cash flows (coupon payments and redemption value) to the transaction price.

This rate of interest is called the yield to maturity (or the yield to redemption),
which is the return on the bond investment if the investor holds the bond until it
matures, assuming all the entitled payments are realized.
It can be seen that the yield to maturity is indeed the internal rate of return of
tlle bond investment. Specifically, for an n-year annual coupon bond with transaction
price P, the yield to maturity, denoted by iy, is the solution of the following equation:
11

P=FTL

J=l

1
(I+iyY

.+--- .
(1+iy)l1

In the case of an n-year semiannual coupon bond, we solve iy from the equation (the
coupon rate

is now per half-year)

Thus, for an annual coupon bond iy is an annual effective rate, while for a semiannual coupon bond iy is a nominal rate (per annum) convertible semiannually. Note
tl1at equations (6.10) and (6.11) are applicable from the pricing perspective, while
equations (7.1) and (7.2) evaluate the Teturn of the bond investment when an investor
purchases it at the price P and holds it until it matures.
To calculate the solutions of equations (7.1) and (7.2), numerical methods are
required. The Excel Solver may be used for the computation.
Example 7.1: A$I,OOO par value IO-year bond with redemption value of$I,080 and
coupon rate of 8% payable semiannually is purchased by an investor at the price of
$980. Find the yield to maturity of the bond.
Solution: The cash flows of the bond in this example are plotted in Figure 7.1. We
solve for i from the following equation:
980

= 40a2Oli + 1,080(1 + i)-20

to obtain i = 4.41 %, so that the yield to mahlrity iy is 8.82% per annum convertible
semiannually.

210

CHAPTER

Figure 7.1

Cash-flow diagram of the bond in Example 7.1

Cash flow

Time

980

40

40

40

40

1,120

19

20

Example 7.2: The

secondary market:

following

shows the information

of a bond

Type of bond

Non-callable government

Issue date

March 10, 2002

Maturity

date

Face value
Redemption
Coupon rate

traded

III

the

bond

March 10,2012
$100

value

$100
4% payable semiannually

Assume that the coupon dates of the bond are March 10 and September 10 of each
year. Investor A bought the bond on the issue date at a price of$105.25. OnJanuary 5,
2010 Investor B purchased the bond from A at the purchase (dirty) price of $104.75.
Find (a) the yield to maturity of Investor A's purchase on March 10, 2002, (b) the
realized yield to Investor A on the sale of the bond, and (c) the yield to maturity of
Investor B's purchase on January 5,2010.
Solution: (a) We need to solve for i in the basic price formula

105.25 = 2a251i

+ 100(1 + i)-20.

The numerical solution of i is 1.69% (per half-year). Thus, the yield to maturity is
3.38% per annum convertible semiannually.
(b) Investor A received the 15th coupon payment on September 10, 2009 and there
are 117 days between September 10,2009 and the sale date ofJanuary 5,2010. The
number of days between the two coupon payments, namely, September 10, 2009 and

105.25

= 2aTIli + 104.75(1 + i)-

15

1I7

m,

the solution of which is 1.805 % (per half-year). Thus, the realized yield is 3.61 % per
annum convertible semiannually.
(c) Investor B will receive the next five coupon payments starting on March 10,2010.
There are 64 days between the purchase date and the next coupon date. Investor B's
return i per half-year is the solution of the following equation:

104.75

= [ 2ii51i + 100(1 + i)-4 ]

=

which is 1.18%. Thus,

semiannually.

2a51i

+ 100(1 + i)-) -]

the yield to maturity

IS

(1

+ i)-m

(1

117
+ i)m,

2.36%

per annum

convertible

If a bond is callable prior to its maturity, a commonly quoted measure is the yield
to call, which is computed in the same way as the yield to maturity, with the following
modifications: (a) the redemption value in equations (7.1) and (7.2) is replaced by the
call price, and (b) the maturity date is replaced by the call date. An investor will be
able to compute a schedule of the yield to call as a function of the call date (which
also determines the call price), and assess her investment over the range of possible
yields.
Example 7.3: An investor purchased the callable bond in Example 6.8 at the price
of $950. Find the minimum implied rate of return this investor is expected to
obtain.
Solution: We solve the internal rate of return i of the bond at all possible call dates
with P = 950, r = 0.02 and F = 1,000. Also, the value of C follows the given call
price formula in Example 6.8. The results are summarized in Table 7.1.
Thus, the minimum yield is 2.315% per half-year or 4.63% per annum convertible semiannually. This occurs when the bond is called after the 20th coupon
payment.

.I

212

CHAPTER

Table 7.1

Results of Example 7.3

i (%)

15

1,000

2.401

16

1,000

2.379

17

1,000

2.360

18

1,000

2.344

19

1,000

2.329

20

1,000

21

1,010

2.315
2.342

22

1,020

2.364

23

1,030

2.384

24

1,040

2.402

25

1,050

2.417

26

1,060

2.430

27

1,070

2.441

28

1,080

2.451

29

1,090

2.460

30

1,100

2.467

Although the Excel Solver can be used to calculate the solution of equations (7.1)
and (7.2), the computation can be more easily done using the Excel function YIELD,
the specification of which is given as follows:

srnt = settlement date

rnty = maturity date
crt = coupon rate of interest per annum
prc = quoted (clean) price of the bond per 100 face value
rdv = redemption value per 100 face value
frq = number of coupon payments per year
basis = day count, 30/360 if omitted and actual/actual if set to 1
Output = yield to maturity of the bond
Exhibit 7.1 illustrates tl1e use of the function YIELD to solve Example 7.2. We
first enter the dates March 10, 2002, January 5, 2010 and March 10, 2012 into
Cells Al through A3, respectively. In Cell A4, the YIELD function is entered, with
settlement date AI, maturity date A3 and price of bond 105.25. The output is the

A
3/1012002
1/5/2010
3/10/2012
338%
236%

1
2
3
4
5
6

YIELD(A 1 ,.A3,004,105.25,100,2,1)
= YIELD(.A2 ,.A3,0.04,103.4572,100,2,1)
,

..'
I

.'
yield to maturity ofInvestor A's purchase on March 10, 2002, i.e., 3.38%, which is
the answer to Part (a). Part (b), however, cannot be solved by the YIELD function, as
the bond was not sold on a coupon-payment
date.2 For Part (c), note that the input
price of the bond required in the YIELD function is the quoted price. Thus, to use
the YIELD function, we must first compute the quoted price of the bond on January
5,2010, which is
117
104.75 - 2 x 181

$103.4572.

Given the prevailing spot-rate curve and that bonds are priced according to the existing term structure, the yield to maturity iy is solved from the following equation (for
an annual coupon bond):3
1

77

FrL.

)=1

(1

+ iy)/

.+

C
(1

11

+ ly)'1

=F7~L
.
(1
J=1

+1.05))
.!

.+

C
(1

+ is)
77

(7.3)

77'

which is obtained from equations (6.10) and (7.1). Hence, iy is a nonlinear function
averaging the spot rates
j = 1, ... , n. As an averaging measure of the spot rates,

1,

however, iy has some disadvantages.

2The

function

compute

YIELD assumes

the internal

First, no analytic solution of iy exists and it has

that the last payment

consists of both coupon

and redemption.

It can be used to

rate of reUJrll of the bond (i.e., the return over the holding period of the bond, which will be

discussed in Section 7'-+) if the transaction

occurs on a coupon-payment

date. In this ease, the "redemption

value" is

the quoted (clean) price of the bond.

3 Tote that the right-hand

side of equation

(7.3) is the price of the bond based on the prevailing

term structure.

'

to be computed using numerical methods. Second, iy varies with the coupon rate of
interest, even for bonds with the same maturity. To overcome these difficulties, the
par yield may be used, which is defined as the coupon rate of interest such that the
bond is traded at par based on the prevailing term structure. Thus, denoting the par
yield by ip and setting F = C = 100, we have
1

100

100 i p
.

L
j=1

1p

(1 + 1)

1 - (1

'sr '

100
j

+(

1 + 1"

+ i~) -n

L}=1 (1 + 1)~/

More generally, if the bond makes level coupon payments at time t1, ... , tn, and the
term structure is defined by the accumulation function aC), the par yield is given by

Thus, the par yield can be computed easily without using numerical methods.
Table 7.2 illustrates the par yields computed from two different spot-rate curves: an
Table 7.2

Par yields of two term structures

Case 1

'n

Case 2

ip

'n

ip

3.50

3.50

6.00

6.00

3.80

3.79

4.08

5.71
5.42

4.10
4.40

5.70
5.40

4.37

5.10

5.14

4.70

4.64

4.80

4.86

5.00

4.91

4.50

4.58

5.30

4.20

4.30

5.60

5.18
5.43

3.90

4.02

5.90

5.67
5.91

11

6.20
6.50

3.60
3.30

3.74

10

6.13

3.00

3.18

12

6.80

6.34

2.70

2.89

3.46

upward sloping curve and a downward sloping curve. In Case 1, the spot-rate curve is
upward sloping, and we observe that the par yield increases with the time to maturity.
Hence, we have an upward sloping par-yield curve as well, although the par yield is
below the spot rate of the same maturity. In Case 2, we have a downward sloping
spot-rate curve, which is accompanied by a downward sloping par-yield curve. The
par-yield curve, however, is above the spot-rate curve and its slope is less steep.
It should be noted that the par yield is more a summary measure of the existing term structure than a measure of the potential return of a bond investment. On
the other hand, the yield to maturity is an ex ante measure of the return of a bond. It
assumes that the bond is held to maturity and that all coupon payments are reinvested
at the same yield. If the bond is sold before it matures, or if the interest-on-interest
is different from the prevailing yield rate, the ex post return of the bond will be different. We now consider the evaluation of the return of a bond investment taking
account of the possibility of varying interest rates prior to redemption as well as sale
of the bond before maturity.

7.4

Holding-period Yield

Bonds are actively traded in the secondary markets. For various reasons, investors
often sell their bonds before maturity. The holding-period
yield, also called the
realized compound yield or the total retum, is often computed on an ex post
basis to evaluate the average return of the investment over the holding period of the
bond (not necessarily until it matures or is called; for instance, see Example 7.2 (b.
This methodology, however, can also be applied to assess the possible return of the
bond investment over a targeted horizon under different interest-rate scenarios. This
application, called horizon analysis, is a useful tool for active bond management.
We shall denote the holding-period yield of a bond by iH. To fix the ideas, we first
discuss the simple case of a one-period holding yield. Suppose a bond is purchased
at time t - 1 for Pt-I. At the end of the period the bondholder receives a coupon
of Fr and then sells the bond for Pt. The holding yield over the period t - 1 to t,
denoted by iH, is then given by
(Pt

+ Fr)

- Pt-l

Pt-l

Example 7.4: A $1,000 face value 3-year bond with semiannual coupons at 5% per
annum is traded at a yield of 4% per annum convertible semiannually. If interest rate
remains unchanged in the next 3 years, find the holding-period yield at the third
half-year period.
Solution: Using the basic price formula, the prices of the bond after the second and third coupon payments are, respectively, P2 = 1,019.04 and P3 = 1,014.42.

(1,014.42

IH == ------------

+ 25.00)

- 1,019.04

1,019.04

==

2 Yo.

The above example illustrates that when the yield rate is unchanged after the
purchase of the bond until it is sold prior to maturity, the holding-period yield in
that period is equal to the yield to maturity. However, when the prevailing yield rate
fluctuates, so will the bond's holding-period yield. An increase in the bond's required
current yield reduces its price, which translates into a lower holding-period yield
than the initial yield to maturity. On the other hand, a decline in the current yield
will result in a higher holding-period yield than the initial yield to maturity.
The computation of the one-period holding yield can be extended to multiple
periods. In order to calculate the n-period holding yield over n coupon-payment
periods, we need to know the interest earned by the coupons when they are paid. Let
Po be the beginning price of the bond, Pn be the ending price of the bond and V
be the accumulated value of the coupons at time n. The n-period holding yield iH is
then the solution of the equation

11-1 =

[P

+ V]*

Po

Example 7.5: Consider a $1,000 face value 5-year non-callable bond with annual
coupons of 5%. An investor bought the bond at its issue date at a price of $980.
After receiving the third coupon payment, the investor immediately sold the bond
for $1,050. The investor deposited all coupon income in a savings account earning
an effective rate of 2% per annum. Find the annualized holding-period yield iH of
the investor.
Solution: We have Po = $980 and P3 = $1,050. The accumulated
interest of the coupons, V, is

interest-on-

iH

1,203.02]3
[ 980

- 1 = 7.0736%.

In the above examples, the holding period yields are computed as ex post returns of
the bonds over the holding periods, for which the interest-rate variations are known.
This calculation can be used in a horizon analysis in which the interest-rate movements are assumed scenarios. The analyst examines the returns of different bond
investment strategies under different scenarios and chooses the best strategy under
the scenario that is deemed to be most likely. The following example illustrates this
application.
Example 7.6: Consider two bonds, A and B. Bond A is a 10-year 2% annual-coupon
bond, and Bond B is a 3-year 4% annual-coupon bond. The current spot-rate curve is
flat at 3%, and is expected to remain flat for the next 3 years. A fund manager assumes
two scenarios of interest-rate movements. In Scenario 1, the spot rate increases by
0.25 percentage point each year for 3 years. In Scenario 2, the spot rate drops to
2 % next year and remains unchanged for 2 years. If the manager has an investment
horizon of 3 years, what is her recommended strategy unde~ each scenario? You may
assume that all coupons and their interests a~e reinvested to earn the prevailing I-year
spot rate.
Solution: We first compute the current bond prices. For Bond A, the current price is
2aTQlO.03

+ 100(1.03r-10

4a310.03

+ 100(1.03)-3 =

2a710.0375+ 100(1.0375)-7

= 91.4698,

102.8286.

= 89.3987,

-1 = 1.4851%.

89.3987+6.2073]3
[
91.4698

Under Scenario 2, Bond A is traded at par in year 3 with the accumulated

the coupons being

value of

100+6.1208]3
[ 91.4698

-1 = 5.0770%.

On the other hand, Bond B matures in 3 years so that its holding-period

Scenario 1 is

yield under

100 + 4 x (1.0325 x 1.035 + 1.035 + 1)]

102.8286
[

- 1 = 3.01

56o/c
0,

100+4
[

x (1.02 x 1.02 + 1.02 + 1)]5 -1 = 2.9627%.

102.8286

Thus, Bond B is the preferred investment under Scenario 1, while Bond A is preferred
under Scenario 2.

7.5

Discretely Compounded Yield Curve

We have so far used the prevailing term structure to price a bond or compute the
net present value of a project, assuming the spot-rate curve is given. In practice,

spot rates of interest are not directly observable in the market, although they can be
estimated from the observed bond prices. In this section we discuss the estimation
of the spot rates of interest, which are assumed to be compounded over discrete
time intervals. Specifically, we consider the estimation of the spot rates of interest
convertible semiannually using a series of semiannual coupon bonds.
The simplest way to estimate the spot-rate curve is by the bootstrap method.
This method requires the bond-price data to follow a certain format. In particular,
we assume that the coupon-payment dates of the bonds are synchronized and spaced
out the same interval apart. The following example illustrates the use of the bootstrap
method.
Example 7.7: Table 7.3 summarizes a series of semiannual coupon bonds with different time to maturity, coupon rate of interest r (in percent per annum) and price
per 100 face value. Using the given bond data, estimate the spot rate of interest
over tyears, for t = 0.5, 1, ... ,6.

if

Solution: We first compute the spot rate of interest for payn1ents due in half-year,
which can be obtained from the first bond. Equating the bond price to the present
value of the redemption value (there is no coupon), we have
100

is '
1+~

Price per
Maturity (yrs)

Coupon rate r (%)

100 face value

0.5

0.0

98.41

1.0

4.0

100.79

1.5

3.8

100.95

2.0

4.5

102.66

2.5

2.5

98.53

3.0

5.0

105.30

3.5

3.6

101.38

4.0

3.2

99.83

4.5

4.0

102.83

5.0

3.0

98.17

5.5

3.5

100.11

6.0

3.6

100.24

.s = 2 x [ 98.41
100
]
- 1 = 2 x 0.016157 = 3.231 %.

10.S

For the second bond, there are two cash flows. As a coupon is paid at time 0.5 year
and the spot rate of interest of which has been computed, we obtain the following
equation of value for the bond:

100.79

2
1.016157

+[

102
is

]2'

1+-.1
2

if

from which we obtain

= 3.191 %. Similarly, for the third bond the equation of
value involves i5.s'
and ifs' of which only ifs is unknown and can be solved from
the equation. Thus, for the bond with k semiannual coupons, price Pk and coupon
rate 1} per half-year, the equation of value is

if

Pk = 1007}

L
)=1

These equations can be used to solve sequentially for the spot rates. Figure 7.2
plots the spot-rate curve for maturity of up to 6 years for the data given in
Table 7.3.

Although the bootstrap method is simple to use, there are some data requirements that seriously limit its applicability. First, the data set of bonds must have
synchronized coupon-payment
dates. Second, there should not be any gap in the
series of bonds in the time to maturity. We now consider the least squares method,
which is less demanding in the data requirement.
Let us assume we have a set of 11Z bonds for which the coupon-payment
dates
are synchronized. We denote the prices of these bonds per 100 face value by p;,
their coupon rate by 7] per half-year and their time to maturity by n) half-years, for

5
4.5
4

'::R
0

3.5

+-'
Vl

Q)

'-

Q)

+-'

'+0

2.5

Q)

+-'

+-'
0
D..
Vl

2
1.5

345
Time to maturity (yrs)

S]h'

l/;

1+2
2

which is the discount factor for payments due in h half-years. Thus, the equation of
value for the jth bond is
11)

Pj

100r)

LVh + 100v

11j"

h=l

If the last payment (redemption plus coupon) of the bonds occur in M periods (i.e.,
M is the maximum of all 12) for j = 1, ... , m), the pricing equations of the bonds can
be written as

in which C;b are known cash-flow amounts and Vb are the unknown discount factors.4
Thus, in equation (7.10) we have a multiple linear regression model with M
unknown coefficients VI, ... , VM and 711 observations (Pj is the dependent variable
and Cjl, ... , CjM are the independent variables, for j = 1, ... , 711). We can solve for
the values of Vb using the least squares method, and subsequently obtain the values
oS
o f lb'
"[

7.6

Continuously Compounded Yield Curve

We now introduce the estimation of the term structure assuming that interest is credited based on continuous compounding. Let us denote the current time by 0, and use
if to denote the continuously compounded spot rate of interest for payments due at
time t. As shown in equation (3.27), if we consider the limiting value of the forward
rate of interest if for r approaching zero, we obtain the instantaneous forward rate,
which is equal to the force of interest, i.e.,
T

An important method to construct the yield curve based on tl1e instantaneous forward
rate is due to Fama and Bliss (1987).5 Note that if we denote the current price of a
zero-coupon bond with unit face value maturing at time t by pet), we have
pet) = vet) = - 1

= exp

aCt)

a' (t)

o(t) = -

a(0

[.S]-tit,

Vi(t)
pi (t)
= -= --.

v(0

P(0

Thus, if we had a continuously observable sequence of zero-coupon bond prices pet)

maturing at time t > 0, tl1e problem of recovering tl1e spot rates of interest is straightforward using equation (7.11). In practice, however, this sequence is not available.
The Fama-Bliss method focuses on the estimation of the instantaneous forward rates,
from which the spot-rate curve can be computed.
4Cjb is the bth payment

than the maturity

(coupon

and/or

redemption)

5See E. Fama and R. Bliss, "The information

680-692.

of the jth bond. Note that these values are zero if b is larger

of the bond.
in long-maturity

forward rates", American Economic Reviezv 77, 1987,

[I

aCt) = exp

11

oCu) dUl

if = -

oCu) du,

which says that the continuously compounded spot rate of interest is an equallyweighted average of the force of interest. Thus, if we have a sequence of estimates
of the instantaneous forward rates, we can compute the spot-rate curve using (7.14).
To apply the Fama-Bliss method, we assume that we have a sequence of bonds
with possibly irregularly spaced maturity dates. We assume that the force of interest
between two successive maturity dates is constant. Making use of the equations of
value for the bonds sequentially in increasing order of the maturity, we are able to
compute the force of interest over the period of the sample data. The spot rates of
interest can then be calculated using equation (7.14). Although this yield curve may
not be smooth, it can be fine tuned using some spline smoothing methods. Example
7.8 illustrates the use of the Fama-Bliss method to estimate the force of interest and
the spot-rate curve.
Example 7.8: You are given the bond data in Table 7.4. Thejth bond matures at time
per unit face value, which equals the redemption value, for
< t2 < t3 < t+ Bonds 1 and 2 have no coupons, while Bond
3 has two coupons, at time t31 with t1 < t31 < t2 and at maturity t3. Bond 4 has three
'1 coupon d ates t-1-I'
* t42
* an d t4, were
h
* < t3 an d t3 < t42
* < t4
coupons, Wltl
t2 < t41
It is assumed that the force of interest oCt) follows a step function taking constant values between successive maturities, i.e., oCt) = 0i for ti-1 .:s t < ti, i = 1, ... , 4
with to = O. Estimate oCt) and compute the spot-rate curve for maturity up to
time t+

t; with current price Pj

j = 1, ... , 4 and 0 < tl

Coupon per

Bond

face value

t31,

Maturity

price

t1

P1

t2

P2

< t2

t3

P3

< t41 < t3

t4

P4

t1 <

t31

t3
t41, t2
t42, t3

< t42 < t4

t4

PI

exp [ -t] i~]

exp [ -

01

~tl

o(u)

dU]

exp

[-0] tIl,

= --lnPl,
tl

which applies to the interval (0, tl). Now we turn to Bond 2 (which is again a zerocoupon bond) and write down its equation of value as

For Bond 3, there is a coupon payment of amount C3 at time t31, with t] < t31 < t2.
Thus, the equation of value for Bond 3 is

P3 = (1
= (1

+ C3)

- la)
[ latl . o(u) du ] + C3 exp [t~1

exp -

+ C3)exp[-0[tl

- 02(t2 - t]) - 03(t3 - t2)]

o(u) du

+ C3 exp

[-Oltl

- 02(t31 - tl)J,

Going through a similar argument, we can write down the equation of value for Bond
4 as
P4

(1

+ C4)P3'

+ P3'C4exp

exp [-04(t4
[-04(t42

- t3)]

+ P2 C4 exp [-03

(t4[ - t2)

- t3),

Thus, the right-hand side of the above equation can be computed, while the lefthand side contains the unknown quantity 04. The equation can be solved numerically
for the force of interest 04 in the period (t3, t4)' Finally, using (7.14), we obtain the
continuously compounded spot interest rate as

O[t[
oS
It

+ 02(t

- tJ)

Ott]

+ 02(t2

- t[)

+ 03(t

- t2)

t
O[tl

+ 02(t2

- t[)

+ 03(t3
t

- t2)

+ 04(t

- t3)

The above example shows that the instantaneous forward rate of interest can
be computed successively using the bond data, although numerical methods may be
required in some circumstances. Using the estimated step function of instantaneous
forward rates, the spot-rate curve can be computed by equation (7.14).7

We showed some samples of the yield curves of the US market in Chapter

ically the yield curve can take various shapes. Figure 7.3 presents the term
of the UK market monthly from January 2001 through December 2007.
Figure 7.4 summarizes the term structure of the US market for the same

3. Empirstructure
Likewise,
period. It

Historical UK spot-rate curves

(Source: Bank of England, www. bankofengland.

co . uk)

:;- 4.5
Qj

>=

4
3.5

7Empirically it may occur that the forward rates of interest over some intervals are found to be negative. Such
is an indication

of the existence of arbitrage

opportunities

data. Thus, some data cleflning may be required

{//Io7l/aly

in the market and may be due to the poor quality of the

prior to applying the Fama-Bliss

method.

Historical US spot-rate curves

(Source: J.H.

McCulloch,

www.econ.ohio-state.edu/jhm/ts/

ts. html)

~
~

-0

Q)

>= 2
1

Jun 2004
Dec 2002

\\{{\e

can be seen that the term stmctures took quite different shapes during this period.
For the US market the yield curve was mostly upward sloping from 2001 tl1rough
2004. It showed inverted humps in parts of 2005 and 2006, while in 2007 it was
generally quite flat, even showing slightly downward slopes at long maturities. In
comparison, the UK market showed more frequent occurrences of downward sloping yield curves. However, similar to the US market, it also experienced several years
of rather steep normal yield curves in the early parts of the decade. It will be interesting to examine the factors determining the shapes of the yield curve, how the yield
curve evolves over time, and whether the shape of the yield curve has any implications
for the real economy such as the business cycle.
There are several approaches in defining the term-stmcture
models. We shall
examine the theories of the term stmcture in terms of the one-period holding-period
yield introduced in Section 7.4. For simplicity of exposition, we assume investments
in zero-coupon bonds and relate different measures of returns to the bond prices.

To this effect, we first define some notations prior to discussing the term-structure
models.
We denote i~) as the one-period holding-period
(from time 0 to 1) yield of a
bond maturing at time n. The current time is 0 and the price of a bond at time t with
remaining n periods to mature is denoted by Pt(n). We introduce the new notation
ti~ to denote the spot rate of interest at time t for payments due r periods from t (i.e.,
due at time t + r). Thus, for t > 0, ti~ is a random variable at time 0.8 Suppose an
investor purchased an n-period bond at time 0 and held it for one-period, the bond
price at time 1 is PI (n - 1), so that the one-period holding-period yield from time
o to 1 is
PI (n - 1) - Po(n)
Po(n)

.(n)

=--------

[-[

Note that PI (n - 1) is a random variable at time 0, and so is i~). Furthermore,

given by

ti~ is

If we assume that all market participants are risk neutral (they neither avoid nor
love risks) and that they have no preference for the maturities of the investments,
then their only criterion for the selection of an investment is its expected retun? This
assumption leads to the pure expectations hypothesis, which states that the expected
one-period holding-period yields for bonds of all maturities are equal, and thus equal
to the one-period spot rate of interest (which is the one-period holding-period yield
of a bond maturing at time 1). Thus, if we denote E[i~)] as the expected value of i~)
at time 0, the pure expectations hypothesis states that
[.(17)]
1[_/

-11,

However, while the one-period holding-period yield for a I-year zero-coupon

bond is known at time 0 (i.e., if), it is unknown for bonds with longer maturities.
Thus, the bonds with longer maturities involve uncertainty and may have higher
risks. Investors may demand higher expected return for bonds with maturities longer
SIt is important

to distinguish

between

,if

and

if.

observed at time t > O. It is the spot rate applicable

time 0, determined

by the no-arbitrage

conditions

The former is an unknown

to period t to t

+ r.

and satisfies equations

quantity

at time 0 as it can only be

On the other hand,

(3.4) and (3.5).

if is a known

quantity

at

than a year, which is due to the risk premium. If the risk premium is constant
for bonds of all maturities, we have the expectations (or constant premium)
hypothesis, which states that
E[1.(n)]
H

oS

11

+ Q,

where Q is a positive constant independent of n. However, if investors prefer shortmaturity to long-maturity assets due to their better liquidity, then the expected return
for bonds with longer maturities must be higher to compensate the investors. This
leads to the liquidity premium hypothesis, which states that
E[1.(n)]
H

oS

1)

+ Q (n) ,

where the risk premium for an n-period bond Q(n) increases with n, so that Q(2) .:::
Q(3) .::: .. '. Some theorists, however, argue that investors do not necessarily prefer
short-maturity assets to long-maturity assets. Some institutions may prefer shortterm assets (e.g., banks), while others may prefer long-term assets (e.g., insurance
companies and pension funds). Thus, the risk premiums of bonds with different
maturities Q(n) may not be a mono tonic function of n, but may depend on other
covariates w(n), which are functions of the maturity n. This is called the market
segmentation hypothesis, for which we have

so that the risk premium QC,) is a function of the specific asset market. Finally, the
preferred habitat hypothesis states that institutions do not have a rigid targeted
maturity class of assets to invest, but will be influenced by the returns expected of
assets with different maturities. Thus, bonds with similar maturities will be close
substitutes of each other. Under this hypothesis, equation (7.19) is applicable and the
risk premium QC,) will be a slowly moving function of the maturity n.
We now examine the implications of the prevailing term structure for the future
movements of interest rates under the aforementioned term-structure models. Let
us consider the one-period holding-period yield of a two-period bond,
which is
given by

iW,

P) = _P1_C_1
)_-_P_o_C2_)= P_1_0_)
J-J

Po(2)

Po(2)'

_ 1

If we consider the spot rate of interest over the two-period horizon,

(1

l)2
2

_1_
Po(2)

PI(1)

x _1_
PI (1)

Po(2)

Using equation (3.4) to rewrite ( 1 +

in-,

ii, we have

(1 + /2)) (1 + is)
j-J

I I

(1 + i0)) (1 + if)
I

we have

(1 + if) (1 + if) .

Note that the left-hand side of the above equation involves two random variables, while the right-hand side involves two known quantities at time O. Now we
take expectations on both sides of the equation. If we adopt the pure expectations
hypothesis, we have E[i~;)J = if, so that equation (7.24) implies

which says that the expected value of the futun one-period spot rate is equal to
the prevailing one-period forward rate for that period. This statement is called the
unbiased expectations hypothesis, which is itself implied by the pure expectations
hypothesis. Note that equation (7.25) can be generalized to

so that the prevailing forward rates have important implications for the expected
future values of the spot rates at any time t over any horizon T.
We have seen that if the term structure is upward sloping, the forward rate of
interest is higher than the spot rate of interest. Thus, under the pure expectations
hypothesis, an upward sloping yield curve implies that the future spot rate is expected
to be higher than the current spot rate.
On the other hand, if long-term bonds command a risk premium, an upward
sloping yield curve may not imply that the spot rate is expected to rise. For example,

assuming the constant-premium

we have

model and taking expectations

of equation (7.24),

if

if -

Now as an upward sloping yield curve implies

> if, we conclude E[] if] >
Q.
However, this does not imply E[,if] >
Thus, after taking account of the risk premium, the expected future spot rate may be lower than the current spot rate even if
the term structure is upward sloping.

if.

1.

A bond's yield to maturity

is the internal rate of return an investor would achieve if she

purchases the bond at its current

coupon and principal

payments

market price and holds it until maturity, assuming all

are received as scheduled.

There

are other bond yield

measures such as current yield, nominal yield and yield to call.

2. The par yield is the coupon rate of interest of a bond such that the bond price is at par
based on the prevailing

term structure.

The par yield may be regarded

as a summary

measure of the existing term structure.

3.

The holding-period

yield is the average rate of return of a bond over the holding (multi-

ple) period. It takes account of the actual interest-on-interest

and is also called the realized compound
holding-period

yield may be computed

earned on an ex post basis,

yield or total return.

On an ex ante basis, the

under different assumed scenarios and is a useful

tool in active bond management.

4.

The term structure

method

may be estimated using bond price data in the market. The bootstrap

and the least squares method

ing spot-rate

curve. There

can be used to estimate the discrete compound-

are, however, data limitations

which restrict the use of these

methods.
5.

Assuming

continuous

compounding,

the instantaneous

using bond price data. The step function

of instantaneous

lated from a sequence of bonds with possibly irregularly

is quite versatile and has fewer data limitations.
ward rates, the spot-rate
rates.
6.

There

forward rate can be estimated

forward rates can be calcu-

spaced maturities.

Upon estimating

This method

the instantaneous

curve can be calculated by averaging the instantaneous

are several theories

that explain the determination

most widely used theOlY is probably

that the forward rate is an unbiased

the pure expectations

of the term structure.

hypothesis,

for-

forward

The

which implies

estimate of the future spot rate. The expectations

hypothesis, liquidity premium hypothesis, market segmentation

habitat hypothesis

7.1

are other competing

A $1,000 par value 10-year bond with redemption

8% payable semiannually

value of $1,080 and coupon rate of

by an investor at price P.

is purchased

(a) Find the yield to maturity of the bond if P

= $1,000.

(b) Find the yield to maturity of the bond if P

(c)

Determine

hypothesis and preferred

theories.

$1,080.

P if the yield to maturity of the bond is 8% per annum convertible

semiannually.
7.2

The following shows the information

of an investment-grade

Type of bond

Corporate bond

Issue date

March 2, 2007

Maturity

date

March 2, 2013
$1,000

Face value
Redemption

bond.

value

Coupon rate

$1,035
9% payable semiannually

If the I-year forward rates are 7% for the first 3 years and 10% for the last 3 years, find
the price of the bond at issue. What is the yield to maturity of the bond?
7.3

Louis bought a $100 par value 5-year bond with 10% semiannual coupons at a purchase
price of $94. After receiving the fifth coupon, Louis sold the bond to Raymond.

Find

the yield to maturity for Raymond, if the realized yield for Louis is 12% compounded
semiannually.
7.4

You are given the following incomplete

value 10-year bond with semiannual
redeemable

Half-year
11
12
13

bond amortization

coupons, purchased

schedule for a $1,000 par

at $864.90. The bond is not

at par.

Coupon

Effective

Amortized amount

Book

payment

interest earned

of premium

value

(a)

Find the yield to maturity of the bond.

(b) Find the redemption

value of the bond.

lHint: Study the column "amount amortized" in Table 6.3 carefully.]

7.5

The following shows the information

of a bond:

Type of bond

Non-callable municipal bond

Issue date

June 20, 2003

Maturity

date

June 20,2013

Face value

$100

Redemption

value

Coupon rate

$100
8% payable semiannually

Assume that the coupon dates of the bond are June 20 and December
Isaac bought

20 of each year.

the bond on the issue date at a price of $89. Slightly over 4 years on

August 5, 2007 Simon purchased

the bond from Isaac at a purchase

(dirty) price of

$93.70. Find
(a)

7.6

the yield to maturity of the bond upon issue.

(b)

the realized yield (internal rate of return) to Isaac on the sale of the bond.

(c)

the yield to maturity of Simon's purchase on August 5, 2007.

For a particular bond market, zero-coupon

bonds with face value $100, redeemable

at

par, are priced as follows:

bonds redeemable

in exactly 1 year are priced at $98.

bonds redeemable

in exactly 2 years are priced at $93.

bonds redeemable

in exactly 3 years are priced at $89.

bonds redeemable

in exactly 4 years are priced at $85.50.

Find the yield to maturity of a bond redeemable

at 103% of the face value in 4 years

with annual coupons of 5%.

7.7

You are given tl,at the risk-free force of interest

(j(t)

0.03,
0.03

(a)

(j(t)

+ 0.005(t

at time

is given by

for 0 < t < 5,

- 5), for t > 5.

Find aCt).

(b) A $100 par value 7-year bond has 8% semiannual

107%. Find the price of the bond.
(c)

Find the yield to maturity of the bond in (b).

coupons and is redeemable

at

7.8

If the callable bond in Exercise 6.19 has a market price of$105,

find the minimum

implied required rate of return the investor is expected to obtain.

7.9

i~, for n

Given the term structure

corresponding

'ns
1

(b)

1. 2, ... , 12, in the following table, compute

the

forward rates and par yields.

7.10 (a)

'n'F

ip

3.50%

3.80%

3
4

4.10%
4.40%

4.70%

5.00%

7
8

4.50%
4.30%

4.10%

10

3.90%

11

3.80%

12

3.50%

Rewrite equation (7.5) for an n-year semiannual

coupon bond.

Given the term structure

i~, for n

compute the corresponding

forward rates and par yields.

n
0.5

'ns

4.12%
4.38%

1.5

4.50%

4.60%

2.5

4.80%

4.50%

3.5

4.30%

4
4.5

4.35%
4.44%

4.60%

5.5

4.80%

4.84%

0.5,1,1.5,

'n

... ,6, in the following

ip

table,

eO.03t.

aCt)

eO.06+0.0025(l

+t)1,

for 0 < t S 5,
for t > 5.

A 10-year bond makes level coupon payments at years 2, 4, 6, 8 and 10. Find the par
yield of this bond.
7.12

Suppose

the yields to maturity

zero-coupon

of 6-month,

bonds are, respectively,

l2-month,

l8-month

and 24-month

10%, 8%, 7% and 6% per annum convertible

semiannually.
(a) vVhat is the 2-year par yield?
(b) Find the price of a 2-year semiannual

coupon bond with coupon rate of interest of

3.0205% per annum and face value 100.

(c)
7.13

Comment

on the result in (b).

For the bond in Exercise 6.7, determine

(a)

the nominal yield.

(b)

i/-/

for the 13th half-year period, assuming the rate of interest remains unchanged.

(a)

if-!

for the sixth year, assuming the investor can reinvest the coupons at 13% per

annum compounded
7.14

the following:

semiannually.

A $100 par value non-callable

bond has 4% semiannual

$103 after 20 years. The bond is currently

(a)

coupons and is redeemable

at

selling at $105.

Find the yield to maturity of the bond convertible yearly.

(b) If coupons can be reinvested

holding-period

at 4.5% compounded

yield convertible

yearly. Compare

semiannually,

find the 20-year

this with the answer obtained in

(a).
7.15

A $ lOO par value bond has 7.5% annual coupons and is callable at tlle end of the eighth
through the 12th years at par. The price of the bond at issue was determined
ing that tlle yield to maturity is 7%. Mary purchased

by assum-

tlle bond and held it until it was

called after 10 years.

(a)

Calculate the yield to maturity of Mary's investment

(b)

Calculate tlle 10-year holding-period

in the lO-year period.

yield of Mary if coupons can be reinvested

at only 6%.
7.16

Consider two bonds, A and B. Bond A is a 5-year 2% annual-coupon

is a 3-year 4% annual-coupon

bond, and Bond B

bond. In addition to the current spot-rate

manager assumes two scenarios of spot-rate

curve movements

curve, a fund

in tlle next 3 years:

't
t:

5.60%

5.70%

5.80%

5.60%

5.70%
5.60%

Year 3

5.40%

Scenario

Year 2

5.30%

5.50%
5.40%

UP

Year 1

5.20%

5.30%

5.50%
5.40%

Year 0

5.10%

5.20%

5.30%

5.50%
5.40%

Current spot rate

Year 0

5.00%

5.10%

5.20%

5.30%

5.40%

Year 0

4.90%

5.00%

5.10%

5.20%

5.30%

Scenario

Year 1

4.80%

4.90%

5.00%

5.10%

5.20%

DOWN

Year 2

4.70%

4.80%

4.90%

5.00%

5.10%

Year 3

4.60%

4.70%

4.80%

4.90%

5.00%

Scenario UP assumes an instantaneous

5.50%

0.1 % parallel shift upwards in the spot-rate

curve in year 0 and the shift continues annually for the next 3 years. Scenario DOWN
assumes an instantaneous

0.1 % parallel shift downwards in the spot-rate curve in year 0

and the shift continues annually for the next 3 years. If the manager has an investment
horizon of 3 years and we assume that all coupons are invested at the prevailing I-year
spot rate, what is her recommended
7.17

strategy under each scenario?

The following table gives the prices of zero-coupon and semiannual coupon bonds:
Maturity

Coupon rate r

Price per

(years)

(% per annum)

100 face value

0.5

0.0

98

1.0

0.0

95

1.5

4.0

96

2.0

6.0

97

Calculate the spot rates for maturities of 0.5, 1, 1.5 and 2 years using the bootstrap
method.
7.18

The following table gives the prices of some zero-coupon and annual-coupon

Maturity

Coupon rate

(years)

(% per annum)

100 face value

0.0

98

0.0

95

4.0

96

6.0

97

Price per

bonds:

7.19

The

following

table gives the prices of some zero-coupon

and semiannual

coupon

bonds:

7.20

Maturity

Coupon rate

(years)

(% per annum)

100 face value

0.25

0.000

99.46

0.50
1.00

0.000

98.82

2.250

99.66

1.50

2.250

99.23

2.00

2.500

2.50

2.875

99.15
99.47

3.00

3.000

99.47

3.50

3.125

99.64

4.00

100.54

4.50

3.500
3.375

5.00

3.500

99.68

Calculate

the spot rates for maturities

bootstrap

method.

Price per

99.60

of 0.25,0.5,1.0,1.5,

... and 5 years using the

The following table gives the yield to maturity of some zero-coupon

and semiannual

coupon bonds:

Maturity

Coupon rate

(years)

(% per annum)

Yield to maturity
100 face value

0.25

0.000

0.50

0.000

2.17
2.38

1.00

2.250

2.61

1.50

2.250

2.85

2.00

2.500

3.11

2.50

2.875

3.00

3.000

3.23
3.38

3.50

3.125
3.500

3.46

4.50

3.375

3.68

5.00

3.500

3.80

4.00

Calculate

the spot rates for maturities

bootstrap

method.

3.50

of 0.25,0.5,1.0,1.5,

... and 5 years using the

Advanced Problems
7.21

A 5-year 6% semiannual
5-year 2% semiannual

coupon bond with face value $100 currently

sells for $98. A

coupon bond with face value $100 currently sells for $90. What

is the current 5-year spot rate?

7.22

The

following table gives the prices of some zero-coupon

and semiannual

coupon

bonds:

Calculate

Price per

Maturity

Coupon rate

(years)

(% per annum)

100 face value

0.5

0.000

98.00

1.5

2.250

96.07

1.5

2.200

96.00

1.5

2.000

95.72

2.0

2.500

93.60

2.5

2.875

92.10

3.0

3.000

90.00

the spot rates for maturities

of 0.5, 1.0, 1.5, ... and 3 years using the least

squares method.
7.23

The cash prices of 3-month

and 9-month

zero-coupon

98.0 and 94.0, respectively. A I-year semiannual

bonds with face value 100 are

coupon bond that pays coupons of $4

every 6 months from now currently sells for $99.50. A 34-montll

coupons
of interest

of $10 starting

10 months

in tlle periods (in years): (0,

calculate the spot rates for maturities

bond that pays annual

from now sells for $103.27. Calculate

?2)' [-6, 72)' [?2' 1)

of 0.25, 0.5,1.0

and [1,2

and 1.5 years.

the force

In.

Hence,