Term Structure of Interest Rates

Goals for the Session

• Yield Curve

• Strips

• Forward Rate

• Bootstrapping
 Yield Curve

• Is a plot between yield and time to maturity.

• A pure yield curve (called the term structure) is one which plots the relationship using
the yield of zero coupon bonds.

Yield Curve
12%

10%

8%

6%

4%

2%

0%
0 1 2 3 4 5 6
 Rising Yield Curve Constant Slope Yield curve
12% 8%

7%
10%
6%
8%
5%

6% 4%

3%
4%
2%
2%
1%

0% 0%
0 1 2 3 4 5 6 0 1 2 3 4 5 6

Inverted Yield Curve

12%

10%

8%

6%

4%

2%

0%
0 1 2 3 4 5 6
 Use of Yield Curve

• Is used to price a bond or any financial asset.

• Generally the interest rate for discounting 1-year cash-flow is different from the one
which is used to discount a 2-year cash-flow and so on.

• Shape of the yield curve provides the direction of future interest rates.

• On the run yield curve is for recently issued coupon bonds selling at par or near par.
 YTM Vs Yields from yield curve

• Yield curve provides YTM’s for a specific maturity. (Zero coupon bond)

• For a coupon bond (say a 3-year, 10% bond) provides different maturity cashflows so it
is not actually a specific maturity.

• It contains a one, two and three year cashflows.

• So YTM of a 3-yr coupon bond and YTM from the yield curve will not match.
 YTM Vs Yields from yield curve: Example

• Given a 3-year, 10% bond, Face Value:100

• Compute the bond price and the YTM of the bond, given the term structure below

Rising Yield Curve

12%

10%

8%

6%

4%

2%

0%
0 1 2 3 4 5 6
• Compute the bond price by discounting the cashflows using yields from the term
structure
10 10 110
Price=(1+7%)1 + (1+8%)2 + (1+9%)3 =102.86

• Find the YTM that equates the present value of cashflows to this price.
10 10 110
102.86=(1+𝑟)1 + (1+𝑟)2 + (1+𝑟)3 , solving r = 8.87%

7% 8% 9%
0 1 2 3
10 10 110
PV using YTM 10/(1+y)^1 10/(1+y)^2 110/(1+y)^3
PV using YC 10/(1+7%)^1 10/(1+8%)^2 110/(1+9%)^3
PV using YC 9.35 8.57 84.94
Price 102.86
 Inference

• YTM of a coupon bond is the some amalgamation of return on a portfolio of different

maturity zero coupon bonds.

• Investing in a coupon bond is same as investing in different maturity zero coupon

bonds.

• This is also called as bond stripping.

 Bond Stripping

• A 10% coupon bond of maturity 3-years has the following cash-flows:

• Rs.10 payable at the end of each year for 3 years

• Rs.100 payable at maturity

• This is a mix of three zero coupon bonds of 1,2,3 year maturity paying a face
value of Rs.10 and one zero coupon bond of 3-year maturity paying a FV of
Rs.100.

• Thus a coupon bond can be stripped in series of ZCB’s and yield curve can
be used to price the coupon bond.
Given the YTM for following ZCB’s, price a 10% 3-year coupon bond
using this data. Also compute the YTM.

n YTM(%)
1 5
2 6
3 7
4 8

10 10 10 100
Price= (1+5%)1 + (1+6%)2 + (1+7%)3 + (1+7%)3 = 108.22

Computing YTM

10 10 10 100
108.22 = + + +
(1 + 𝑦)1 (1 + 𝑦)2 (1 + 𝑦)3 (1 + 𝑦)3

YTM=6.88%
 Yield Curve Under certainty

• Given 1-year rate at 8% while 2-yr rate at 9%, as per the yield curve. Under certainty
all rates should be same since there is no risk. Then why are they different?

• Consider an investor with a holding period of 2-yr. She can invest either in a 2-yr
instrument or in a 1-yr instrument now and then invest the proceeds after 1-yr again
in a 1-yr instrument

• By arbitrage principle the return earned should be same.

The mathematical way of understanding is that a two year interest rate is a product of two single year
interest rates assuming no arbitrage exists i.e.
1 + 𝑟1 ∗ 1 + 𝑓1 = (1 + 𝑟2 )2
Where 𝑟1: is 1-year interest rate
𝑓1 : is 1-year rate 1-year after also called as forward rate
𝑟2: is 2-year interest rate
Given 𝑟1 = 8%, 𝑟2 = 9% 𝑓1 can be arrived as

1 + 𝑟1 ∗ 1 + 𝑓1 = 1 + 𝑟2 2

1 + 8% ∗ 1 + 𝑓1 = (1 + 9%)2
(1 + 9%)2
1 + 𝑓1 =
1 + 8%

𝑓1 = 10%
 Inference

• A 2-yr rate is a combination on 1-yr rate and 1-yr rate after one year. Higher interest
rate for 2-year bonds imply that interest rates for 1-yr maturing instruments are
expected to change from one year to the next.
 Forward Rates

Forward Rate: Implied future rate from the term structure

Future short rate: expected short term interest rate in future i.e. 1-yr rate 1-yr after or 1-yr
rate 2-yr after.

As per expectations hypothesis forward rate equals the market consensus expectation of the
future short interest rate.

(1  rn ) n
(1  f n ) 
(1  rn 1 ) n 1
A upward sloping yield curve indicates that the market
expects the future short term rate to be higher than the
current short term rate.
12

10

8
Rate

0
0 5 10 15 20 25
Year
A downward sloping yield curve indicates that the market
expects the future short term rate to be lower than the
current short term rate.
12%

10%

8%

6% Series1

4%

2%

0%
0 2 4 6 8 10 12 14
A flat yield curve indicates that the market expects the future
short term rate to be equal to the current short term rate.

9%

8%

7%

6%

5%

4%

3%

2%

1%

0%
0 2 4 6 8 10 12 14 16 18
Given the price of zero coupon bonds of 1,2,3 and 4 year maturity.
1. Calculate the YTMs.
2. The implied forward rates.
3. The expected price path of 4-year bond as time passes.

Maturity Price
1 943.4
2 898.47
3 847.62
4 792.16
Given the price of zero coupon bonds of 1,2,3 and 4 year maturity.
(a) Calculate the YTMs.

Maturity Price
1 943.4
2 898.47
3 847.62
4 792.16
 Computing the YTM’s

Bond 0 1 2 3 4
1 943.4 1000
2 898.47 1000
3 847.62 1000
4 792.16 1000

1000
943.4= , 𝑔𝑖𝑣𝑒𝑠 𝑟1 = 6%
1+𝑟1 1

898.47= 1000/(1 + 𝑟2 ) 2 , 𝑔𝑖𝑣𝑒𝑠 𝑟2 = 5.5%

847.62= 1000/(1 + 𝑟3 ) 3 , 𝑔𝑖𝑣𝑒𝑠 𝑟3 = 5.67%

792.16= 1000/(1 + 𝑟4 ) 4 , 𝑔𝑖𝑣𝑒𝑠 𝑟4 = 6%

Given the price of zero coupon bonds of 1,2,3 and 4 year maturity.
(a) Calculate the YTMs.
(b) The implied forward rates.

Maturity Price
1 943.4
2 898.47
3 847.62
4 792.16
 Computing the Forward Rates

Bond YTM
1 6% 1 + 6% ∗ 1 + 𝑓1 = (1 + 5.5%)2
2 5.5% 𝑓1 =5%
3 5.67%
4 6% (1 + 5.5%)2 ∗ 1 + 𝑓2 = (1 + 5.67%)3

𝑓2 = 6%

(1 + 5.67%)3 ∗ 1 + 𝑓3 = 1 + 6% 4

𝑓3 =7%
1-year rate today 6%
1-year rate 1-year after 5%
1-year rate 2-yr after 6%
1-year rate 3-yr after 7%
Given the price of zero coupon bonds of 1,2,3 and 4 year maturity.
(a) Calculate the YTMs.
(b) The implied forward rates.
(c) The expected price path of 4-year bond as time passes.

Maturity Price
1 943.4
2 898.47
3 847.62
4 792.16
 The expected price path of 4-year bond as time passes

Forward
rates 6% 5% 6% 7%
Bond 0 1 2 3 4

1000/(1+7%)*(1+6%)*(1+5%) 1000/(1+7%)*(1+6%) 1000/(1+7%)

Price 792.16 839.69 881.68 934.58 1000

 Maturity YTM F
1 6.00% 6.00%
2 5.50% 5.00%
3 5.67% 6.00%
4 6.00% 7.00%

Maturity Price YTM F Price

1 943.4 6.00% 6.00% 792.16
2 898.47 5.50% 5.00% 839.6862
3 847.62 5.67% 6.00% 881.6766
4 792.16 6.00% 7.00% 934.5697
Prices of zero-coupon bonds reveal the following pattern of forward
rates: Year forward rate(%)
1-yr rate today 5
1-yr rate after 1 yr 7
1-yr rate after 2 yr 8

In addition to the zero-coupon bond, investors also may purchase a 3-

year bond making annual payments of $60 with par value Rs.1000.

a) What is the price of the coupon bond?

 0 1 2 3
60 60 1060
Present Value 60/1.05 60/(1.07)*(1.05) 1060/(1.08)*(1.07)*(1.05)
984.14 57.14 53.40 873.59
Prices of zero-coupon bonds reveal the following pattern of forward
rates: forward
Year rate(%)
1 5
2 7
3 8

In addition to the zero-coupon bond, investors also may purchase a 3-

year bond making annual payments of $60 with par value Rs.1000.

a) What is the price of the coupon bond?

b) What is the yield to maturity of coupon bond?
 0 1 2 3
60 60 1060
Present Value 60/1.05 60/(1.07)*(1.05) 1060/(1.08)*(1.07)*(1.05)
984.14 57.14 53.40 873.59

(b) YTM=6.60%
Prices of zero-coupon bonds reveal the following pattern of forward
rates: forward
Year rate(%)
1 5
2 7
3 8

In addition to the zero-coupon bond, investors also may purchase a 3-

year bond making annual payments of $60 with par value Rs.1000.

a) What is the price of the coupon bond?

b) What is the yield to maturity of coupon bond?
c) Under expectations hypotheses, what is the expected realized
compound yield of the coupon bond?
 0 1 2 3
60 60 1060
Present Value 60/1.05 60/(1.07)*(1.05) 1060/(1.08)*(1.07)*(1.05)
984.14 57.14 53.40 873.59

Payment received Will grow by To a future

Period
at end of period: a factor of: value of:
(b) YTM=6.60%
1 $60.00 1.07  1.08 $69.34

2 $60.00 1.08 $64.80

(c ) Realized yield=6.66%
3 $1,060.00 1.00 $1,060.00
$1,194.14
Prices of zero-coupon bonds reveal the following pattern of forward
rates: forward
Year rate(%)
1 5
2 7
3 8

In addition to the zero-coupon bond, investors also may purchase a 3-

year bond making annual payments of $60 with par value Rs.1000.

a) What is the price of the coupon bond?

b) What is the yield to maturity of coupon bond?
c) Under expectations hypotheses, what is the expected realized
compound yield of the coupon bond?
d) If you forecast that the yield curve in 1-year will be flat at 7%, what
is your forecast for the expected return on the coupon bond for 1-
year holding period?
 0 1 2 3
60 60 1060
Present Value 60/1.05 60/(1.07)*(1.05) 1060/(1.08)*(1.07)*(1.05)
984.14 57.14 53.40 873.59

Payment received Will grow by To a future

Period
at end of period: a factor of: value of:
(b) YTM=6.60%
1 $60.00 1.07  1.08 $69.34

2 $60.00 1.08 $64.80

(c ) Realized yield=6.66%
3 $1,060.00 1.00 $1,060.00
$1,194.14

(d) Next year, the price of the bond will be:

[$60 × Annuity factor (7%, 2)] + [$1,000 × PV factor (7%, 2)] = $981.92
Therefore, there will be a capital loss equal to: $984.10 – $981.92 = $2.18

The holding period return is: $60  ($2.18)  0.0588  5.88%

$984.10
 Term structure in an uncertain world

• A short term investor wishing to invest in 1-yr security (zero coupon) can’t be
persuaded to invest in 2-yr zero coupon since the 1-yr interest rate after 1-yr may not
be as expected. There is a risk.

• If the 1-yr rate after 1-yr is more than the expectation, then his yield would be less
than what he could have earned by investing in a simple 1-yr instrument.

• The investor thus wants a higher return to bear this risk. This is called as the liquidity
premium.

• Since the coupon is fixed, his return is higher only if the purchase price is lesser than
estimated by the equilibrium relationship.
 Theory of Term Structure

Expectation Hypothesis

Forward Rate: Implied future rate from the term structure

Future short rate: expected short term interest rate in future i.e. 1-yr rate 1-yr after or 1-yr
rate 2-yr after.

In times of certainty forward rate equals the market consensus expectation of the future
short interest rate.
 …Theory of term structure

Liquidity Premium Theory

• Long term bonds are more risky than the short term bonds
• Investors demand a premium for bearing the risk of holding a long term bond.

According to this theory the forward rate would exceed the future short rate. This excess is
called the liquidity premium.

Forward rate =liquidity premium + future short rate.

1-year zero coupon bond is trading at a yield of 10% while a two year is trading at
10.5%. If the short term rates remain constant (expected short term rate one year
hence =10%) then how much premium is the investor demanding to hold a two year
bond?

(1  10%) * (1  r )  (1  10.5%) 2

r  11% Implied forward rate

The investor is asking for 1% premium to hold the 2-year zero coupon bond. The 1% is
the difference between the implied forward rate and the expected short term rate.
 Interpreting the term structure

Given an upward sloping yield curve:

Can we assume that interest rates are going to rise?

Not necessary. The upward slope can be on account of liquidity

premium.
 Term structure in an uncertain world
Given that the spot 1-yr interest rates are at 7%. Also assuming that short rate after 1-
yr and 2-yr is expected to remain at 7%.

What would be the 2-yr rate and 3-yr rate?

In certain world would be 7%.

However in uncertain world, the forward rate would be more than the short rate on
account of liquidity premium demanded by the investor.
 Term structure in an uncertain world
Assuming constant liquidity premium of 1%, the two year rate is

(1+y2)2 =(1+7%)*(1+8%) , y2=7.5%

Similarly , (1+y3)3 =(1+7%)*(1+8%)*(1+8%), y3=7.67%

And so on.

This is what is the liquidity premium theory, which states that since most of
the investors are short term so they need a premium to move from short
term investment to long term investment.

This results in upward sloping yield curve, even when the interest rates are
not expected to rise in future.
 Bootstrapping: Inferring Zero coupon yields from Coupon Bonds

Using the following data on coupon bonds, construct the term structure of interest rates
after computing the zero-coupon yields for various maturities.

Coupon Rate (%) Maturity (in years) Current Price

2 1 100
3 2 100.5
4 3 101
5 4 102
6 5 103
7 6 104
8 7 105
8.5 8 106
9 9 107
9.5 10 110
10 11 109.5
10.5 12 111
Assuming annual coupons, we can infer that 1-yr rate to be 2%.
For 2-yr maturity bond we can write the following:
3 103
100.5 = 1
+ 2
, 𝑔𝑖𝑣𝑒𝑛 𝑟1 = 2%, 𝑤𝑒 𝑐𝑎𝑛 𝑐𝑜𝑚𝑝𝑢𝑡𝑒 𝑟2 = 2.75%
(1 + 𝑟1 ) (1 + 𝑟2 )
For 3-yr maturity bond we can write the following:

4 4 104
101 = 1
+ 2
+ 3
, 𝑔𝑖𝑣𝑒𝑛 𝑟1 = 2%, 𝑟2 = 2.75%,
(1 + 𝑟1 ) (1 + 𝑟2 ) (1 + 𝑟3 )

𝑤𝑒 𝑐𝑎𝑛 𝑐𝑜𝑚𝑝𝑢𝑡𝑒 𝑟3 = 3.69%

Coupon (%) Maturity Date Price Yield
2 1 100
2.00%
3 2 100.5
2.75%
4 3 101
3.69%
5 4 102
4.55%
6 5 103
5.52%
7 6 104
6.58%
8 7 105
7.73%
8.5 8 106
8.25%
9 9 107
8.83%
9.5 10 110
8.98%