THE TERM STRUCTURE AND

INTEREST RATE DYNAMICS

CHAPTER 10

© 2016 CFA Institute. All rights reserved.

TABLE OF CONTENTS
01 INTRODUCTION
02 SPOT RATES AND FORWARD RATES
03 THE SWAP RATE CURVE
04 TRADITIONAL THEORIES OF THE TERM STRUCTURE OF
INTEREST RATES
05 MODERN TERM STRUCTURE MODELS
06 YIELD CURVE FACTOR MODELS
07 SUMMARY

2
 1. INTRODUCTION
• Interest rates are both a barometer of the economy and an
instrument for its control.
• The term structure of interest rates—market interest rates
at various maturities—is a vital input into the valuation of
many financial products.
• The goal of this topic is to explain the term structure and
interest rate dynamics—that is, the process by which the
yields and prices of bonds evolve over time.

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 2. SPOT RATES AND FORWARD RATES
•   any point in time, the price of a risk-free single-unit payment (e.g., $1)
At
at time T is called the “discount factor” r with maturity T, denoted by
P(T).

Spot rate • The yield to maturity of the payment, denoted by r(T)

• The spot curve represents the term structure of interest rates at any
point in time.
- The spot curve shows, for various maturities, the annualized return on an
option-free and default-risk-free zero-coupon bond with a single payment
of principal at maturity.

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 SPOT RATES AND FORWARD RATES
Forward • It is an interest rate that is determined today for a
rate loan that will be initiated in a future time period.

• The term structure of forward rates for a loan made on a specific

initiation date is called the “forward curve.”
- Forward rates and forward curves can be mathematically derived
from the current spot curve.

When the spot curve is

upward sloping, the Conversely, when the spot
forward curve will lie curve is downward sloping,
above the spot curve. the forward curve will lie
below the spot curve.

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 FORWARD PRICING MODEL
••  The forward pricing model describes the valuation of
forward contracts.
• The forward pricing model can be expressed in terms
of rates, which is the forward rate model:

where r(T*+T) is the spot rate for the time (T*+T) and
f(T*,T) is T years forward rate T* years from now.

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 SPOT AND FORWARD PRICES AND RATES
•  
Example. Consider the following spot rates:
Maturity (T) 1 2 3
Spot rates r(1) = 9% r(2) = 10% r(3) = 11%

Calculate f(1,1), f(2,1) and f(1,2).

Solution:
1)

2)

3)

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 PAR CURVE AND BOOTSTRAPPING
When spot rates cannot be observed directly from the market,
they can be generated through a process of forward
substitution called “bootstrapping.”
In this process, the par curve is
used to construct a zero-
coupon yield curve. Par yields
are used to solve for the zero- Bootstrapped spot rates are
coupon rates one by one, in called “implied spot rates.”
order from earliest to latest
maturities.
•  
Example: One-year par rate = 5%, Two-year par rate = 5.97%.
Bootstrap the two-year zero-coupon rate by solving the following
equation in terms of one monetary unit of current market value
and r(1) = 5%:

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 YIELD TO MATURITY IN RELATION TO SPOT
RATES AND BOND RETURNS
• The yield to maturity (YTM) is the expected rate of return for a
bond only if the bond is held until its maturity; no defaults on
payments and coupons are reinvested at the original YTM.
- However, the assumption regarding the reinvestment of coupons at
the original yield to maturity typically does not hold.
• The YTM is a poor estimate of expected return if the following
applies:
• Interest rates are volatile.
1
• The yield curve is steeply sloped.
2
• There is a significant risk of default.
3
• The bond has embedded options.
4

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 YIELD CURVE MOVEMENT AND
THE FORWARD CURVE
• An important observation about forward prices and the spot yield
curve is that the forward contract price remains unchanged as
long as future spot rates evolve as predicted by today’s forward
curve.

A change in the forward price reflects a deviation of the spot

curve from that predicted by today’s forward curve.

• If one expects that the future spot rate will be lower/higher than
what is predicted by the prevailing forward rate, the forward
contract value is expected to increase/decrease.
To capitalize on this expectation, the trader would buy/sell the
forward contract.

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 YIELD CURVE MOVEMENT AND
THE FORWARD CURVE
• The riding the yield curve strategy assumes an upward-sloping
yield curve where the forward curve is always above the current
spot curve.
• If the trader does not believe that the yield curve will change its
level and shape over an investment horizon, then buying bonds
with a maturity longer than the investment horizon would provide
a total return greater than the return on a maturity-matching
strategy.
Spread
The total
between the
return of the The maturity of
forward rate
bond will the bond
and the spot
depend on:
rate

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 3. THE SWAP RATE CURVE
Interest rate swaps are derivative contracts, where one
party exchanges fixed-rate interest payments for floating-
rate interest payments with another party.

The swap rate is the

Floating rates are based
interest rate for the
on some short-term
fixed-rate leg of an
reference interest rate.
interest rate swap.

The level of the swap

rate is such that the The yield curve of swap
swap has zero value at rates is called the
the initiation of the swap “swap curve.”
agreement.

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 THE SWAP RATE CURVE
The swap rate curve (versus the government spot curve) might be
used in fixed-income valuation depending on the business
operations of the institution using the benchmark.
For example, wholesale banks frequently use the swap curve to
value assets and liabilities because these organizations hedge
many items on their balance sheets with swaps.

Swap contracts are non-standardized and are simply customized

contracts between two parties in the over-the-counter market.

The fixed payment can be specified by an amortization schedule

or be coupon paying with non-standardized coupon payment
dates.

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 THE SWAP SPREAD

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”
government security with the same maturity as the swap.

Often, fixed-income prices will be quoted in SWAPS +,

for which the yield is simply the yield on an equal-
maturity government bond plus the swap spread.

Example. If the fixed rate of a five-year fixed-for-float Libor

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.

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 THE LIBOR/SWAP CURVE
A Libor/swap curve is probably the most widely used interest
rate curve because it is often viewed as reflecting the default
risk of private entities at a rating of about A1/A+, roughly the
equivalent of most commercial banks.

The swap • Time value

spread helps an • Credit
investor to • Liquidity components of a bond’s
identify: yield to maturity

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.

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 Z-SPREAD

Zero-spread • A more accurate measure of credit and

(Z-spread) liquidity than swap spreads

The Z-spread is the constant basis point spread that would need
to be added to the implied spot yield curve so that the discounted
cash flows of a bond are equal to its current market price.

This spread will be more accurate than a

linearly interpolated yield, particularly with
steep interest rate swap curves.

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TED SPREAD AND LIBOR–OIS SPREAD

• Calculated as the difference between

Libor and the yield on a T-bill of matching
TED maturity
spread • An indicator of perceived credit risk in the
general economy

• The difference between Libor and the

LIBOR– overnight indexed swap (OIS) rate
OIS • An indicator of the risk and liquidity of
spread
money market securities

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 4. TRADITIONAL THEORIES OF THE TERM
STRUCTURE OF INTEREST RATES

Pure expectations theory Liquidity preference theory

There are four

traditional theories
of the term
structure of interest
rates.

Segmented markets theory Preferred habitat theory

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 PURE EXPECTATIONS THEORY

The pure expectations theory says that the forward rate is an

unbiased predictor of the future spot rate.

• Its broadest interpretation suggests that investors expect the

return for any investment horizon to be the same.
• The narrower interpretation—referred to as the local
expectations theory—suggests that the return will be the same
over a short-term horizon starting today.

(1  zT )   (1  z1 )(1  f1, 2 )    (1  fT 1,T )

1/ T

Under pure expectations theory, the shape of the yield curve

reflects the expectation about future short-term rates.

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 LIQUIDITY PREFERENCE THEORY

The liquidity preference theory makes the following assertion:

• Liquidity premiums exist to compensate investors for the added

interest rate risk they face when lending long term, and these
premiums increase with maturity.

(1  zT )   (1  z1 )(1  f1, 2  L2 )    (1  fT 1,T  LT )

1/ T

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

liquidity preference theory predicts an upward-sloping yield
curve.

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 SEGMENTED MARKETS AND
PREFERRED HABITAT THEORIES
The segmented markets theory assumes that market participants are
either unwilling or unable to invest in anything other than securities of
their preferred maturity.
• It follows that the yield of securities of a particular maturity is
determined entirely by the supply and demand for funds of that
particular maturity.

The preferred habitat theory also assumes that many borrowers and
lenders have strong preferences for particular maturities.

• However, if the expected additional returns to be gained become

large enough, institutions will be willing to deviate from their
preferred maturities or habitats.

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 5. MODERN TERM STRUCTURE MODELS
• Modern term structure models provide quantitatively
precise descriptions of how interest rates evolve.
• Interest rate models attempt to capture the statistical
properties of interest rate movements.

Two major types of

such models

General equilibrium,
Arbitrage-free models,
including Vasicek and
including the Ho–Lee
Cox–Ingersoll–Ross (CIR)
model
models

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 MODERN TERM STRUCTURE MODELS
• Equilibrium term structure models are models that seek to
describe the dynamics of the term structure using
fundamental economic variables that are assumed to affect
interest rates.
• They share the following characteristics:

They are one-factor or multifactor models.

They make assumptions about the behavior of factors.

They are, in general, more sparing with respect to the number

of parameters that must be estimated compared with arbitrage-
free term structure models.

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 CIR MODEL
• The
  CIR model assumes that every individual has to make
consumption and investment decisions with his or her limited
capital. The CIR model can explain interest
rate movements in the following terms:

An individual’s preferences for The risks and returns of the

investment and consumption productive processes of the economy

where dr and dt = infinitely small increments of short-term interest rate

and time, respectively; a deterministic part, where b = a long-run value of
interest rate and a = a positive parameter; = a stochastic part, which
models risk and follows the random normal distribution with a mean of
zero; is the standard deviation factor.
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 VASICEK MODEL

••  The Vasicek model is similar to CIR model.

• It has the same drift term as the CIR model and

thus tends toward mean reversion in the short
rate.

• Unlike the CIR model, interest rates are

calculated assuming that volatility remains
constant over the period of analysis.

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ARBITRAGE-FREE MODELS: THE HO–LI MODEL
•   arbitrage-free models, the analysis begins with the observed
In
market prices of a reference set of financial instruments and the
underlying assumption is that the reference set is correctly
priced.

An assumed random process with a drift term and volatility

factor is used for the generation of the yield curve.

These models are called “arbitrage-free” because the

prices they generate match market prices.

The Ho-Lee model is expressed as .

- The model can be calibrated to market data by inferring the
form of the time-dependent drift term, , from market prices.

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 6. YIELD CURVE FACTOR MODELS

• defined as the sensitivity of a bond’s price to

Shaping risk
the changing shape of the yield curve

• For active bond management, a bond investor may want to base

trades on a forecasted yield curve shape or may want to hedge
the yield curve risk on a bond portfolio.
• defined as a model or a description of yield
A yield curve
curve movements that can be considered
factor model
realistic when compared with historical data

• Litterman and Scheinkman (1991) decomposed yield curve

movements into a combination of three independent movements,
which they interpreted as level, steepness, and curvature.

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 FACTORS AFFECTING THE SHAPE
OF THE YIELD CURVE

The method to determine the number of

factors—and their economic
interpretation—begins with a
measurement of the change of key rates
on the yield curve.
Then, the historical variance/covariance matrix
of these interest rate movements is obtained.
The next step is to try to
discover a number of
independent factors that can
explain the observed
variance/covariance matrix.
• The approach that focuses on identifying the factors that best
explain historical variances is known as principal components
analysis (PCA).

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 YIELD CURVE RISK
•  
Yield curve risk can be managed on the basis of several measures
of sensitivity to yield curve movements:

1 Effective duration, which measures the sensitivity of a bond’s

price to a small parallel shift in a benchmark yield curve.

Key rate duration, which measures a bond’s sensitivity to a

2 small change in a benchmark yield curve at a specific
maturity segment.

- We can calculate a measure based on the decomposition of yield

curve movements into parallel, steepness, and curvature movements:

where DL, DS, and DC = sensitivities of portfolio value to small changes

in the level, steepness, and curvature factors, respectively; is change
in respective factors.

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 THE MATURITY STRUCTURE OF
YIELD CURVE VOLATILITIES

• Quantifying interest rate volatilities is important for at least two

reasons:
The values of bonds with embedded options crucially depend
on the level of interest rate volatilities.
Risk management includes controlling the impact of interest
rate volatilities on the instrument’s price volatility.

• The term structure of interest rate volatilities is a representation

of the yield volatility of a zero-coupon bond for every maturity of
security.
• This volatility curve (or “vol”) or volatility term structure
measures yield curve risk.
- The volatility term structure typically shows that short-term rates are
more volatile than long-term rates.

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 7. SUMMARY

Relationships among spot rates, forward rates, yield to

maturity, expected and realized returns on bonds, and the
yield curve

• 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.

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 7. SUMMARY

Forward pricing and forward rate models

• 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., a T*-period zero-coupon
bond earns the T*-period forward rate as it rolls down to be
a T* – 1 period security). This 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.

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 SUMMARY
Spot rates in relation to forward rates in active bond portfolio
management
• Active bond portfolio management is consistent with the
expectation that today’s forward curve does not accurately
reflect future spot rates.

Swap rates, swap, and other spread measures

• The swap curve provides another measure of the time value
of money.
• The swap spread, the I-spread, and the Z-spread are bond-
quoting conventions that can be used to determine a bond’s
price.
• Swap curves and Treasury curves can differ because of
differences in their credit exposures, liquidity, and other
supply/demand factors.

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 SUMMARY

Maturity structure of yield volatilities

• The volatility term structure can be measured using

historical data and depicts yield curve risk.
• The sensitivity of a bond value to yield curve changes may
make use of effective duration; key rate durations; or
sensitivities to parallel, steepness, and curvature
movements. Using key rate durations or sensitivities to
parallel, steepness, and curvature movements allows one to
measure and manage shaping risk.

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 SUMMARY
Term structure theories and models
• The local expectations theory, liquidity preference theory,
segmented markets theory, and preferred habitat theory
provide traditional explanations for the shape of the yield
curve.
• Modern finance seeks to provide models for the shape of the
yield curve and the use of the yield curve to value bonds
(including those with embedded options) and bond-related
derivatives. General equilibrium and arbitrage-free models
are the two major types of such models.
Factors driving the yield curve
• Historical yield curve movements suggest that they can be
explained by a linear combination of three principal
movements: level, steepness, and curvature.

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