Fixed Income Securities

Session -3

Term Structure of Interest Rates

Learning Objectives
Yield Measures
Term Structure of Interest Rates
Spot Rates
Zero Coupon Yield Curve

Forward Rates
2

Learning Objectives
Yield Measures
Term Structure of Interest Rates
Spot Rates
Zero Coupon Yield Curve

Forward Rates
3

Term Structure of Interest Rates

Relationship between maturities and yields/spot rates
in the bond market
Such graph is called yield curve
Short term rates are determined by the monetary policies, but
Long term interest rates indicates the investors expectations about:
Future inflation
Future interest rates
Demand supply of bonds of various maturities

But traded prices are available only for a few bonds

and maturities
Interpolation techniques are used to fill those data gaps

Term structure is usually upward sloping but it may

be declining, Flat or humped as well !
4

Why Term Structure of Interest Rates is Reqd.

For some maturity dates, no issues are available
It is difficult to estimate the correct yield at any given
maturity time
Term structure provide a benchmark which in turn
provides estimates of yield for all maturity dates
Shape of yield curve captures and summarize the cost
of credit for loans of various maturities
Spot rates and forward rates are implied by the term
structure

Types of Yield Curves

Rising

Declining

Flat

Humped

Term Structure of Interest Rates

: Current Status

Snapshot of regularly traded G-Secs.

First task is to fill the data gaps through interpolation
Security name

7.17% GOVT.STOCK 2015

7.83% GOVT.STOCK2018
8.19% GOVT.STOCK 2020
7.80% GOVT.STOCK 2021
8.79% GOVT.STOCK 2021
8.13% GOVT.STOCK 2022
9.15% GOVT.STOCK 2024
8.26% GOVT.STOCK 2027
8.97% GOVT.STOCK 2030
8.83% GOVT.STOCK 2041

ytm

Year of maturity

8.2014

2015

8.6869

2018

8.7619

2020

8.5662

2021

8.7471

2021

8.7152

2022

8.8402

2024

8.8016

2027

9.0099

2030

8.5756

2041

*Ref date: 05 June, 2012, Source: RBI

Learning Objectives
Yield Measures
Term Structure of Interest Rates
Spot Rates
Zero Coupon Yield Curve

Forward Rates
8

Spot Interest Rates

Yield on zero coupon bond is called the spot rate
The equilibrium price of a bond is the price obtained by
discounting the bonds CFs by spot rates
If this price does not hold, then an arbitrage opportunity exist
By buying the bond and stripping it into a series of ZCBs and selling
them
Or by buying ZCBs, bundling them, and then selling the bundled bond

But ZCBs with all the maturities are not available for trade
In such case spot rates are derived by term structure of interest rates
Bootstrapping method is used to arrive at the spot rates for different
maturities

Spot Interest Rates: Equilibrium Price

Let St = spot rate on a bond with a maturity of t
Assume: S1 = 7%, S2 = 8%, and S3 = 9%
The equilibrium price, P0*, of a 3-year, 8% coupon
bond (paid annually) with F = 100 is:
C3 F
C1
C2
P

1
2
(1 S1 )
(1 S2 )
(1 S3 )3
*
0

$8
$8
$108
P

$97.73
1
2
3
(1.07)
(1.08)
(1.09)
*
0

Suppose the market prices of the 3-year, 8% bond is

95
10

Spot Interest Rates : Equilibrium PriceContd

Arbitrage Strategy

Buy the bond for 95

Form three stripped ZCBs and sell them:
1-Year ZCB with F = 8: Selling Price = 8/1.07 = 7.4766
2-Year ZCB with F = 8: Selling Price = 8/(1.08)^2 = 6.8587
3-Year ZCB with F = 108: Selling Price = 108(1.09)^3 = 83.3958
Sale of strip bonds = 97.73

Risk-free profit = 97.73-95.00 = 2.73

Arbitrageurs would implement this strategy of buying and
stripping the bond until the price of the coupon bond reached
to its equilibrium price i.e., $97.73

11

Term Structure of Spot Rates

12

Estimating Spot Rates: Bootstrapping

One problem in valuing bonds with spot rates or in
creating stripped securities
Not enough longer-term pure discount bonds available to determine the
spot rates on higher maturities.
Therefore, long-term spot rates have to be estimated

One estimating approach that can be used is a

sequential process commonly referred to as
bootstrapping
(1) The approach requires having at least one pure discount bond
(2) Given this bond's rate, a coupon bond with the next highest maturity
is used to obtain an implied spot rate
(3) Then another coupon bond with the next highest maturity is used to
find the next spot rates, and so on
13

Estimating Spot Rates: Bootstrapping

Maturity

Annual Coupon

Principal

Price

1 Year
2 Years
3 Years

7%
8%
9%

100
100
100

100
100
100

S1 .07 :
100

107
(1 S1 )1

107
S1
1 .07
100

S2 .08042 :
100

8
108

1.07
(1 S2 ) 2

108
108
95.52

2
95.52
(1 S2 ) 2

1/ 2

1 .08042

S3 .0912 :
100

9
9
109

1.07
(1.08042) 2
(1 S3 ) 3

109
109
83.88

3
83.88
(1 S3 ) 3

1/ 3

1 .0912

Explanation of Term Structure: Forward Rates

15

Expected Spot rates and Forward Rates

16

Relationship btw Spot Rates and Forward Rates

What will be the spot rate over year 2?

This is not known at date 0.
What will be the price of the two year bond at date 1?
One will make expectations about spot rates.

It may be 6%, 7%, .,14%......

The amount the bond is expected to sell at date 1 will be
= 1210/ (1+ spot rate expected over year 2)
Expectation of individuals may vary therefore the bond price
at date 1 will vary as well. (what will be consensus expected
value?)
what will be the bond price at date 1 forecasted at date 0
17

Relationship btw Spot Rates and Forward Rates

An investor can choose one of the two strategies
1) Buy a one year bond
2) Buy a two year bond and sell it at date 1 at
= 1000* 1.1*1.1 / (1+ spot rate expected over year 2)
= 1000*1.08* 1.2104 / (1+ spot rate expected over year 2)
Expected returns from both the strategies will be same if (1+
spot rate expected over year 2) = 1.2104 (i.e. forward rate over
year two)

18

Theories Explaining The Term Structure

The actual shape of the yield curve depends on:
The types of bonds under consideration (e.g., AAA bond versus
B bond)
Economic conditions (e.g., economic growth or recession, tight
monetary conditions, etc.)
The maturity preferences of investors and borrowers
Investors' and borrowers' expectations about future rates,
inflation, and the state of economy.

There are three popular explanations of the term structure

of interest rates (i.e., why the yield curve is shaped the
way it is):
The expectations hypothesis
The liquidity preference hypothesis
The market segmentation hypothesis (preferred habitats)

19

The (Pure) Expectations Hypothesis

PEH: Shape of the yield curve is explained by
expectations of interest rates
Forward rates exclusively represent expected future rates
If interest rates are expected to rise, the yield curve slopes
upward
If interest rates are expected to fall, the yield curve slopes
downward

Expectation theories address the question of what impact

expectations have on the current yield curve
PEH posits that the yield curve is governed by the
condition that the implied forward rate is equal to the
expected spot rate
Forward price = spot rate expected over period 2

20

The Expectations HypothesisContd

Consider a market consisting of only two bonds: a riskfree one-year zero-coupon bond and a risk-free two-year
zero-coupon bond, both with principals of $100
Suppose that supply and demand conditions are such that
both the one-year and two-year bonds are trading at an
8% YTM
Suppose that the market expects the yield curve to shift
up to 10% next year, but, as yet, has not factored that
expectation into its current investment decisions
Finally, assume the market is risk-neutral

21

The Expectations HypothesisContd

What will be the impact of the expectation on the current yield
curve?
Consider investors with investment horizon = 2 years
Alternatives:
Buy 2-year bond at 8% (Scenario I)
Buy a series of 1-year bonds: 1-year bond today at 8% and 1-year bond
one year later at E(r12) = 10%. The expected return from the series
would be 9%: (Scenario II)

YTM 2:Series (1.08)(1.10)

1/ 2

1 .09

In a risk-neutral world, investors with investment horizon 2 years

would prefer the series of 1-year bonds (Scenario -II) over the 2-year
bond (Scenario -I)
22

The Liquidity Preference Hypothesis

In PEH we assume that the investors are risk neutral
What if investors are averse to risk
Which strategy would appear more risky?
Invest in a one year bond
Invest in a two year bond and sell it after one year

Investors can choose second strategy only if the

returns are higher than in strategy 1
If Forward price> spot rate expected over period 2

23

The Liquidity Preference Hypothesis

LPH also called Risk Preference Hypothesis contends
Long-term bonds are more price sensitive to interest
rate changes than short-term bonds
As a result, the prices of long-term securities tend to be
more volatile and therefore more risky than short-term
securities
Investors require a premium for the increased volatility for
long-term investments as compared to short term
investments
Thus, it suggests that, all other things being equal, longterm rates should be higher than short-term rates

Note: Implies an always upward sloping yield curve

There is good evidence that such premiums exist
24

The Market Segmentation Hypothesis (MSH)

Market segmentation (preferred habitat) Hypothesis Different groups of investors have different maturity needs
and they confine their selection of bands to certain
segments of yield curve. Thus, shape of yield curve is
dependent on relative supply/demand in each segment.
MSH assumes that investors and borrowers are willing to
give up their desired maturity segment and assume market
risk if rates are attractive
S
D

S
D

Insurance
Companies

Banks

25

The Market Segmentation Hypothesis

Example: The yield curve for high quality corporate
bonds could be segmented into two markets:
(1) Sort-Term Market
The supply of short-term corporate bonds, such as commercial
paper would depend on business demand for short-term assets
such as inventories, accounts receivables
The demand for short-term corporate bonds would emanate from
investors looking to invest their excess cash for short periods.

(2) Long-Term Market

The supply of long-term bonds would come from corporations
trying to finance their long-term assets (plant expansion,
equipment purchases, acquisitions, etc.)
The demand for such bonds would come from investors, either
directly or indirectly through institutions (e.g., pension funds,
mutual funds, insurance companies, etc.), who have long-term
liabilities and horizon dates
26

Learning Objectives
Yield Measures
Term Structure of Interest Rates
Spot Rates
Zero Coupon Yield Curve

Forward Rates
27

Zero Coupon Yield Curve (ZCYC)

ZCYC: helps in valuation of sovereign securities
across all maturities irrespective of its liquidity
It provides benchmark spot rates and helps in creating
uniform valuation standards in the market
ZCYC helps in improving Asset Liability
Management of institutions with realistic valuations
of fixed income portfolios
It is useful in evaluating the emerged forward rates
and in pricing of derivative products and STRIPS

28

Why: Zero Coupon Yield Curve (ZCYC)

ZCBs with different maturities are not available for
trade
Bond specific Issues drive YTM
Age of the bond
Issue size
Yield Curve does not provide ideal benchmark for the rates

Few bonds drive the underlying market

Hence we require a model that will give us
appropriate rates for different time horizon

29

Estimating the ZCYC: Functional form

Nelson-Siegel (1987) form for the spot rate function
r(m) = 0 + (1+2)[1 - exp(-m/)]/(m/) - 2exp(- m/)
- o, 1 2 are parameters to be estimated
- These rates r(m) are used to derive the model price
o - Represent long run levels of interest rates
1 - Slope parameter (short term component)
2 - Curvature parameter (medium term component)
>0 means hump and <0 means a trough

- decay factor (small values produce slow decay)

2 and control the location and height of the

hump in the yield curve
30

Nelson-Siegel Parameters
ZCBs with different
Date 1

Date 2

beta 0

7.5660

7.7941

beta 1

-1.3694

-2.1969

beta 2

-2.3341

-0.0175

tau

2.8686

8.1058

r(m) = 0 + (1+2)[1 - exp(-m/)]/(m/) - 2exp(- m/)

Spot rate on date 2 for 10yr ZCB
r(10) = 7.7941+(-2.1969-0.0175)*(1-exp(-10/8.1058))/(10/8.1058)
(-0.0175) *exp(-10/8.1058) = 6.5270%
31

Estimating the ZCYC : Steps Involved

Numerical optimization procedures to estimate 0, 1, 2
and that minimize the sum of squared price errors,
0, 1, 2 and are used to determine the spot rate
function and hence the model prices of securities
Filtering Data
Outliers given least weight (dropped)
Market lot trades considered
NDS-OM trades given more weight as they go through price
discovery process

Inclusion Criteria
3 trades
Rs.25crores
32

Learning Objectives
Yield Measures
Term Structure of Interest Rates
Spot Rates
Zero Coupon Yield Curve

Forward Rates
33

Forward Rates
Suppose that a firm would like to commit to a rate for
a loan to occur in the future, can a bank offer such a
rate?
Yes, this is the forward rate
How to estimate the forward rates ?

Forward interest rates are the spot rates expected to

rule on future date, as implied by the term structure
Provide the indicative future spot rate only
Calculated on the assumption that there is risk free
arbitrage opportunity in term structure

34

Spot Rates and Forward Rates

Notation:

1f2

When issued

Time to maturity

A spot rate is a rate agreed upon today, for a loan that is to be

made today. (e.g. r1 = 5% indicates that the current rate for a
one-year loan is 5%)
A forward rate is a rate agreed upon today, for a loan that is to
be made in the future. (e.g. 2f3 = 7% indicates that we could
contract today to borrow money at 7% for one year, starting
two years from today)
When the beginning subscript is omitted, it is understood that the
forward rate is for one period only: 3f4 = f4

35

Forward Rates
Forward rates of interest are implicit in the term structure of interest rates
t=0

r1

1f2

r2

2f3

r3

3f4

Note the notation: 3f4 means the forward rate from period 3 to period 4.

Forward Rates: Example

Suppose today is March 4, 2001 and a firm sold a piece of
equipment to a client for $100 million
The client will pay in six months, i.e. on T1 = September 4,
2001
Suppose the firm does not need that cash immediately, but it
will need it six month later, at T2 = March 4, 2002,to fund
some capital investment
Today, the firm would like to fix the interest rate to be applied
on the receivable of $100 million for the six month period
from T1 to T2
The firm calls up its bank to ask for a quote, and the bank
quotes the (semi-annually compounded) annualized rate of f2
= 4.21%

37

Forward Rates: ExampleContd

That is, the bank is ready to commit today to receive in six
months (at T1) $100 million from the firm, and return six
months later (at T2) the amount $102.105 = $100 (1 + f2/2)
million
The rate, f2, which the bank commits to today is called
forward rate
How does the bank determine the forward rate f2?
By no arbitrage

Suppose, on March 4, 2001 (today), the value of 6-months

Treasury bills is $97.728 and the value of 1-year Treasury bills
is $95.713

38

Forward Rates: ExampleContd

In order to guarantee the rate f2 to the client, the bank can
perform the following strategy:
Today the bank:
Borrows T-bills with maturity T1 = 6 months and sells them
for $97.728 million
This amount of cash is then invested in 1-year T-bills expiring
in T2
Given the price of the latter of $95.713 the bank can now
purchase M = 1.02105 = $97.728/$95.713 million of 1-year Tbills (for $100 of face value)
The net cash flow remaining to the bank is zero, as all the cash
obtained from the sale of the T1 T-bill has been used to
purchase T2 T-bills
39

Forward Rates: ExampleContd

At time T1 the bank:
Pay back $100 million to the counterparty it borrowed the T1
T-bills from
At T1 the net cash flow is zero, as the bank receives $100
million from the firm and uses it to close the short position
At time T2:
The M = 1.02105 T-bills mature
The bank receives M $100 = $102.105 million
This is the cash flow promised to the firm in return on the
investment of $100 million at T1
Indeed, the return for the firm from T1 to T2 is 2.105% =
($102.105$100)/$100, which implies the annualized interest
rate of f2 = 2.105%2 = 4.21%
40

Deriving a 6-Month Forward Rate

To compute forward rate, yield curve and the corresponding
spot rate curve are utilized
The following 2 investments should have the same value:
1-year Treasury bill and
2 six-month Treasury bills (one purchased now and the other in six months)

An investor should be indifferent since they should produce

the same investment income over the same investment horizon
Although an investor does not know the interest rate of the
second 6-month T-bill, it is possible to compute it because the
forward rate must such that it equalizes the dollar return
between the two alternatives
41

Deriving a 6-Month Forward Rate

The value of first six-month T-bill is: X(1 + z1)
The value of the total investment following the second six-month T-bill is:
X(1 + z1)(1 + f)
Where z1 is one-half the bond-equivalent yield of the 6-month spot rate and
f is one-half the forward rate on a 6-month Treasury bill available 6 months
from now. X is the amount of the investment.
The value of alternative investment (a 1-year T-bill) is computed as:

= X(1 + z2)2
Because the two alternatives should generate identical returns:
=X(1

+ z1)(1 + f) = X(1 + z2)2

Multiplying f by 2 to get the forward rate on a bond-equivalent yield basis

Forward rates can be computed on various combinations of short- and
longer-term interest rates
42

General Formula for Forward Rates

One-period forward rates:

(1 rn )n (1 rn1 ) n1 (1 fn )1
implying that ...

(1 rn ) n
fn
1
n1
(1 rn1 )

n-period forward rates:

(1 rk n )k n (1 rk ) k (1

f k n) n

implying that...
1

(1 r )k n n
kn
1
fk n
k

(1 rk )

43

Example: Forward Rates

Compute one-year implied forward rates from the following
spot rates?
Maturity Year

Spot Rate (rt)

Forward Rate (ft)

4.0%

5.0%

5.5%

(1 r2 )2 (1 r1 )(1 f2 )

(1 r3 )3 (1 r2 )2 (1 f3 )

(1.05)2 (1.04)(1 f2 )

(1.055)3 (1.05)2 (1 f3 )

f2 6.01%

f3 6.507%

44

Thank You!

45