F- 506: Fixed Income Securities

Chapter # 6
Yield Measure, Spot Rates and Forward Rates
 Measuring Yield
Example: An investor with a three-year investment horizon is considering purchasing a 20-year, 8%
coupon bond for 828.40. The yield to maturity for this bond is 10%. The investor expects to be able to
reinvest the coupon payments at an annual interest rate of 6% and at the end of the investment horizon the
then 17-year bond will be selling to offer a yield to maturity of 7%, determine the total rate of return of the
bond.
Total future value of coupon and
3-year investment horizon, 20-year 8% coupon interest on interest
bond
Bond price Bo = 828.4 3 years’ coupon and reinvestment 40 6 =258.74
1.03 −1
of coupons .03
Face Value = 1000
Coupon Rate = 8% Price at the end of investment 40 1 1000 = 1098.50
1− 34
+
horizon .035 1.035 (1.035)34
Annual coupon = 80
Semiannual coupon = 40 Total return amount = 1357.24
Annual reinvestment rate= 6% Total rate of return(semi-annual) 1/6 = 8.58%
1357.24
−1
Semiannual reinvestment 3% 828.4
YTM for the 17-year bond 7%
Total rate of return(annual) = 17.15%
Semiannual YTM 3.5%
 Spot Rate
Yield Curve Should Not Be Used In Pricing Bond
The price of a bond is the sum of the present values of its cash flows. In discounting the cash flows
the discount rate used should be the yield on a Treasury security with the same maturity plus a
spread or margin that is appropriate with the risk. However, there is a problem with using
Treasury yield curve to determine the appropriate yield or discount rate. The following example
illustrates the problem:
The two hypothetical 5-year Treasury bonds A and B have coupon rates of 12% and 3%
respectively. Therefore, the semiannual cash flows are as follows:
Bond A: 1 – 9 time periods. CF = 6 Time period 10 CF=106
Bond B: 1 – 9 time periods. CF=1.5 Time period 10 CF=101.5
Because the cash flows are occurring at different points in time, as such, it is incorrect to use the
same interest rate for discounting all the cash flows. Instead, each cash flow should be discounted
by a unique interest rate appropriate for the time in which the cash flow is occurring. The correct
approach is to consider the bonds A and B as packages of cash flows i.e. packages of zero-coupon
instruments. Therefore, the amount of interest is the difference between maturity value and the
price paid.
 Spot Rate
Time Cash flow from Bond A Cash flow from Bond B consider
6m 6 1.5 A zero coupon of 6m maturity
1 year 6 1.5 A zero coupon of 1 year maturity
1.5 years 6 1.5 A zero coupon of 1.5 years maturity
2 years 6 1.5 …..
2.5 years 6 1.5 ….
3 years 6 1.5 …..
3.5 years 6 1.5 ….
4 years 6 1.5 ….
4.5 years 6 1.5 …..
5 years 106 101.5 A zero coupon of 5 years maturity
 Spot Rate
Bond A can be viewed as 10 zero-coupon bonds one with a maturity value of 6 maturing 6
months from now, a second with a maturity value of 6 maturing 12 months or 1 year from
now, a third with a maturity value of 6 maturing 18 months or 1½ years from now & so on.
The same is the case with Bond B. Therefore, the value of the bonds should equal
the total value of all the component zero-coupon bonds. Otherwise, arbitrage profit
can be made.
To determine the value of each zero-coupon bond it is necessary to know the yield
on a zero-coupon Treasury with the same maturity. This yield is called the
Treasury spot rate and the graphical depiction of the relationship between the spot
rate and maturity is called the Treasury spot rate curve. As there are no zero-
coupon Treasury debt issues with a maturity greater than one year, it is not
possible to construct such a curve solely from observations of market activity on
Treasury securities. Rather it is necessary to derive the curve from theoretical
considerations as applied to the yields of the actually traded Treasury debt
securities. Such a curve is called a theoretical spot rate curve and is the graphical
depiction of the term structure of interest rate.
 Spot Rate

Development of Theoretical Spot Rate Curve for Treasuries

A default-free theoretical spot rate curve can be constructed from the yield on Treasury
securities. The Treasury issues that can be considered are:
i) on-the-run Treasury issues
ii) on-the-run Treasury issues and selected off-the-run Treasury issues
iii) all Treasury coupon securities and bills
iv) Treasury coupon strips
The methodology of constructing the theoretical spot rate curve varies on the basis
of the type of securities included for construction. The following two methods are
used for on-the-run Treasury issues:
 Spot Rate
On-the-Run Treasury Issues
These are the most recently auctioned issues of given maturity. These issues include 3-month
and 6-month Treasury bills, 2-year, 5-year, and 10-year Treasury notes and the 30-year
Treasury bond. Treasury bills are zero-coupon instruments and the notes and bonds are
coupon securities. There is an observed yield for each of the on-the-run issues. For the
coupon securities, these yields are not the yields used in the analysis when the security is not
trading at par. Rather, for each on-the-run coupon security, the estimated yield necessary to
make the issue trade on par is used. The resulting on-the-run yield curve is called the par
coupon curve.
The objective is to develop a theoretical spot rate curve with 60 semiannual spot rates: 6-
month rate to 30-year rate. Excluding the 3-month bill, there are only 6 maturity points
available when only on-the-run issues are used. The 54 missing points are interpolated from
the surrounding maturity points on the par yield curve. The simplest and most commonly
used interpolation method is the linear extrapolation.
 Spot Rate
On the basis of the yields at two maturity points on the par coupon curve, the following is
calculated:
(yield at higher maturity – yield at lower maturity)
Number of semiannual periods between two maturity points + 1
The yield for all intermediate semiannual maturity points is found by adding to the yield at the
lower maturity the amount computed from the formula.
For example, the yield from the par coupon curve for the 2-year and 5-year on-the-run issues are 6% and
6.6% respectively. There are 5 semiannual time periods between the two maturity points. The extrapolated
yield for the 2.5, 3, 3.5, 4, and 4.5 is computed as follows:
6.6−6 %
= = 0.1%
5+1
Therefore, 2.5-year yield = 6.0%+.1% = 6.1%
3.0-year yield = 6.1%+.1% = 6.2%
3.5-year yield = 6.2%+.1% = 6.3%
4.0-year yield = 6.3%+.1% = 6.4%
4.5-year yield = 6.4%+.1% = 6.5%
 Spot Rate
There are two problems with using just the on-the-run issues.
First, there is a large gap between some of the maturity points which may result in misleading yields for
those maturity points when estimated using the linear extrapolation method. The problem is more prevalent
in case of gap between 5 and 10-year maturity points and in case of 10 and 30-year maturity points.
Second problem is that as the true yields are different from the quoted yields in the market, the yields of the
on-the-run issues themselves may be misleading.
The par yield curve can be converted to theoretical spot rate curve by using bootstrapping. For example,
for computing theoretical spot rate curve for 10 years, 20 semiannual spot rates have to be computed. The
hypothetical par yield is shown in the Table where the annualized yield (YTM), price, maturity, and
computed spot rates of 20 Treasury securities are stated. The coupon rate and YTM of the issues are
same, as such, their price is equal to par except for 6-month and 1-year issues. It should be noted
that all the analysis have been done keeping in view the basic principal that the value of treasury
coupon security should be equal to the total value of the package of zero-coupon Treasury
securities that copies or duplicates cash flows of the coupon bond.
 The 6-month Treasury bill is a zero-coupon issue, as such, its annualized yield 5.25% is equal to the
spot rate. Similarly, 1-year Treasury has a rate of 5.5% which is equal to the 1-year spot rate.
Considering these rates, the spot rate for the 1.5-year Treasury can be computed.

Semiannual
Time YTM
coupon 2.875
Period Years CR % Price z1 0.0263
1 0.5 5.25
2 1 5.5 z2 0.0275
3 1.5 5.75 100
4 2 6 100
5 2.5 6.25 100
6 3 6.5 100
PV of cash flow 2.875 2.875 102.875
7 3.5 6.75 100 + + = 100
8 4 6.8 100 1.0263 (1.0275)2 (1+𝑧3 )3
9 4.5 7 100
10 5 7.1 100 102.875
11 5.5 7.15 100 5.5246281 + (1+𝑧3 )3 = 100
12 6 7.2 100 102.875
13 6.5 7.3 100 (1+𝑧3 )3 = 94.47537
14 7 7.35 100
15 7.5 7.4 100 (1 + 𝑧3 )3 = 0.918351
16 8 7.5 100
17 8.5 7.6 100 𝑧3 = 0.028799
18 9 7.6 100
19 9.5 7 100
20 10 7.8 100
Therefore, theoretical annual spot rate = 5.76%
 Bootstrapping
• Similarly, z4 = .030095 Time YTM/ Spot
Period Years CR % Rate %
• and annual spot rate = 6.02% 1 0.5 5.25 5.25
2 1 5.5 5.5
3 1.5 5.75 5.76
4 2 6 6.02
5 2.5 6.25 6.28
6 3 6.5 6.55
7 3.5 6.75 6.82
8 4 6.8 6.87
9 4.5 7 7.09
10 5 7.1 7.20
11 5.5 7.15 7.26
12 6 7.2 7.31
13 6.5 7.3 7.43
14 7 7.35 7.48
15 7.5 7.4 7.54
16 8 7.5 7.67
17 8.5 7.6 7.80
18 9 7.6 7.79
19 9.5 7 7.93
20 10 7.8 8.07
 Forward Rate
It has been demonstrated how the theoretical spot rates can be extrapolated from the yield
curve. Similarly, the market consensus future interest rates can also be developed. The
following example illustrates the significance of the market consensus future interest rates:
An investor with one-year investment horizon faces two investment alternatives.
Alternative I: Buy a one-year instrument
Alternative II: Buy a 6-month instrument and when it matures
buy another 6-month instrument
In case of the first alternative, the investor will realize the 1-year spot rate with certainty.
Whereas, with the second alternative, the investor will realize the 6-month spot rate for
sure, but the 6-month rate 6 months from now is unknown. As such, with the alternative II,
the rate that will be earned over one year time period is not known with certainty.
 Forward Rate
• The following graph shows this.
 Forward Rate
The investor will be indifferent between the two investment alternatives if they produce the
same amount of return over the 1-year investment horizon. Given the 1-year spot rate, there
is some rate on a 6-month instrument 6 months from now which will make the investor
indifferent between the two alternatives. That rate is denoted by f. If the 1-year and 6-month
spot rates are known, then the rate f can be determined readily.
If 100 is invested in 1-year instrument, then after one year the amount will be 100*(1+z2)2
where z2 is the 1-year spot rate. If 100 is invested in 6-month instrument then after 6 months
the amount will be 100*(1+z1) where z1 is the 6-month spot rate. If this amount is reinvested
at the 6-month rate 6 months from now i.e. at rate f, the total amount at the end of one year
will be 100*(1+z1)*(1+f). The investor will be indifferent if 100*(1+z1)*(1+f) = 100*(1+z2)2.
If solved for f then
(1+z2)2
f= [(1+z2)2 ÷ (1+z1)] – 1 or, f= -1
(1+z1)
 Forward Rate
If the 6-month rate 6 months from now is less than the computed forward rate then the
investor will get more return from alternative I, otherwise, the alternative II will provide
higher return to the investor. If the above two rates are equal then the investor will be
indifferent between the two alternatives.
The rate determined for f is called market’s consensus for the 6-month rate 6 months from
now. A future interest rate calculated either from spot rate or the yield curve is called the
forward rate.
The notation that is used to indicate 6-month forward rates is 1fm where the subscript 1
indicates a 1-period (6-month) rate and the subscript m indicates the period beginning m
periods from now. When m is equal to zero, this means the current rate. Thus, the first 6-
month forward rate is simply the current 6-month spot rate. That is, 1f0 = z1.
 Forward Rate
The general formula for determining a 6-month forward rate is:
m+1 ÷ (1 + z )m] −1
1fm = [(1 + zm+1) m
For example, assuming that the 6-month forward rate four years (eight 6-month
periods) from now is sought. In terms of our notation, m is 8 and we seek 1f8. The
formula is then:
1f8 = [(1 + z9) ÷ (1 + z8) ] −1
9 8

From Exhibit 4, since the 4-year spot rate is 5.065% and the 4.5-year spot rate is
5.1701%, z8 is 2.5325% and z9 is 2.58505%.
Then, 1f8 = [(1.0258505)9 ÷ (1.025325)8]− 1 = 3.0064%
Doubling this rate gives a 6-month forward rate four years from now of 6.01%

Exhibit 12 shows all of the 6-month forward rates for the Treasury yield curve shown
in Exhibit 4. The forward rates reported in Exhibit 12 are the annualized rates on a
bond equivalent basis.
 Forward Rate

Using spot rates, any forward rate can be computed. With the same arbitrage arguments as
shown above to derive the 6-month forward rates, any forward rate can be obtained.
There are two elements to the forward rate. The first is when in the future the rate begins.
The second is the length of time for the rate. For example, the 2-year forward rate 3 years
from now means a rate three years from now for a length of two years. The notation used for
a forward rate, f, will have two subscripts—one before f and one after f i.e. t fm
The subscript before f is t and is the length of time that the rate applies. The subscript after f
is m and is when the forward rate begins. That is, the length of time of the forward rate f
when the forward rate begins. The time periods are 6-month periods.
 Forward Rate
Given the above notation, here is what the following mean:

Notation Interpretation for the forward rate

1f12 6-month (1-period) forward rate beginning 6 years (12 periods) from now

2f8 1-year (2-period) forward rate beginning 4 years (8 periods) from now

6f4 3-year (6-period) forward rate beginning 2 years (4 periods) from now

8f10 4-year (8-period) forward rate beginning 5 years (10 periods) from now
 Forward Rate
To illustrate, for the spot rates shown in Exhibit 4, suppose that an investor wants
to know the 2-year forward rate three years from now. In terms of the notation, t is
equal to 4 and m is equal to 6. Substituting for t and m into the equation for the
forward rate we have:
4f6 = [(1 + z10)10 ÷ (1 + z6)6 ]¼ − 1
This means that the following two spot rates are needed: z6 (the 3-year spot rate)
and z10 (the 5-year spot rate). From Exhibit 4 we know z6 (the 3-year spot rate) =
4.752% ÷ 2 = 0.02376 z10(the 5-year spot rate) = 5.2772% ÷ 2 = 0.026386
Then 4 f6 = [(1.026386)10 ÷ (1.02376)6 ]¼ − 1 = 0.030338
Therefore, 4 f6 is equal to 3.0338% and doubling this rate gives 6.0675% the forward rate
on a bond-equivalent basis.
 Forward Rate

We can verify this result. Investing $100 for 10 periods at the spot rate
of 2.6386% will produce the following value: $100 (1.026386)^10 =
$129.7499
Investing $100 for 6 periods at 2.376% and reinvesting the proceeds for
4 periods at the forward rate of 3.030338% gives the same value:
$100 (1.02376)6(1.030338)4 = $129.75012
 Valuation Using spot rate & Forward Rates
Suppose that the cash flow in period T is $1. Then the present value of the cash flow can be found
using the spot rate for period T as follows:
PV of $1 in T periods = 1 ÷ (1 + z T )T
Using forward rates,
PV of $1 in T periods = 1 ÷ (1 + z1)(1 +1 f1)(1 +1 f2 )….. (1 +1 f T−1)
In practice, the present value of $1 in T periods is called the forward discount factor for period T.
The forward discount rate for period 4 is found as follows:
z1 = 3%/2 = 1.5% 1f1 = 3.6%/2 = 1.8%
1f2= 3.92%/2 = 1.958% 1f3 = 5.15%/2 = 2.577%
forward discount factor of $1 in 4 periods
= $1 ÷ (1.015)(1.018)(1.01958)(1.02577)
= 0.925369
 Valuation Using spot rate & Forward Rates
Using that spot rate, we find: z4 = 3.9164%/2 = 1.9582%
PV of $1 in 4 periods = $1 ÷ (1.019582)4 = 0.925361
The answer is the same as the forward discount factor (the slight difference is due to
rounding).
Exhibit 14 shows the computation of the forward discount factor for each period
based on the forward rates in Exhibit 12. The forward rates as well as the spot rates
can be used to value a 2-year 6% coupon Treasury bond. The present value for each
cash flow is found as follows using spot rates: (cash flow period t) ÷ (1 + zt )t
 Forward Rate
The following table uses the spot rates in Exhibit 4 to value this bond:
Spot rate Semiannual Cash PV of
Period BEY (%) spot rate (%) PV of $1 flow cash flow
1 3.0000 1.50000 0.9852217 3 2.955665
2 3.3000 1.65000 0.9677991 3 2.903397
3 3.5053 1.75266 0.9492109 3 2.847633
4 3.9164 1.95818 0.9253619 103 95.312278
Total 104.018973
Based on the spot rates, the value of this bond is $104.0190.
Using forward rates and the forward discount factors, the present value
of the cash flow in period t is found as follows:
cash flow in period t × discount factor for period t
 Forward Rate
The following table uses the forward rates and the forward discount factors in
Exhibit 14 to value this bond:

Semiann. Forward Cash PV of

Period forward rate discount factor flow cash flow
1 1.5000% 0.985222 3 2.955665
2 1.8002% 0.967799 3 2.903397
3 1.9583% 0.949211 3 2.847633
4 2.5773% 0.925362 103 95.312278
Total 104.018973

The present value of this bond using forward rates is $104.0190. So, it does
not matter whether one discounts cash flows by spot rates or forward rates,
the value is the same.