FINS2624 WEEK 2

CHAPTER 15 – THE TERM STRUCTURE OF INTEREST RATES

[42] The Yield Curve

 Bonds of different maturities typically sell at different YTMs

o Long term bonds sold at higher yields than short term bonds
 Yield curve: plot of yield to maturity as a function of time to maturity
o Can vary widely
o A plot of all the t spot rates (denoted 0yt)

Bond prices

 Treasury stripping suggests exactly how to value a coupon bond

 If each cash flow can be sold off as a separate security, then value of the whole bond should be the
same as the value of its cash flows bought piece by piece in the STRIPS market
 If not – arbitrage possible
o Bond stripping: if bond selling for less than amount at which sum of its parts could be sold
 Buy bond, strip it into standalone zero coupon securities, sell off stripped cash
flows, and profit by price difference
o Bond reconstitution: bond selling for more than sum of the values of its individual cash
flows
 Buy individual zero coupon securities in STRIPS market, reconstitute cash flows into
coupon bond, and sell whole bond for more than cost of the pieces
 Pure yield curve: curve for stripped, or zero-coupon, Treasuries
 On the run yield curve: plot of yield as function of maturity for recently issued coupon bonds
selling at or near par value

[45] How to determine term structure

Yield Curve under Certainty

 Spot rate: YTM on zero coupon bonds – rate prevailing today for a time period corresponding to
the zero’s maturity
o Appropriate discount rates for pricing (risk-free) future cash flows
 Short rate: interest rate for given interval available at different points in time
 Yield or spot rate on a long term bond reflects the path of short rates anticipated by the market
over the life of the bond
o At least in part, the yield curve reflects the market’s assessments of coming interest rates
 Multiyear cumulative returns on all competing bonds ought to be equal

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Finding implied spot rate:

(1) From zero coupon bonds:

(2) From bonds paying coupons – bootstrapping

e.g. for a two year bond, pricing equation is…

First find r1 from a one year zero coupon bond:

Then substitute into equation for P2;0:

Calculating arbitrage trades

Example: suppose that the following bonds trade in the market

Back out the implied term structure from the pricing equations of bonds A and B

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Use the term structure to calculate the arbitrage free (or implied) price of bond C

Bond C trades for less than the arbitrage free price – there is an arbitrage opportunity

 Construct a synthetic version of Bond C from bonds A and B

 Buy underpriced real bond and sell overpriced synthetic bond

(1) Replicate CFs of the C bond

(2) Replicate first CF (10)

a. Each A bond gives CF1 = 100
b. The synthetic bond contains XA A-bonds, so that XA satisfies:

(3) Replicate second CF (110)

(4) Calculate the CFs

This makes a riskless profit at t=0. When doing so, the supply and demand our trades create will
push bond prices to their arbitrage free values

Reinvestment risk

 Cashflows in future will be unknown as we cannot know the future spot rates valid for time periods
in the future

Example: I hold a bond with an investment horizon of two years. We must reinvest the coupon bond at t=1
to get all cash flows at t=2

If spot rate valid at time 1 for an investment maturing at time 2 is denoted by 1y2, our cash flows at t=2 will
be:

CF2 = FV + c + c(1 + 1y2)

• Since 1y2 is unknown at t = 0, so is CF2

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Holding period returns

 Holding period returns will be the same, even if bonds sell at higher YTMs than others
 See [47-8]
 Now, as total CF at t=2 is unknown due to reinvestment risk, holding period return is denoted:

Forward rates

 Def’n: interest rates for investments we agree on today but that take place in the future
 Notation: forward rate (determined today) for an investment that starts at time s and ends at time
t is denoted sft
 In the absence of arbitrage opportunities, the term structure determines all forward rates

Determining forward rates

Example: we want to determine the forward rate between year 2 and 3, 2f3

Cash flow consequences of investing $1 at this rate:

(1) To get negative CF of $1 at t=2

Borrow

(2) Calculate repayment

a. At t = 2 we must repay this with interest

(3) Calculate CF at t=3

a. If we invest the money we borrowed for three years we achieve a CF at t = 3 of

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 (4) Equate CFs at t=3

Refer to [SP8-9] for implied forward rates

Interest rate uncertainty and forward rates

Liquidity risk

 Arises as investment horizon is not matched to cash flows

Example: suppose investor has an investment horizon of one year. If they hold a coupon bond that matures
a t = 2, they must sell it at t = 1 to achieve their period 1 cash flow

 Bond price at t=1: P1 = (c + FV)/(1 + 1y2)

 CF at t=1: CF1 = c + P1
 HPR is:

Since 1y2 is unknown at t = 0, so is P1 and HPR

Example: suppose that most investors have short-term horizons and therefore are willing to hold a 2 year
bond only if its price falls from 943.40 to 881.83. (Originally had 1-year interest rate of 6%, with a HPR of
5%). At the price wanted, the expected HPR on the 2 year bond is 7% (943.40/881.83=1.07) Risk premium
of the 2 year bond is therefore 2%, as it offers an expected rate of return of 7% v 5% risk free return on the
1 year bond.

 Forward rate 1f2 no longer equals expected short rate 1y2.

 YTM on 2 yr zeros selling at 881.83 = 6.49m and:

(1 + 𝑦2 )2 1.06492
1 + 𝑓2 = = = 1.08
1 + 𝑦1 1.05

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