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Pricing Convention:
• Priced at a discount from par or face value using the “true discount” formula and a 360-day
count. The “true discount” formula is just simple interest calculation in reverse
• Following market convention, how much of the annual yield you will actually earn is
directly proportional to the number of days (tenor) you are invested in a 360-day year. That is,
tenor
interest income is computed as: amount invested x annual yield x
360
• Final tax of 20% is paid upon purchase, i.e., front-loaded tax
Example:
Simple interest means that if you were to invest P 97,534.54 for 182 days at a quoted (before tax)
annual yield of 5%, you will earn an interest income of:
182
97,534.54 x 0.05 x = 2,465.46
360
So, after 182 days, you can expect to receive a total of P100,000 = 97,534.54 + 2,465.46
Investing in treasury bills means buying a future value (the face or par value). In our example, this
is the P100,000 we expect to receive in 182 days. Hence, T-bills are sold at a discount from par,
with the discount constituting your interest income. The formula for the discounted price
(97,534.54 in our example) is just simple interest calculation in reverse:
Philippine tax laws however impose a front-loaded final tax of 20% on interest or discount income.
Hence, the T-bill’s selling price (S) should include the tax:
Notice that if the tax had been back-loaded as is the case with bank deposits, our after-tax yield
would have been: 4% = 5% (1 – 0.20). Paying the tax up front means that we lose interest that we
could have earned on the tax payment. Hence, our after-tax yield is only:
1,972 .37 360
3.98 % = 98 ,027 .63 x
182
Selling Price
The multiple steps involved in determining a T-Bill’s selling price inclusive of tax can be simplified
in one formula:
F x (360 + Y x T x 0.2)
S=
(360 + Y x T)
Given that face value is fixed, price is inversely related to yield, consistent
with the present value principle that the higher the discount rate, the lower is
present value.
S x (360 + Y x T)
F=
(360 + Y x T x 0.2)
Many dealers allow clients to set the exact amount they wish to invest. For example, investors often
roll over all of the maturity value, i.e., “maximize” their investment. This could result in maturity
values that are fractions of the face values that T-Bills are typically denominated in (which are
round multiples of P1 million). This simply means that the investor will be part-owner of a mother
certificate with a face value that is a round multiple of P1 million.
360 x y
Y= where y is the after-tax yield
288 – y x T x 0.2
Simple buy-and-hold strategies involve a choice of tenors which are then held to final maturity.
Selling before maturity is not a deliberate part of the investment strategy.
In general:
• If rates are expected to increase, buy/invest in the short tenor
• If rates are expected to decrease, buy/invest in the long tenor
Suppose an investor has P100,000 available to invest for 203 days. Today's spot rates are 5.75% for
91-day T-bills, 5.85% for 112-day T-bills, and 6% for 203-day T-bills. The investor is considering
two investment options: initially invest for 112 days, then reinvest for 91 days; and an outright
purchase of a 203-day T-bill. Choosing the short tenor means accepting the lower rate but he
anticipates the 91-day T-bill rate to rise to from today’s spot rate to 6.4%. The shorter tenor may be
more profitable since he can subsequently reinvest at a higher rate.
The maturity value of a P100,000 112-day T-bill invested at today's spot rate is:
which maturity value, if reinvested for 91 days at the expected rate of 6.4%, yields :
Hence, based on the rate expectation, choosing the short tenor will earn an additional P71.01, and a
203-day yield of 6.16%, 16.0 basis points more than the 203-day spot rate of 6%.
These transactions illustrate a decision to invest cash. However, the same considerations apply in a
choice to swap tenors, e.g., replacing a treasury bill of a short tenor with a T-bill of a longer tenor in
anticipation of a decline in interest rates.
The Implied Forward Interest Rate
The forward rate implied in the spot rates of two unequal tenors is illustrated below. Y1 is the annual
yield of the shorter tenor while Y2 is the annual yield of the longer tenor. The forward rate F2 is that
equivalent annual yield that will result in equal terminal values at time N2, where the maturity value
of the short tenor is ‘reinvested’ at F2 to from time N1 to time N2.
0 N1 N2
Y1 F2
Y2
In the case of T-bills, the implied forward rate can be determined using the formula:
C x 360
F2 = where C = (M2/M1 – 1)
T x (0.8 – 0.2 x C)
The forward rate is also often referred to as the “lock-in” rate. The long tenor is in effect equivalent
to two sequential placements: the first at the spot rate Y1, and then a reinvestment to N2, but at an
assured rate. Choosing the long tenor over the short tenor eliminates the uncertainty about the
reinvestment yield by locking it in at the forward rate.
Yet another way to view the forward rate is that it reflects the market’s expectations about future
interest rates; specifically, the yield for tenor T expected to prevail at time N1. How so?
In the buy-and-hold illustration, the investor is expecting the 91-day T-bill rate to rise from today’s
spot rate of 5.75% to 6.4% in about 112 days time. He finds that investing in the shorter tenor and
subsequently reinvesting at the expected higher rate will be more profitable than buying outright a
203-day T-bill. In fact, he estimates that for as long as the 91-day T-bill rate will rise to a level
higher than the forward rate of 6.052%, a strategy of investing in the short tenor promises a higher
expected return.
Suppose other investors share his view that interest rates, particularly the 91-day T-bill rate, will
rise. These investors will likewise favor the shorter tenor, or if they are currently holding long
tenors, may even switch out of their current positions into the shorter tenors. If there are enough of
these investors, their transactions will tend to increase the demand for the shorter tenor, and reduce
that of the longer tenor. This will push up the price of the short tenors, i.e., reduce their yield. The
reduced demand for longer tenors will in turn lower their price and increase their yields.
As yields adjust in this manner, the forward rate must rise. In short, the forward rate will eventually
adjust to reflect market consensus on future interest rates.
But is the forward rate an unbiased estimate of market consensus about future interest rates? Not
quite, because other factors systematically affect the yield curve. For one, we know that the present
value of more distant cash flow is more sensitive to discount rate changes than that of nearer cash
flow. This means that for fixed-income securities, the longer the tenor of bills/bonds, the greater
their price sensitivity to changes in yields, i.e., the greater the price risk. And since investors
demand a premium for risk-taking, longer tenors will generally command higher yields than shorter
tenors, even in the absence of expectations of interest rate changes.1 Hence, the term premium
reflects both market expectations about future interest rates and a risk premium.
1
That’s why the yield curve is normally upward sloping.
Credits to Prof. R.C. Ybañez
UP CBA
We can safely say that the forward rate reflects market consensus about the future level of interest
rates, but we would need a more complex model of the yield curve to isolate that from the other
effects on the yield curve, e.g., the price risk premium.
Riding the yield curve is an investment strategy that requires selling T-bills before final maturity. It
utilizes the positive slope of a normal yield curve to enhance investor returns by taking advantage of
price increases (yield decreases) as the T-bill’s remaining tenor declines over the investor’s holding
period.
An investor buys a T-bill with a tenor (say 273 days) longer than his planned holding period (say
182 days), and then sells on the day cash is needed (day 182) when its remaining tenor (91 days) is
now shorter. Riding down the yield curve in effect means riding up the price curve – buying at a
high yield (lower price) and eventually selling at a low yield (high price).
To illustrate, suppose the current yield curve has the following spot rates: 91 days at 5%; 182 days
at 5.5%; and 273 days at 6%.
Tail-end gapping generates a net advantage of P3,479.72, or an additional 90.2 basis points. Once
again, the break-even rate between the two strategies is the (91-day) forward rate.
Spread Trading
Spread trading or rate anticipation swaps are relatively more complex and more risky strategies, but
can also offer greater rewards. Previous examples focused on yield changes of a single security.
Spread trading strategies focus on spread changes, which can be between tenors of the same
security class, two security classes of the same tenor, two currencies of the same tenor and security
class, etc.
The spread adjustment could occur via yield changes in one, or both of the securities. Thus, spread
trading strategies generally involve simultaneous buying (long) and selling (short) positions. The
investor buys the security whose price is expected to rise (yield to fall) and sells the security whose
price is expected to fall (yield to rise).
The first Gulf war in 1990 led to high volatility in oil prices and in FX and T-bills yields. The Dec.
28 yield curve showed a negative spread between short and long tenors: 91-day yield was at
35.154%, 182-day yield at 35.593%, and 31.112% for 364-day T-bills. Many expected the spread to
normalize once the Gulf crisis was resolved: the yield for the short tenor should fall relative to the
long tenor. A spread trading strategy would involve the following:
By the second week of January, the US coalition had won the war and global markets had begun to
normalize. Yields adjusted to 31.909% for the 168-day tenor and 31.546% for the 350-day tenor.
The investor can already profitably unwind his positions at this point.
Note that over the 14-day holding period, the long position in 6-month T-bills resulted in an annual
yield of 67.4%, while the short position in 1-year T-bills resulted in a yield of −14.605%. The risk
of course is that the spread will move in the opposite direction.
The price-yield relationship that is the basis for active asset management applies as well to
liabilities. Asset-liability investment strategies typically involve a deliberate tenor mismatch, or gap,
between assets and liabilities.
Suppose interest rates are expected to rise. We’ve seen that investors will prefer short tenors to be
able to reinvest at the higher rate, and to avoid the price loss from long tenors. On the liability side
however, we would prefer the long tenor to be able to lock in borrowings at today’s low interest
rate. This type of tenor or maturity mismatch is called a ‘positive gap’.
A ‘positive gap’ exists if the amount of assets that will mature or will be repriced exceeds the
amount of liabilities that will mature or will be repriced over a particular time period. A gap is
necessarily defined over a particular time frame, e.g., over the next 12 months, as the type of gap
could vary over different time intervals.
A ‘negative gap’ is the reverse, maturing (or repricing) assets are less than the maturing (or
repricing) liabilities. When interest rates are expected to fall, investors prefer to invest in long tenors
and borrow in the short tenor. Note that ‘riding the yield curve’ is a form of negative gapping.
A zero gap or ‘square position’ means there is no mismatch in assets and liabilities.
Gapping strategies seek to maximize the profit potential from expected interest rate or yield
changes, but it can also be quite risky. A positive gap is driven by expectations of rising interest
rates, but if rates move in the opposite direction, declining interest rates would mean the investor is
forced to reinvest in low yield assets and may end up locked in at high borrowing costs. Note
Effective execution of gapping strategies requires that both assets and liabilities are in relatively
liquid securities. Hence, gapping is typically exercised by financial institutions that have ready
access to financial markets and have the ability to quickly reverse or unwind asset-liability positions
that have become exposed to changing interest rate directions.
Financial prudence suggests that non-financial corporations, which have mainly illiquid real assets,
should generally aim for maturity matching.
Illustration of Gapping
We illustrate the possible outcomes of gapping strategies for a financial institution (FI). Many FI’s
earn a good part of their profits by lending/investing, earning a spread over borrowed funds. In this
illustration, we assume a normal spread of 400 basis points and a conservative debt-equity ratio of
4:1. To simply the arithmetic, we assume zero taxes and simple interest calculation over a 364-day
year. The FI expects interest rates to drop by 200 basis points in six months time:
Consider first the full year results of a square position, e.g., 1-year loans and borrowings:
Given the expectation of declining interest rates, a more aggressive FI will go for a negative gap,
i.e., 1-year loans and 6-month borrowings: