Part-09

Fundamentals of Yield Curves

&
The Term Structure of Interest
Rates

1
Introduction
 At any point in time an investor will
have access to a wide variety of
bonds.
 These will differ with respect to
 Their yields, and
 Their times to maturity

2
Introduction (Cont…)
 Investors and traders will be
interested in the relationship
between the time to maturity, and
yield to maturity, for bonds
belonging to a given risk class.
 A plot of yield versus time to
maturity is termed as the
 Yield Curve
3
Introduction (Cont…)
 The Yield Curve
 Is an important indicator of the state
of the bond market
 And provides valuable information

4
Introduction (Cont…)
 While constructing the yield curve it is
important to ensure that
 The bonds belong to the same risk class
 And have a comparable degree of liquidity
 For instance
 We may construct a curve for government
securities
 Or for AAA rated corporate bonds

But we cannot mix the data for the two categories

5
Introduction (Cont…)
 The primary yield curve in the
domestic capital market is
 The Government or Treasury Bond
Yield Curve
 This is because
 Such instruments are free of default
risk

6
Analyzing The Curve
 The Yield Curve
 Is an indication of where the bond
market is trading currently
 It also has implications for what the
market thinks will happen in the
future

7
Analyzing…(Cont…)
 The curve sets the yield for all debt
market instruments
 It fixes the price of money over the
maturity structure
 Thus issuers of debt in the market
use the yield curve to price debt
securities.

8
Analyzing…(Cont…)
 The yields of government bonds
set the benchmark for yields on
other debt securities.
 For instance if the 5 year T-bond is
trading at a yield of 5%
 All other bonds irrespective of the issuer
will be trading at yields in excess of 5%

The excess over the yield on a
comparable T-bond is called the Spread.
9
Analyzing…(Cont…)
 The yield curve acts as an
indicator of future yield levels.
 It assumes certain shapes in response
to market expectations of future
interest rates.
 Analysts therefore study the current
shape of the curve in order to
determine the direction of future
interest rates.
10
Interest in the curve
 The curve is analyzed by
 Bond traders
 Fund managers
 Central bankers
 Corporate finance personnel

11
Interest…(Cont…)
 Central bankers and government
Treasury departments analyze the
curve for the information it
provides
 Regarding forward rates
 Future interest levels
 This information is used to set rates for
the economy as a whole

12
Interest…(Cont…)
 Portfolio managers use the curve
to assess the relative values of
investments across the maturity
spectrum.
 The curve indicates the returns that
are available at different points of
time.
 Consequently it helps determine
which bonds are cheap or costly.
13
YTM
 Consider a bond that makes an
annual coupon of C on a semi-
annual basis.
 The face value is M, the price is P,
and the number of coupons
remaining is N.

14
YTM (Cont…)
 The YTM is the value of y that
satisfies the following equation.

15
YTM (Cont…)
 The YTM is a solution to a non-linear
equation.
 We generally require a financial
calculator or a computer to calculate it.
 However it is fairly simple to compute
the YTM in the case of a coupon paying
bond with exactly two periods to
maturity.
 In such a case it is simply a solution to a
quadratic equation. 16
YTM for a Zero Coupon
Bond
 The YTM is also easy to compute in
the case of zero coupon bonds.
 Consider a ZCB with a face value
of $1,000, maturing after 5 years.
 The current price is $500.
 The YTM is the solution to

17
Spot Rates
 The spot rate of interest for a
particular time period, is the YTM
of a zero coupon bond that is
maturing at the end of the period.
 For instance assume that a six
month zero coupon bond with a
face value of $1,000 is selling for
$961.54.
18
Spot Rates (Cont…)
 If we consider six months to be
one period, then the one period
spot rate is given by:
961.54 = 1,000 ⇒ s1 = 0.04 ≡ 4%
---------
(1 + s1)

19
Spot Rates (Cont…)
 Similarly, if a one year bond is
selling for $873.44, then the two
period spot rate is given by:
873.44 = 1,000 ⇒ s2 = .07 ≡
7.00%
______
(1 + s2)2

20
Spot Rates & YTM
 A Plain Vanilla bond is a series of
cash flows arising at six monthly
intervals.
 Each cash flow can be perceived
as a zero coupon bond maturing at
that point in time.
 Thus a Plain Vanilla bond is
essentially a portfolio of zero
coupon bonds. 21
Spot Rates & YTM (Cont…)
 The correct way to price a Plain
Vanilla bond is by discounting each
cash flow at the spot rate that is
applicable for that period.
 Take the case of a Plain Vanilla
bond with a face value of $1,000
and one year to maturity, with a
coupon of 7% per annum, paid on
a semi-annual basis. 22
Spot Rates & YTM (Cont…)
 Using the spot rates calculated
earlier the price of the bond can be
calculated to be:
P = 35 1,035 = 937.66
____ + _____
(1.04) (1.07)2

23
Spot Rates & YTM (Cont…)
 What is the YTM of this bond?
 It is obviously the solution to:
937.66 = 35 + 1,035
______ ______
(1+ y/2) (1 + y/2)2
⇒ y/2 = 0.069454 ≡ 6.9454%

24
Spot Rates & YTM (Cont…)
 The YTM is therefore a complex
average of the spot rates.
 This per se need not pose any
problems.

The problem is that the YTM is a function
of the coupon rate.

In other words, if we compare two bonds
with the same time to maturity, but with
different coupons, the YTMs for the two
will differ.

25
Spot Rates & YTM (Cont…)
 This is despite the fact that both
bonds have been priced correctly,
using the appropriate spot rates.
 This is known as the Coupon Effect.
 For instance let us consider a bond
with a face value of $1,000 and
one year to maturity, but with a
coupon of 12% per annum.
26
Spot Rates & YTM (Cont…)
 Its price can be calculated to be:
P= 60 + 1,060 = 983.54
____ ______
(1.04) (1.07)2
 The YTM is obviously given by:
983.54 = 60 + 1,060 ⇒ y/2 = 0.069092
____ _____
(1+y/2) (1+y/2)2 ≡ y/2 = 6.9092%

27
Analyzing the Coupon
Effect
 Quite obviously the YTM, which is a
complex average of the spot rates,
varies with the coupon rate when
comparisons are sought to be
made among bonds with an
identical maturity.
 What is the reason for the 7%
coupon bond to have a higher YTM
than the 12% bond? 28
The Coupon Effect
(Cont…)
 Take the 7% bond first.
 It has a price of 937.66.

 The present value of the first cash flow

is
35
____ = 33.65
(1.04)
 Thus 33.65 = 0.0359 ≡ 3.59% of the

value
_____ of the bond is tied up in one29
The Coupon Effect
(Cont…)
 The balance 96.41% is obviously
tied up in two period money.
 In the second case the price is
983.54 while the present value of
the first cash flow is 60
_____ = 57.69, which is
5.87%
(1.04) of the value of the
bond. 30
The Coupon Effect
(Cont…)
 The one period spot rate is 4%
while the two period spot rate is
7%.
 Thus one period money is cheaper
than two period money.
 Since the second bond has a
greater percentage of its value tied
up in one period money, it is
obvious that its yield to maturity 31
Yield Curves and the Term
Structure
 What is a Yield Curve?
 It is a graph depicting the YTM,
which is plotted along the Y-axis,
and the time to maturity, which is
plotted along the X-axis.
 For the purpose of constructing the
yield curve it is imperative that the
bonds being compared belong to
the same credit risk class. 32
Term Structure
 The expression `Term Structure of
Interest Rates’ refers to the relationship
between spot rates of interest, as
depicted along the Y-axis, and the
corresponding Time to Maturity, as
depicted along the X-axis.
 Once again, to facilitate meaningful
inferences the data should be applicable
to bonds of the same risk class.
 The term structure is also referred to as
the Zero Coupon Yield Curve.
33
Bootstrapping
 What is bootstrapping?
 In order to calculate the spot rates and
thereby construct the term structure,
we need access to the prices of zero
coupon bonds maturing at different
intervals.
 However, in real life most of the data
that we have pertains to coupon paying
bonds.
 Bootstrapping is a technique for 34
 Illustration
 Assume that we have the following
data.
Time to Price Coupon
Maturity
1 Year 1,000 6%
2 Years 975 8%
3 Years 950 9%
4 Years 925 10%
35
Illustration (Cont…)
 The one year bond is selling at par.
 So the one year spot rate must be
6%, which is the coupon rate on
this bond.
 The two year spot rate can be
determined as follows:
80 + 1080
975 = ____ ______ ⇒ s2 = 9.57%
36
2
Illustration (Cont…)
 Similarly the three year spot rate is
given by:
90 90 1090
950 = ____ + ______ + ____
(1.06) (1.0957) (1+s3)3
⇒ s3=11.32%

37
Illustration (Cont…)
 Using the same logic:
100 + 100 + 100 + 1100
925 = _____ ______ ______ ________
(1.06) (1.0957) (1.1132)
(1+s4)4

⇒
s4 = 12.99%

38
Practical Difficulties With
Bootstrapping
 One problem that is often
encountered in practice is that a
bonds may not exist for certain
maturities, for which spot rates are
sought to be calculated.
 Or else, even if it were to exist, a
bond may not be traded actively.
 And in the absence of active trading,
the observed prices would be suspect.
39
Difficulties (Cont…)
 Secondly as our example shows, a
combination of par, premium and
discount bonds are likely to be
used to construct the term
structure.
 The problem while using bonds with
different coupons is that we are
exposed to the coupon effect and the
liquidity effect.
40
Difficulties (Cont…)
 The Liquidity Effect:
 For a given maturity the more recently
issued or on-the-run securities tend to be
more liquid than the earlier issues or off-
the-run securities.
 For instance at Treasury bill maturing on 16
May 1991 was trading at 6.31%, whereas an
8.125% Treasury note maturing on 15 May
1991 was trading at 6.37%.

41
Difficulties (Cont…)
 Off-the-run securities are less liquid
since most of them tend to be in the
hands of investors who intend to hold
them until maturity.
 Thus the demand for on-the-run
securities will be relatively higher and
the yields will be lower, although both
securities are virtually identical.

42
Difficulties (Cont…)
 Finally some of the earlier Treasury
issues are callable in nature.
 It is not theoretically correct to
treat bond with embedded options,
such as callable bonds, on par with
Plain Vanilla bonds, for the purpose
of inferring the term structure.

43
The Coupon Yield Curve
 One of the problems with
bootstrapping is that we typically
have data for bonds with different
coupons.
 At times however we may have
data for bonds, all of which have
the same coupon.
 The resulting yield curve is called the
Coupon Yield Curve. 44
The Par Bond Yield Curve
 It is an estimate of the yield curve
obtained by using data for bonds,
which have different coupons, but
all of which trade at par.
 In this case, the coupon for each bond
will be equal to its YTM.

45
Illustration
Time to Price in Coupon
Maturity Dollars
1 Year 1,000 6%

2 Years 1,000 8%

3 Years 1,000 9%

4 Years 1,000 10%

46
Illustration (Cont…)
 The one year spot rate is 6%.
 The 2 year spot rate can be
determined as follows.
80 1080
1000 = _____ + ______
(1.06)
(1+s2)2
⇒
S2 = 8.08% 47
Illustration (Cont…)
 Similarly the 3 year spot rate can
be calculated as 9.16%, and the 4
year spot rate as 10.30%.
 The par bond yield curve is often
used by primary market analysts.
 Since new bonds are always issued at
par, such a curve can be used to
estimate the coupon to be offered on
a new bond whose issue is being
contemplated.
48
Deriving the par bond
curve in the absence of
par bonds
 In the absence of data on par
bonds, the par bond yield curve
can still be derived.
 Assume that we have the following
vector of spot rates.

49
Deriving…(Cont…)
Time to Maturity Spot Rate

1 Year 6%

2 Years 9.57%

3 Years 11.32%

4 Years 12.99%

50
Deriving…(Cont…)
 The yield for a one year par bond
is obviously 6%.
 The yield or coupon for a two year

par bond may be calculated as:

C + 1000+C
1,000 = _____ ________
(1.06)
(1.0957)2
⇒ C = 94.0441 ⇒ c = 9.4044% 51
Deriving…(Cont…)
 Similarly:
C + C +
1000+C
1000 = _____ _____ ________
(1.06) (1.0957)2
(1.1132)3

⇒
C = 109.9837 ⇒ c= 10.9984%
52
Patterns
 Having derived the spot rates, we
can plot them versus the time to
maturity.
 In practice the graph may be
upward sloping, or inverted, or else
may be humped.

53
Upward Sloping Curve

54
Inverted Yield Curve

55
Humped Yield Curve

56
Forward Rates
 Let 1f1 be the one period forward
rate one period from now.
 That is, it represents the applicable
rate for a forward contract that is
made today, at time 0, to extend a
one period loan next period, that
is, at time 1.

57
Forward Rates (Cont…)
 Consider an investor who is
contemplating making a loan for
two periods.
 He will be indifferent between
making a two-period loan at the
two-period spot rate, and a one-
period loan at the one-period spot
rate with a forward contract to
rollover the proceeds for one 58
Forward Rates (Cont…)
 That is, if arbitrage opportunities
were to be non-existent, we would
require that:
(1+s2)2 = (1+s1)(1+1f1)
 f is known as the one period
1 1
implied forward rate.
 In general, if we have an m period spot
rate and an n period spot rate, where
m>n, then (1+sm)m = (1+sn)n(1+nfm-n)m-n59
Illustration
 Assume that the five year spot rate is
10% and that the four year spot rate is
9%.
 The one year forward rate four years
from now is given by:
1 + 4f1 = (1.10)5 = 1.1409 ⇒ 4f1 =
14.09%
________
(1.09)4
60
Theories of the Term
Structure
 The first theory that we shall look at is
called the Expectations Hypothesis.
 As per this theory, forward rates are
nothing but unbiased expectations of
future spot rates.
 Thus nfm-n = E0[nsm-n]
 In other forwards the (m-n) period
forward rate, n periods from now is the
current expectation of the (m-n) period
spot rate that is expected to prevail n
periods from now.
61
Theories (Cont…)
 The Expectations hypothesis can
explain any shape of the yield
curve.
 For instance an expectation that
future short term interest rates will
be above the current level would
lead to an upward sloping yield
curve.
62
Illustration (Cont…)
 Assume that s1 = 5.50%; E[1s1] =
6%;E[2s1] = 7.5%, and that E[3s1] =
8.5%
 S2 = [(1.055)(1.06)]1/2 – 1 = 5.75%
 S3 = [(1.055)(1.06)(1.075)]1/3 – 1 =
6.33%
 S4 =
[(1.055)(1.06)(1.075)(1.085)]1/4
63
Theories (Cont…)
 If the unbiased expectations
theory is true, then the yield curve
is an important forecasting tool,
since it is an indicator of the
direction of future short term
interest rates.
 According to the unbiased
expectations hypothesis, investors
care only about expected returns 64
Theories (Cont…)
 Take the two period case.
 An investor can buy a two year bond
yielding a rate of s2.
 Or else he can buy a one period bond
yielding s1 and then roll over into
another one period bond at maturity.
 According to the expectations
hypothesis he will be indifferent if the
expected returns from the two
strategies are equal.
65
Theories (Cont…)
 In other words the market will be
in equilibrium if:
(1+s2)2 = E[(1+s1)(1+1s1)]
 But if arbitrage is to be ruled out
we require that:
(1+s2)2 = (1+s1)(1+1f1)
 Thus if the expectations hypothesis
is valid, then 1f1 = E(1s1)
66
Theories (Cont…)
 How can expectations of rising interest
rates lead to an upward sloping yield
curve?
 If rates are expected to rise then
investors in long term bonds will indeed
be perturbed.
 Rising interest rates imply falling bond
prices, and long term bonds are more
vulnerable to changing interest rates
than short term bonds.
67
Theories (Cont…)
 In such a scenario investors will
start selling long term bonds and
buying short term bonds.
 This will push up the yield on long
term bonds, and lead to a decline
in yields on short term bonds.
 The overall effect will manifest
itself as an upward sloping yield
curve.
68
Policy Implications
 As per this theory changes in the
relative amounts of long term and short
term bonds will not affect the shape of
the yield curve, unless investor’s
expectations of the future were to be
affected.
 For instance the central banks of
countries conduct open market
operations on a regular basis by buying
and selling Treasury securities.
69
Policy Implications
(Cont…)
 As per the expectations hypothesis
the central bank cannot influence
the shape of the yield curve by
buying securities of one maturity
and selling another.
 This is because as per this theory,
investors regard all securities,
whatever their maturity, as perfect
substitutes. 70
Liquidity Premium
Hypothesis
 We know that long term bonds are more
vulnerable to interest changes than
short term bonds.
 Most investors prefer to lend short-term.
 Take the case of an investor who
intends to invest for one period.
 He can buy a one period bond and get a
rate of s1.

71
Liquidity…(Cont…)
 Or else he can by a two period
bond and sell it after one period.
 In this case the rate of return will
be uncertain since the price of the
bond at the end of the period will
be uncertain.
 Take the case of a zero coupon
bond with a face value of $1,000.
72
Liquidity…(Cont…)
 Its current price is:
1000
____________
(1+s1)(1+1f1)
The expected price after a period is:
E[ 1000] 1000
______ ≥ _________
(1+1s1) [1 + E(1s1)]
73
Liquidity…(Cont…)
 The rate of return from the two period
bond over the first year is:
E[ 1000] 1000 1000 1000
______ - __________ ________ - __________
(1 + 1s1) (1+s1)(1+1f1) [1+E(1s1)] (1+s1)(1+1f1)
______________________ ≥______________________
1000 1000
________ ___________
(1+s1)(1+1f1) (1+s1)(1+1f1)

74
Liquidity…(Cont…)

≥ (1+s1)(1+1f1)
__________ - 1
1 + E(1s1)
 This will be greater than s1 only if
f > E(1s1)
1 1
75
Liquidity…(Cont…)
 In other words an investor with a one
period horizon will hold a two period
bond only if its expected return is
greater than the rate of return on a one
period bond, which implies that the
forward rate must be greater than the
expected spot rate.
 Thus if investors are risk averse, the
forward rate will embody a risk or
liquidity premium. In other words, the
forward rate will exceed the expected
future spot rate by the amount of the
premium. 76
The Liquidity Premium
Theory and the Term
Structure
 We know that:
(1+s2)(1+s2) = (1+s1)(1+1f1)
 According to the liquidity preference
theory:
(1+s1)(1+1f1) > (1+s1)[1+E(1s1)]
 Therefore:
(1+s2)(1+s2) > (1+s1)[1+E(1s1)]

77
Liquidity…(Cont…)
 Consider a downward sloping term
structure, that is, s1 > s2.
 The inequality will hold only if
E(1s1) is substantially smaller than
s1.
 Thus a downward sloping yield
curve will be observed only if the
market expects spot rates to
decline significantly.
78
Illustration
 Assume that s1 = 7% and that s2 = 6%.
 The term structure is obviously
downward sloping.
1f1 = (1.06)(1.06)


______________ - 1 = 5.01%
(1.07)
 If we assume that the liquidity premium is
.41%, then E(1s1) = 4.60%, which implies that
the spot rate is expected to decline
significantly.
79
Illustration (Cont…)
 The expectations hypothesis would
also say that the spot rate is
expected to decline significantly.
 However, according to it, E(1s1) =
5.01%

80
Liquidity…(Cont…)
 What about a flat term structure?
 If s1 = s2, then according to the liquidity
premium hypothesis, E(1s1) < s1.
 Thus according to this hypothesis a flat
term structure is an indication that spot
rates are likely to decline.
 In contrast a flat term structure would
imply no change in the one period spot
rate, if the expectations hypothesis
were to be valid.
81
Illustration (Cont…)
 For instance if s1 = s2 = 7% and
the liquidity premium is .41%, the
liquidity premium would imply that
E(1s1) = 6.59%.
 In contrast according to the
expectations hypothesis E(1s1) =
7%.

82
Liquidity…(Cont…)
 What about an upward sloping term
structure?
 If s1 < s2 and the curve is slightly
upward sloping, then the liquidity
premium hypothesis would be
consistent with an expectation that
interest rates are going to slightly
decline.
 However if the curve were to be steeply
sloped upward it would be consistent
with the expectation that rates are 83
going to rise.
Illustration
 Assume that s1 = 7% and s2 =
7.1%.
 Let the liquidity premium be .41%.
 If so, 1f1 = 7.2% ⇒ E(1s1) = 6.79%
 However if s2 = 7.3%, then 1f1 =
7.6% ⇒ E(1s1) = 7.19%.
 However in both cases the
expectations hypothesis would
predict a rise in the spot rate. 84
Market Segmentation
 The market segmentation or the
hedging pressure hypothesis argues
that securities are not perfect
substitutes for each other.
 Different investor groups have their own
maturity preferences.
 A group will not stray from its desired
maturity range unless it is induced to do
so by higher yields or other favourable
terms.
85
Market Segmentation
(Cont…)
 This theory argues that financial
intermediaries like banks, pension
funds, and mutual funds, often act like
risk minimizers rather than profit
maximizers as assumed by the
expectations hypothesis.
 That is they prefer to hedge against the
risk of fluctuations in prices and yields
by balancing the maturity structures of
their assets with that of their liabilities.
86
Market Segmentation
(Cont…)
 For instance pension funds have
stable and predictable long term
liabilities.
 Thus they prefer long term assets.
 Banks have relatively short term
liabilities and hence tend to prefer
short term assets.
 Thus financial markets are not one
large pool of loanable funds.
87
Market Segmentation
(Cont…)
 Thus the debt market is essentially a
number of sub markets.
 Demand and supply within each group
is the dominant reason for the level and
structure of interest rates within that
maturity range.
 However rates prevailing in a group are
relatively unaffected by rates prevailing
elsewhere.
88
Policy Implications
 If submarkets are relatively isolated
from each other than government
policymakers can alter the shape of the
curve by influencing supply and
demand in one or more market
segments.
 For instance if a positively sloped yield
curve were to be desired, the market
can flood the market with long term
bonds.
 It could simultaneously purchase short
term bonds. 89
The Preferred Habitat or
Composite Theory
 This theory attempts to unifies all
the earlier theories.
 It argues that investors seek out
their preferred habitat along the
scale of varying maturities, that
matches their risk preferences, tax
exposure, liquidity needs,
regulatory requirements, and
planned holding periods. 90
Preferred Habitat (Cont…)
 An investor will not stray from his
preferred habitat unless the return
on another segment of the market
is high enough to overcome his
preferences.

91
Solution
 Econometric models may be
specified to calculate the rate that
best fits the market prices of
bonds in the sample, using a
technique like non-linear least
squares.

92
The Nelson-Siegel
Technique
 It is a parametric approach for deriving
the zero-coupon yield curve.
 According to this model, the m period
spot rate is given by:
s(m,β) = β0 + β1 x [1 – e-m/τ] +
________
m/τ
β2 x 1 – e-m/τ
[________ – e-m/τ]
m/τ
93
Nelson-Sigel (Cont…)
 The parameters β0, β1, β2 and τ have to
be empirically estimated.
 Advantages of the method:
 It can handle a wide variety of term
structure shapes that are observed in
the market.
 It avoids the need for interpolation to
determine the spot rates between
discrete points in time
94
Nelson-Siegel (Cont…)
 Thus spot rates can be derived at
any point in time and not just at
discrete points in time.
 The parameters can be interpreted
as follows.
 β0 must be positive and is the
asymptotic instantaneous forward
rate.
 It is a function of the term to
maturity. 95
Nelson-Siegel (Cont…)
 β1 measures the deviation from
the asymptote.
 It measures the speed with which
the curve tends towards its long
term value.
 If it is positive, the curve will have
a negative slope and vice-versa.

96
Nelson-Siegel (Cont…)
 τ must be positive and is the
position of the hump or the u-
shape on the curve.
 β2 measures the magnitude and
direction of the hump.
 If it is positive there will be a
hump.
 Else there will be a u-shape.
97