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Chapter 15 The Term Structure of Interest Rates

A. Yield-to-maturity
The yield-to-maturity on any fixed-income security is the single interest rate (with interest
compounded at some specified interval) that, if paid by a bank on the amount invested, would
enable the investor to obtain all the payments made by the security in question.

e.g. Consider three treasury securities (bonds) A, B, and C. Bond A matures in a year, at which
time the investor will receive $1000. Right now, it is sold at $934.58. Similarly, bond B
matures in two years and sells at $857.34 at which time will receive $1000. Bond C is a coupon
bond that pays the investor $50 one year from mow and matures two years from now, paying the
investor $1050 at that time while it is sold at $940.93.
Hence, the yield-to-maturity on bond A is that rate rA:
(1 + rA) * $934.58 = $1000 => $934.58 = $1000/(1 + rA) => rA = 7%
In the case of bond B, its yield-to-maturity rB is:
(1 + rB) * [(1 + rB) * 857.34] = $1000 => 857.34 = $1000/(1 = rB)2 => rB = 8%
whereas bond C, its yield-to-maturity rC is:
(1 + rC) * {[(1 + rC) * $946.93] - $50} = $1050 => [$50 * (1 + rC)] + [$1050/(1 + rC)2] = $946.93
=> rC = 7.975%
(hence, yield-to-maturity is the discount rate that makes the present value of the promised
future cash flows equal to the current market price of the bond. When viewed in this
manner, yield-to-maturity is analogous to internal rate of return.)
B. Spot Rates
A spot rate is measured at a given point in time as the yield-to-maturity on a pure-discount
security, and can be thought of as the interest rate associated with a spot contract.
e.g. Bonds A and B in the previous example were pure-discount securities. Accordingly, the oneyear spot rate is 7% and the two-year spot rate is 8%. In general, the t-year spot rate st is
the solution to the following equation:
Pt = Mt/(1 + St)t
where Pt is the current market price of a pure-discount bond that matures in t years and has a
maturity value of Mt.
Spot rates can also be determined in another manner if only coupon-bearing Treasury bonds are
available for longer maturities. Generally, one-year spot rate (s1) will be known since there
generally will be a one-year pure-discount Treasury security available for making this
calculation. In this situation, the two-year spot rate (s2) is the solution to the following
equation:
P2 = [C1/(1 + s1)1] + [M2/(1 + s2)2]
where P2 is the current market price; C1 is the one year coupon payment one year from now
M2 is the maturity value.
e.g. Assume that only bonds A and C exists. In this situation, it is known that the one-year
spot rate s1 is 7%, P2 is $946.93, C1 = $50 and M2 is $1050. Hence,
$946.93 = [$50/(1 + .07)1] + [$1050/(1 + s2)2] => s2 = 8%
C. Discount Factors
A discount factor dt is equivalent to the present value of $1 to be received t years in the
future from a Treasury security, and is equal to:
dt = 1/(1 + st)t
The multiplication of Ct (denote the cash payment to be made to the investor at year t on the
security being evaluated) by dt is termed discounting: converting the given future value into an
equivalent present value. That is:
PV = =1dt*Ct
D. Forward Rates
f1,2 is known as the forward rate from year one to year two. That is , it is the discount rate
for determining the equivalent value of a dollar one year from now if it is to be received two
years from now.
The link between the one-year spot rate, two-year spot rate and one-year forward rate is:

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[$1/(1 + f1,2)]/[1 + s1] = $1/[1 + s2]2
where $1/(1 + f1,2) is the amount to be received one year from now
Hence, (1 + s1) * (1 + f1,2) = (1 + s2) * (1 + s2)
More generally, for year t-1 and year t spot rate , the link to the forward rate between years
t-1 and t is:
(1 + st-1)t-1 * (1 + ft-1,t) = (1 + st)t
E. Forward Rates and Discount Factors
Given a set of spot rates, it is possible to determine the market discount function in either of
two ways, both of which will provide the same figures.
(1) dt = 1/(1 + st)t
(the spot rates can be used to arrive at a set of discount factors.)
(2) dt = 1/[(1 + st-1)t-1 * (1 + ft-1,t)]
(the spot rates can be used to determine a set of forward rates and then the spot rates and
forward rates can be used to arrive at a set of discount factors.)
F. Compounding
Compounding is the payment of "interest on interest." At the end of each compounding interval,
interest is compounded and added to principal.
e.g. If payment of P dollars now will result in the receipt of F dollars ten years from mow, the
yield-to-maturity can be calculated using annual compounding by finding a value ra that
satisfies the equation:
P * (1 +

ra )10 = F

where F will be received ten annual periods from now.

annual rate with annual compounding.

The result, ra, will be expressed as

e.g. On the other hand, yield-to-maturity can be calculated using semiannual compounding by
finding a value rs that satisfies the equation:
P * (1 + rs)20 = F
The result rs will expressed as a semiannual rate with semiannual compounding. The annual rate
with semiannual compounding would (2 * rs).
G. Yield Curves
A yield curve is a graph that shows the yields-to-maturity (on the vertical axis) for Treasury
securities of various maturities (on the horizontal axis) as of a particular date. This provides
an estimate of the current term structure of interest rates.
H. Term Structure Theories
(1) The Unbiased Expectations Theory
The unbiased expectations theory (or pure expectations theory) holds that the forward rate
represents the average opinion of the expected future spot rate for the period in question. That
is in equilibrium, the expected future spot rate is equal to the forward rate: es1,2 = f1,2
Hence, (1 + s2) * (1 + s2) = (1 + s1) * (1 + es1,2)
(If the left hand side is greater than the right hand rise, the investor will invest all his
wealth in the two-year security. On the other hand, if the right hand side is greater than the
left hand side, the investor will invest all his wealth in a one year security and roll it over
by the end of year 1)
Thus, a set of spot rates that is rising can be explained by arguing that the marketplace (that
is, the general opinion of investors) believes that spot rates will be rising in the future).
In general, when current economic conditions make short-term spot rates abnormally high, (e.g.
high rate of inflation), according to the unbiased expectations theory, the term structure
should be downward sloping. This is because inflation would be expected to abated in the future.
Conversely, when current conditions make short-term rates abnormally low, the term structure
should be upward sloping, as inflation would be expected to rise in the future.

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Conversely, a set of decreasing spot rates is explained by arguing that the marketplace expects
spot rates to be falling in the future.
(2) The Liquidity Preference Theory
The liquidity preference theory starts with the notion that investors are primarily interested
in purchasing short-term securities. That is, even though some investors may have longer
holding periods, there is a tendency for them to prefer short-term securities. This is because
they face less "price risk" (interest rate risk) if they invest in shorter-term securities.
e.g. An investor with a two-year holding period would tend to prefer the rollover strategy since
he or she would be certain of having a given amount of cash at the end of one year when it may
be needed. If a maturity strategy had been followed, then the investor would have to sell the
two-year security after one year if cash was needed. However, it is not known now what price
the investor would get if he or she were to sell the two-year security in one year. Thus, there
is an extra element of risk associated with the maturity strategy that is absent from the
rollover strategy. Hence, the investors with a two-year holding period will not choose the
maturity strategy if it has the same expected return as the rollover strategy, since is riskier.
The only way investors will follow the maturity strategy and buy the two-year securities is if
the expected return is higher. That is, borrowers are going to have to pay the investors a risk
premium in the form of a greater expected return in order to get them to purchase two-year
securities.
The difference between the forward rate and the expected future spot rate is known as the
liquidity premium (L1,2).
f1,2 = es1,2 + L1,2
Hence,

(1 + s2) * (1 + s2) > (1 + s1) * (1 + es1,2)

If s1 > s2, and if es1,2 is substantially smaller than the current one-year spot rate (s1), we
would have a downward-sloping yield curve. This would occur as the marketplace believes that
interest rates are going to decline substantially.
If s1 = s2, and if es1,2 is less than s1, we would have a flat term structure.
only when the marketplace expects interest rates to decline.

It would occur

If s1 < s2 and the yield curve is slightly upward sloping, this can be consistent with an
expectation that interest rates are going to decline in the future.
If the term structure is more upward steeply sloped, then it is more likely that the
marketplace expects interest rates to rise in the future.
In summary, with the liquidity preference theory, downward-sloping term structure are
indicative of an expected decline in the spot rate, while upward-sloping term structures may
indicate wither an expected rise or decline, depending on how steep the slope is.
(3) The Market Segmentation Theory
Since, various investors and borrowers are asserted to be restricted by law, preference, or
custom to certain maturities, hence spot rates are determined by supply and demand conditions in
each market. Furthermore, in the theory's most restrictive form, investors and borrowers will
not leave their market and enter a different one even when the current rates suggest that them
that there is a substantially higher expected return available by making such a move.
An upward-sloping term structure exists when the intersection of the supply and demand curves
for shorter-term funds is at a lower interest rate than the intersection for longer-term funds.
Conversely, a downward-sloping term structure would exist when the intersection for shorter-term
funds was at a higher interest rate than the intersection for longer-term funds.
I. Market Efficiency
Imagine a world in which
(1) all investors have costless access to currently available information about the future,
(2) all investors are good analysts, and
(3) all investors pay close attention to market prices and adjust their holdings appropriately.
In such a market, a security's price will be a good estimate of investment value, where
investment value is the present value of the security's future prospects as estimated by wellinformed and capable analysts. Hence, a market will call efficient for every security's price
equals its investment value at all times.
We describe the market as having weak-form efficiency if it were impossible to make abnormal

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profits on average by using past prices to make decisions about when to buy and sell securities.
On the other hand, we describe the market as having semi strong-form efficiency if it were
impossible to make abnormal profits on average by using all publicly available information.
Finally, we describe the market as having strong-form efficiency if it were impossible to make
abnormal profits on average by using all information, both public and private.
J. Applying the Capitalization of Income Method to Bonds
This method of valuation states that the intrinsic value of any asset is based on the
discounted value of the cash flows that the investor expects to receive in the future from
owning the asset.
(1) Promised Yield-to-Maturity
The promised yield-to-maturity of the bond is the value of y that solves the following
equation:
P = C1/(1 + y)1 + C2/(1 + y)2 + .... + Cn/(1 + y)n
= =1 Ct/(1 + y)t
where P denote the current market price of a bond with a remaining life of n years, and
promising cash flows to the investor of C1 in year one, C2 in year two, and so on.
e.g. Consider a bond that is currently selling for $900 and has a remaining life of three years.
Assume that it makes annual coupon payments amounting to $60 per year and has a par value of
$1000. Then the yield-to-maturity on this bond is the value of y that solves the following
equation:
$900 = $60/(1 + y)1 + $60/(1 + y)2 + $1060/(1 +y)3 =>

y = 10.02%

If subsequent analysis indicates that the yield-to-maturity should be 9.00%, then this bond is
underpriced, since y = 10.02% > y* = 9.00%. On the other hand, if subsequent analysis
indicates that the yield-to-maturity should be 11%, then this bond is overpriced, since y =
10.02% < y* = 11%.
(2) Intrinsic Value
Alternatively, the intrinsic value of a bond can be calculated using the following formula:
V =

C1/(1 + y*)1 + C2/(1 + y*)2 + .... + Cn/(1 + y*)n

= =1 Ct/(1 + y*)t

Since the purchase price of the bond is its market price P, the net present value (NPV) to the
investor i.e. equal to the difference between the value of the bond and the purchase price:
NPV = V - P = [=1 Ct/(1 + y*)t] - P
e.g. The NPV of the bond in the previous example is the solution to the following equation
(assume y* = 9%):
NPV = [$60/(1 + .09)1 + $60/(1 + .09)2 +

$1060/(1 + .09)3] - $900 = $24.06

Since this bond has a positive NPV, it is underpriced. In short, any bond with y > y* will
always have a positive NPV and vice versa, so that under either method it would be
underpriced. On the other hand, if the investor had determined that y* was equal to 11%, then
the bond's NPV would have been -$22.19. This would suggest that the bond was overpriced (for a
bond with y < y* will always have a negative NPV and vice versa).
Finally, if y = y* (that is to say that yield-to-maturity = the appropriate one), then the NPV
of the bond would be approximately zero. In such a situation, the bond would be viewed as being
priced.
K. Bond Attributes
Six primary attributes of a bond are of significant importance in bond valuation: (1) length of
time until maturity; (2) coupon rate; (3) call provisions; (4) tax status; (5) marketability;
and (6) likelihood of default.

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At any time, the structure of market prices for bonds differing in these dimensions can be
examined and described in terms of yields-to-maturity. This overall structure is sometimes
referred to as the yield structure.
The set of yields of bonds of different maturities constitutes the term structure and the set of
yields of bonds of different default risk is referred to as the risk structure.
The differential between the yields of two bonds is usually called a yield spread. Yield
spreads are sometimes measured in basis points, where one basis point equal .01%. (e.g. if the
yield-to-maturity for one bond is 11.50% and that of another is 11.90%, the yield spread is 40
basis points)
(1) Coupon Rate and the Length of Time until Maturity
These attributes of a bond are important because they determine the size and timing of the cash
flows that are promised to the bondholder by the issuer. Given a bond's current market price,
these attributes can be used to determine the bond's yield-to-maturity, which will subsequently
be compared with what the investor thinks it should be.
(2) Call Provisions
Bonds with call provision enables the issuer to redeem the bonds prior to maturity, usually for
a price somewhat above par. This price is known as the call price, and the difference between it
and the par value of the bond is known as the call premium.
An issuer will often find it financially advantageous to call the existing bonds if yields drop
substantially after the bonds were initially sold, since the issuer will be able to replace them
with lower-yielding securities that are less costly.
The higher the coupon rate of a callable bond, the greater is the likely divergence between
actual and promised yields. In short, bonds with higher coupon rates or lower call premiums
will have lower intrinsic values, keeping everything else equal.
(3) Tax Status
Tax-exempt municipal bonds have had yields-to-maturity that were approximately 20% to 40% lower
than the yields-to-maturity on similar taxable bonds.
Also, since, coupon payments and capital gains are taxed as ordinary income, yet the latter can
be deferred until the bond either is sold or matures, deep discount bonds have a tax advantage
because of this deferral. As the result, low-coupon bonds will have a slightly higher intrinsic
value than high-coupon bonds.
(4) Marketability
Marketability refers to the ability of an investor to sell an asset quickly without having to
make a substantial price concession.
Since most bonds are bought and sold in dealer markets, one measure of a bond's marketability is
the bid-ask spread that the dealers are quoting on the bond.
Bonds that are being actively traded will tend to have lower bid-ask spreads than bonds that are
inactive. This is because the dealer is more exposed to risk when making a market in an inactive
security than when making a market in an active security.
Hence, bonds that are actively traded should have a lower yield-to-maturity and a higher
intrinsic value than bonds that are inactive, keeping everything else equal.
(5) Likelihood of Default
Bond ratings are often interpreted as an indication of the likelihood of default by the issuer.
(e.g. Standard & Poor's and Moody's)
A broader set of categories is often employed, with bonds classified as being of either
investment grade or speculative grade. Typically, investment grade bonds are bonds that have
been assigned to one of the top four ratings (AAA through BBB by Standard & Poor's; Aaa through
Baa by Moody's). In contrast, speculative grade bonds are bonds that have been assigned to one

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of the lower ratings (BB and below by Standard & Poor's; Ba and below by Moody's).
Sometimes these low-rated securities are called, junk bonds.
If the junk bonds were of investment grade when originally issued, they are often called fallen
angels.
For corporate bonds, better ratings are generally associated with lower financial leverage (that
is, debt to total assets); smaller past variation in earnings over time; larger asset base (firm
size); more profitable operations; and lack of subordination to other debt issues.
(a) Default Premiums
Formally, all possible yields are considered, along with their respective probabilities, and a
weighted average computed to determine the expected yield-to-maturity. As long as there is any
possibility of default or late payment, the expected yield will fall below the promised yield.
In general, the greater the risk of default and the greater the amount of loss in the event of
default, the greater will be this disparity in yields.
The difference between the promised and expected yields is the default premium.
A bond will be fairly priced if its promised yield-to-maturity (y) is:
y = (y + *pd)/(1 - pd)
where pd denotes as the probability that it will default in any given year;
y denotes as the bond's expected yield-to-maturity;
(1-) denotes as the # of times its market price a year earlier will be made to the
owner of each bond
Hence, the default premium (d) is: d = y - y

= [(y + *pd)/(1 - pd)] - y

e.g. Consider expected yield-to-maturity for this bond is 9% with 6% annual default probability,
and that it is estimated that if the bond does default, each bondholder will receive an amount
equal to 60% of the bond's market price a year earlier. Hence, its default premium is:
d = {[.09 + (.40 * .06)]/(1 - .06)} - .09 = .0313
(b) Risk Premiums
When we compare the expected return of a risky security with the certain return of a defaultfree security, the difference in these returns in the efficient market will be related to the
relevant systematic or nondiversifiable risk of the security.
Traditionally, a risky bond's expected yield-to-maturity is compared with that of a default-free
bond of similar maturity and coupon rate. The difference between these yields is known as the
bond's risk premium.
Every bond that might default should offer a default premium. Any security's expected return
should be related only to its systematic risk, for it is this risk that measures its
contribution to the risk of a well-diversified portfolio; its total risk is not directly
relevant.
L. The Risk Structure of Interest Rates
Bonds are priced so that higher promised yields go with lower ratings.
Agency ratings indicate relative levels of risk instead of absolute levels of risk. (Thus, the
probability of default associated with bonds in a given rating classification would be greater
in economic uncertainty. In turn, the yield spreads between classifications of corporate bonds
and the yield spreads between corporate and government bonds would increase.)