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Chapter 15

The Term Structure of Interest Rates

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Overview of Term Structure of Interest Rates

Relationship between yield to maturity and maturity Information on expected future short term rates can be implied from yield curve The yield curve is a graph that displays the relationship between yield and maturity Three major theories are proposed to explain the observed yield curve

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Yield Curves
Yields Upward Sloping Flat Downward Sloping Maturity
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Expected Interest Rates in Coming Years (Table 15.1)

Expected One-Year Rates in Coming Years

Year 0 (today) 1 2 3

Interest Rate 8% 10% 11% 11%

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Pricing of Bonds using Expected Rates

1 PVn (1 r1 ) (1 r2 )...(1 rn )
PVn = Present Value of $1 in n periods
r1 = One-year rate for period 1 r2 = One-year rate for period 2 rn = One-year rate for period n
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Long-Term Rates and Bond Prices using Expected Rates

Time to Maturity Price of Zero* Yield to Maturity 1 2 3 4 $925.93 841.75 758.33 683.18 8.00% 8.995 9.660 9.993

* $1,000 Par value zero

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Forward Rates from Observed Long-Term Rates

(1 yn ) (1 f n ) (1 yn 1 ) n 1
n

fn = one-year forward rate for period n

yn = yield for a security with a maturity of n

(1 yn ) (1 yn1 ) (1 f n )
n

n 1

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Example of Forward Rates using Table 15.2 Numbers

4 yr = 9.993 3yr = 9.660 fn = ?

(1.0993)4 = (1.0966)3 (1+fn)

(1.46373) / (1.31870) = (1+fn)

fn = .10998 or 11%

Note: this is expected rate that was used in the prior example
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Downward Sloping Spot Yield Curve

Zero-Coupon Rates Bond Maturity 12% 1 11.75% 2 11.25% 3 10.00% 4 9.25% 5

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Forward Rates for Downward Sloping Yield Curve

1yr Forward Rates 1yr [(1.1175)2 / 1.12] - 1 = 0.115006

2yrs [(1.1125)3 / (1.1175)2] - 1 =

3yrs [(1.1)4 / (1.1125)3] - 1 4yrs [(1.0925)5 / (1.1)4] - 1
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= =

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Theories of Term Structure

Expectations Liquidity Preference - Upward bias over expectations Market Segmentation - Preferred Habitat

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Expectations Theory
Observed long-term rate is a function of todays short-term rate and expected future short-term rates Long-term and short-term securities are perfect substitutes Forward rates that are calculated from the yield on long-term securities are market consensus expected future short-term rates

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Liquidity Premium Theory

Long-term bonds are more risky Investors will demand a premium for the risk associated with long-term bonds Yield curve has an upward bias built into the long-term rates because of the risk premium Forward rates contain a liquidity premium and are not equal to expected future shortterm rates

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Liquidity Premiums and Yield Curves

Yields Observed Yield Curve

Forward Rates Liquidity Premium Maturity

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Liquidity Premiums and Yield Curves

Yields

Observed Yield Curve Forward Rates

Liquidity Premium
Maturity
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Market Segmentation and Preferred Habitat

Short- and long-term bonds are traded in distinct markets Trading in the distinct segments determines the various rates Observed rates are not directly influenced by expectations Preferred Habitat - Modification of market segmentation - Investors will switch out of preferred maturity segments if premiums are adequate
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