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The term structure of interest rates

Reading Luenberger, Chapter 4 Fabozzi, Chapters 7, 8, 41, 42 Goals Understand the term structure of interest rates Dene forward and spot rates Understand expectations dynamics Extend the notions of duration and immunization

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

Yield curve
A bond is specied by its face value F , the coupon rate c, the coupon frequency m and the maturity T For a bond (F, c, m, T ) with price P , the YTM is the IRR In the previous chapter, we xed a bond with maturity T and considered the bond price P as a function P () of the yield Now we consider bonds in a given quality class (e.g. treasury bonds, AAA corporate bonds) but with dierent maturities The yield curve displays the yield as a function (T ) of maturity T Normal curve is increasing Inverted curve is decreasing Relative pricing information

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

The term structure

Spot rates Focus is on interest rates, not yields We consider rates that depend on the length of time for which they applywe relax the assumption of a constant ideal bank The spot rate st is the annual interest rate for money held from today (t = 0) until time t; it replaces the time-invariant annual rate r considered above This implicitly assumes a compounding convention, such as annual, m times a year, or continuous compounding The spot rate curve displays st as a function of time t; as the yield curve, it is increasing most of the time

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

The term structure

Determining the spot rate from zero bond prices Let si be the spot rate for i years with annual compounding A dollar deposited at time 0 has value (1 + si )i after i years The corresponding discount factor is di =
1 (1+si )i

Consider a zero coupon bond with face value F that matures i years F from now; its price P is given by P = F di = (1+ si )i For i > 0 we nd the corresponding spot rate si via si = F P
1 i

Given the prices of zero bonds with various maturities, we can construct the spot rate curve
Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

The term structure

Bootstrapping the spot rate from coupon bond prices Observe s1 as the one-year rate available today (e.g. one year Treasury rate) Next consider a 2 year bond with annual coupon C and face value F that has price C +F C + P = 1 + s1 (1 + s2 )2 This can be solved for s2 given s1 and the terms of the bond Next consider 3 year bonds, and so on

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

Forward rates
We consider the interest rate that is available for borrowing money in the future, under terms agreed upon today The forward rate ft1 ,t2 between time t1 0 and t2 > t1 is the annual interest rate for money held over the time period [t1 , t2 ]. This rate is agreed upon today. Clearly f0,t = st for all t. For a set of spot rates (si ) based on annual compounding, the forward rate fi,j between years i and j > i satises (1 + sj )j = (1 + si )i (1 + fi,j )j i so that the forward rate implied by the spot rates is given by fi,j = (1 + sj ) (1 + si )i
j
1 j i

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

Forward rates
Arbitrage argument Consider two ways of investing a dollar for j years at the currently available rates Invest in a j year account. A dollar will grow to (1 + sj )j . Invest in a i year account for some i < j . At i, take out the (1 + si )i and invest in a j i year account that accrues interest at an annual rate fi,j that you agree upon today. A dollar will grow to (1 + si )i (1 + fi,j )j i . In the absence of arbitrage opportunities and transaction costs, we must have (1 + sj )j = (1 + si )i (1 + fi,j )j i

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

Short rates
The short rate ri at year i is the forward rate fi,i+1 Short rates are as fundamental as spot rates, since a complete set of short rates fully species the term structure: (1 + si )i = (1 + r0 )(1 + r1 ) (1 + ri1 ) and also (1 + fi,j )j i = (1 + ri )(1 + ri+1 ) (1 + rj 1 )

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

Compounding conventions
Above we considered spot rates, forward rates and short rates based on annual compounding All these rates can also be dened based on discrete compounding several times a year and continuous compounding Problem: Express the rates under continuous compounding

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Compounding conventions
Solution The accumulation factor is est t with st the spot rate for [0, t] For t1 0 and t2 > t1 the forward rate ft1 ,t2 satises exp(st2 t2 ) = exp(st1 t1 ) exp(ft1 ,t2 (t2 t1 )) and therefore ft1 ,t2 Assuming that
d dt st

st2 t2 st1 t1 = t2 t1

exists, the short rate rt is given by

st+u (t + u) st t st+u u + t(st+u st ) rt = lim ft,t+u = lim = lim u0 u0 u 0 u u st+u st d = st + t lim = st + t st u 0 u dt

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

11

Why is the spot rate curve almost never at?

Expectations theory While forward rates are known today, the corresponding spot rates actually realized in the future are random variables The expectations hypothesis says that today, the markets expected value of the j i year spot rate available in i years from now is equal to the forward rate fi,j quoted today Example: Let s1 = 0.07 and s2 = 0.08. Then the implied forward 10.07 = 0.09. The expectations theory says that rate is f1,2 = 20.08 21 this is the markets expected value of the 1 year spot rate available next year.

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

12

Why is the spot rate curve almost never at?

Expectations theory Since forward rates are implied by a set of current spot rates, expectations about future spot rates are inherent in current spot rates available in the market The other way around, the expectation of future spot rates determines current forward rates and thus current spot rates The theory argues that the market believes (expects) that the spot rate will be higher in the future (e.g. because of ination), and this translates into a rising spot rate curve today Caveat: the market expects rates to increase whenever the spot rate curve is upward sloping, which is almost always the case. Thus market expectations cannot be right even on average.
Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Why is the spot rate curve almost never at?

Liquidity preference theory This theory asserts that investors prefer short-term xed-income securities over long-term securities In other words, investors prefer to stay exible: they like their funds to be liquid rather than tied up, and this exibility costs some yield While this is plausible for time deposits, the argument is less obvious in the case of bonds, which can often be sold in the market In that case the argument is that short-term bonds are preferred over long-term bonds since the former are less sensitive to rate changes, and thus carry less risk if short term sales are necessary

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Why is the spot rate curve almost never at?

Market segmentation theory This theory asserts that the market for xed-income securities is segmented by maturity dates Investors desire a specic set of maturities, based on their projected need for funds or their risk preference The demand and supply for a specic maturity is determined by a specic sect of investors; in the extreme, all points on the spot rate curve are mutually independent

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Expectations dynamics
Forecasting future spot rates Suppose the expectations about future spot rates implied by current spot rates will actually be fullled We can forecast next years spot rate curve from the current one, and this curve implies another set of expectations for the following year. If these are fullled, too, we can predict ahead once again, generating spot rate curve dynamics Let (si ) be the current spot rate curve. If expectations will actually be fullled, then the j year spot rate available next year will be equal to the forward rate f1,1+j implied by (si ), given by f1,1+j = (1 + s1+j ) 1 + s1
1+j
1 j

1,

0<jn

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Expectations dynamics
Forecasting future spot rates Here is an example: s1 Current 1yr Forecast Calculate the forecast rates using annual compounding 6.00 s2 6.45 s3 6.80 s4 7.10 s5 7.36 s6 7.56 s7 7.77

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Expectations dynamics
Forecasting future spot rates Here is an example: s1 Current 1yr Forecast 6.00 6.90 s2 6.45 7.20 s3 6.80 7.47 s4 7.10 7.70 s5 7.36 7.88 s6 7.56 8.06 s7 7.77

Since the j year spot rate available next year will be equal to the forward rate f1,1+j implied by (si ), next years spot rate forecast is f1,2 (1 + s2 )2 = 1 = 0.069 1 + s1 (1 + s3 ) 1 + s1
3
1 2

f1,3 =

1 = 0.0720

Note that the forecast curve is shorter by one term

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

18

Expectations dynamics
Invariance theorem Suppose you have to invest a xed amount in Treasuries for n years, without withdrawing funds before n Multitude of choices whose values depend on future rates Theorem. Suppose interest rates evolve according to expectations dynamics. Then, with annual compounding, a sum invested in the interest rate market for n years will grow by a factor of (1 + sn )n independent of the investment and reinvestment strategy, so long as all funds are fully invested. Interpret this in terms of the short rates, which do not change under expectations dynamics: every investment earns the relevant short rates over its duration
Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Expectations dynamics
Invariance theorem Proof for n = 2. You have two choices: Invest into a 2 year zero that will have grown to (1 + s2 )2 after 2 years Invest into a 1 year zero that will have grown to (1 + s1 ) after a year, and then reinvest into another 1 year zero at the then current 1 year spot rate. Under expectations dynamics, this rate will be equal to todays forward rate f1,2 for next year (the short rate r1 ), and so the investment will have grown after 2 years to (1 + s1 )(1 + f1,2 ) = (1 + s2 )2 by the denition of the forward rate f1,2 A similar argument applies for any n.
Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

20

Running present value

Present value and spot rates Let si be the spot rate for i years with annual compounding A dollar deposited at time 0 has value (1 + si )i after i years The corresponding discount factor is di =
1 (1+si )i

For a spot rate curve (si ), the present value of an investment (x0 , x1 , . . . , xn ) is given by
n

PV =
i=0

xi di

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Running present value

We now start with the nal cash ow and work backward to the present along the cash ow times i The running present value at year i of the remaining investment (xi , xi+1 , . . . , xn ) is dened by the recursive relation P V (i + 1) P V (i) = xi + 1 + ri where ri is the short rate applying at year i and P V (n) = xn Note that the short rates (ri ) are known today, so P V (i) is a deterministic quantity

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

22

Running present value

Theorem. We have P V (0) = P V . Proof. Since r0 = f0,1 = s1 , we calculate P V (1) P V (0) = x0 + 1 + s1 1 P V (2) = x0 + x1 + 1 + s1 1 + f1,2 x1 1 P V (3) = x0 + + x2 + 1 + s1 (1 + s1 )(1 + f1,2 ) 1 + f2,3 x1 x2 P V (3) = x0 + + + 1 + s1 (1 + s2 )2 (1 + s3 )3 and so on, where we use the denition of the forward rates fi,j

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Running present value

Theorem. Suppose that interest rates follow the expectation dynamics. Then the P V (i) will be equal to the realized present value of the cash ows at i, where i = 1, 2, . . . , n. Proof. Under the expectation dynamics, the short rate ri at time i available today equals the one year spot rate available at time i. Then, for i = 1, we have that P V (2) P V (1) = x1 + 1 + r1 1 P V (3) x2 + = x1 + 1 + r1 1 + r2 x2 P V (3) = x1 + + 1 + r1 (1 + r1 )(1 + r2 ) equals the present value of (x1 , x2 , . . . , xn ) at time 1
Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Floating rate bonds

A oating rate bond (or note or oater) has a xed face value, maturity and coupon dates, but its coupon is tied to the rates when the coupon is due. Specically, at each coupon date the coupon rate for the next period is reset to the then current spot rate for that period. Theorem. At any coupon date before the maturity, the value of a oating rate bond is equal to its face value (the bond is at par). Proof. Use a running present value argument.

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

25

Duration
Above, we considered the duration of a bond as a measure for its sensitivity to yield changes (maturity xed) In the context of the term structure, other measures of sensitivity can be constructed For a given short rate curve (si ), we consider a parallel shift in the curve (si + ) for some hypothetical instantaneous change Note that the shifted spot rates apply for the same periods as the original rates This generalizes a change in the yield to a non-at term structure of spot rates

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Duration
We are interested in the response of the bond price to a parallel shift Consider the cash stream (x0 , x1 , . . . , xn ), whose price P () as a function of the shift is equal to
n

P () =
i=0

xi (1 + si + )
i

The relative price sensitivity is given by the quasi-modied duration 1 dP () DQ = P (0) d 1 = PV

n

i xi (1 + si )
i+1

=0

i=1

which has units of time but is not a weighted average of cash ow times
Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Fisher-Weil Duration
We now consider the case with continuous compounding The price P () of the cash stream (x0 , x1 , . . . , xn ) at times (t0 , t1 , . . . , tn ) Rn + is equal to
n

P () =
i=0

xi e(si +)ti

where si is the spot rate applying to [0, ti ] The relative price sensitivity is given by the Fisher-Weil duration DF W 1 dP () = P (0) d 1 = PV
n

ti xi esi ti
i=0

=0

which has units of time and is a weighted average of cash ow times

Kay Giesecke

MS&E 242: Investment Science, The term structure of interest rates

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Immunization
The term structure perspective leads to a more robust method of portfolio immunization, which does not require the selection of bonds with a common yield We construct an immunization portfolio that Matches the present value of our obligations Matches the quasi-modied or Fisher-Weil duration of the obligations This gives protection against parallel shifts in the spot rate curve; keep in mind that other shifts are possible as well

Kay Giesecke