Fixed Income

Term structure and interest rate dynamics

Spot rates yields on zero coupon bonds (aka zero coupon rates)
Pt = 1/(1+St)t - where P is price today of a zero coupon bond, S is spot rate
Forward rates annualized interest rate on a loan to be initiated at a future period
o Notation f(j,k) = annualized interest rate applicable on a k-year loan starting
in j years; for instance f(2,1) is a annualized interest rate for a 1-year loan
starting in 2 years
NOTE - F = forward price and f = annualized interest rate
YTM is the spot interest rate for a maturity of T (assuming spot rate curve is flat); if
the spot rate curve is not flat then YTM will be different

Forward pricing model values forward contracts based on arbitrage-free pricing;

Eg. Forward price 2-years from now for a $1 par, zero-coupon three year bond given
the following spot rates: 2-year spot rate S2 4%; 5-year spot rate S5 6%
Step 1 calculate discount factors
P2 (1/(1.04)^2) = 0.9246) and
P5 (1/(1.06)^5) = 0.7473
Step 2 Calculate Forward Price F(2,3) = P(2+3)/P2 or (0.7473/ 0.9246) = $0.8082 (this
is the price agreed today to pay in two years for a three year bond that will pay $1
at maturity
Alternatively, PV of $1 to be received in five years is 0.7473, if that is invested for
two years @4% (0.7473 x (1.04)^2 = 0.8082) is what youll pay today for a three-
year bond two years hence

Forward rate model relates to forward and spot rates

(1+S1) = (1+f1)

(1+S2)2 = (1+f1) (1+f2); OR

= (1+S1) (1+f2)

(1+S3)3 = (1+f1) (1+f2) (1+f3); OR

= (1+S2)2 (1+f2)

Process to derive spot rates (or zero-coupon rates) from par curve (par rate is YTM
of a bond trading at par) is called Bootstrapping
o First recognize that - S1 = f1 = PR1
o Calculate the second-year spot rate from given two par rates PR 1 (aka S1) and
PR2 assuming $100 coupon paying bond
 100 = PR2/(1+S1) + 100 x PR2/(1+S2)^2

o After calculating S2 go on to calculate S3 by substituting one and two year

spot rates.
Riding the yield curve purchasing bonds (in an upward sloping interest rate term
structure) with maturities longer than his investment horizon.
Swap rate curve (benchmark interest rate curve)
o Swap rate curve vs. government bond yield curve (1) swap rates reflect
credit risk of commercial banks than governments (2) swap market not
regulated by government and is market determined (3) swap rates has
quotes in many maturities
Swap Fixed Rate (SFR)

T
1
(SFR T)t +
( 1+ ST )T
=1
t =1 1+ St

Swap spread difference between swap rate and yield of a government bond
I-spread difference between yield on credit risky bond and a swap rate
Z-spread spread when added to each spot rate on the default-free spot curve
makes the PV of bonds cashflow equal to the bonds market price.
TED spread (T stands for T-bill and ED for Eurodollar futures contract) amount by
which the interest rate on loans between banks exceeds the interest rate on short-
term U.S. government debt or simply, (3m LIBOR 3m T-bill rate)
o A rising TED spread indicates that banks are likely to default; TED spread
captures risk in banking system
(LIBOR OIS) spread OIS (overnight indexed swap) reflects the federal funds rate
and includes minimal counterparty risk.
o Note low LIBOR-OIS spread is a sign of high liquidity; and high LIBOR-OIS
spread is a sign that banks are unwilling to lend
Traditional theories of the term structure of interest rates
o Unbiased expectations theory (pure expectations theory) investors
expectation determine the shape of the interest rate term structure; forward
rates = f(expected future spot rates)
o Local expectation theory unbiased expectations theory + risk neutrality
assumption for the short holding periods (i.e., over longer periods risk
premium should exist); alternatively, over short time periods every bond
should earn the risk-free rate
o Liquidity preference theory unbiased expectations theory + liquidity
premium (to compensate for exposure to interest rate risk)
o Segmented markets theory shape of yield curve is determined by the
preferences of borrowers and lenders (i.e., supply of and demand for loans of
different maturities)
o Preferred habitat theory unbiased expectations theory + premium (related
to supply and demand for funds at various maturities)
Modern term structure theories