Spot Rates

Spot Rates, Part I

In general, interest rates are not the same for different maturities. Cash flows from government
bonds to be received at different future dates should be discounted using different interest rates!
These interest rates are known as spot rates.

The spot rate (denoted by rt ) is the interest rate fixed today on a loan that is made today over a
specified time period t. Spot rates are quoted as annual rates.

Example
£100
The PV of £100 to be received two years from now is
(1 + r2 )
2

£100
(1 + r3 )
3
The PV of £1 to be received in three years from now is
 Spot Rates, Part II

UK government term structure – 31 May and 30 June, 2016

 Spot Rates, Part III

The bonds that we consider for pricing throughout the slides are government bonds from
countries such as the UK, US where we assume they are default-free (unless otherwise
specified).

Bonds are priced using spot rates. For example, if you have a bond with n years to maturity, an
annual coupon of C, and a face value F, then its price is determined from:

C C C C+F
PV = + ............. + +
1 + r1 (1 + r2 ) 2 (1 + rn −1 )
n −1
(1 + rn )
n

If you’re pricing a stream of cash flows, each cash flow has its own relevant interest rate
depending on when it arrives.

The PV of the entire stream is the sum of each cash flow discounted at the appropriate
interest rate.
 Spot Rates Example, Part I

The price of a one-year zero is £96.154, the price of a two-year zero is £91.573, and the
price of a three-year zero is £83.962. All zero-coupon bonds have a face value of £100.

Consider a bond with exactly three years to maturity. The face value is £100 and the
coupon rate is 5% (coupons are paid annually). What is the no arbitrage price of this
bond?
 Spot Rates Example, Part II

£100
£96.154 =
(1 + r1 )
The one-year spot rate is 4%.

£100
£91.573 =
(1 + r2 )
2

The two-year spot rate is 4.5%.

£100
£83.962 =
(1 + r3 )
3

The three-year spot rate is 6%.

 Spot Rates Example, Part III

We can now price the three-year 5% coupon bond using the relevant spot rates.

£5 £5 £105
PV = + + = £97.55
1.04 (1.045 ) (1.06 )
2 3

Once we know the price of the bond we can also calculate the yield to maturity, which is the
constant, hypothetical discount rate that, when used to compute the PV of a bond’s cash flows,
gives you the bond’s market price.

£5 £5 £105
£97.55 = + +
(1 + y ) (1 + y )2 (1 + y )3

Solving for y (using a financial calculator or Excel) the yield to maturity is 5.92%.
The End
Pricing Government Bonds Using
Spot Rates and No Arbitrage
 Arbitrage

Arbitrage
1. An investment strategy that has a positive cash flow today and zero cash
1. Anininvestment
flows the future strategy thatofhas
in all states a positive cash flow today and zero cash flows in the future
nature.
in all states of nature
2. An investment strategy that has zero cash flows today and strictly non negative cash flows
2. all
in Anstates
investment strategy
of nature in thethat haswith
future zeroatcash
leastflows today and
one positive strictly
future cash non-negative cashstate
flow in a future flowsofin
all states of nature in the future with at least one positive future cash flow in a future state of
nature.
nature

Note that definition 1 can be viewed the same as a zero cash flow today and a guaranteed
positive cash flow in the future.

If this is the case, we can borrow the PV of the future positive cash flow today to realise the
arbitrage cash flow now. To illustrate, an example follows.
 Arbitrage (cont.)

Example – The original arbitrage had zero cash flows today and a guaranteed cash inflow of
£110 at t = 1.
t=0 t=1
r = 10%

£110
Repay
£110
Borrow PV ( £110 ) = = £100 − £110 loan with
1.1 interest

£100 0

We now have an investment strategy that has a positive cash flow today and zero cash flows in
the future in all states of nature – definition 1 of arbitrage.
 Short Sales

Short sales: bond example

Before we look at an example of bond pricing and no arbitrage we will define the process of a
short sale for a bond. A short sale consists of selling a bond that we do not own.

Steps

✓ Date 0: Borrow the bond from a broker and sell it in the market.
✓ Between dates 0 and 1: Compensate the broker for any coupons the bond pays.
✓ Date 1: Buy the bond in the market and return it to the broker.

A short sale is profitable if the bond price goes down.

 Pricing Government Bonds Through No Arbitrage Example
One, Part I
Consider the following bond data where coupons are annual and par value is £100. What
should be the price of Bond A?

Bond Coupon rate Maturity Price

A 12% 2 years
B Zero-coupon 1 year £70
C Zero-coupon 2 years £60

We can synthetically replicate Bond A (the coupon bond) using Bonds B and C (the zero-coupon
bonds).
What is the replicating portfolio?

The replicating portfolio consists of being long on (buy) 0.12 units of Bond B and long on (buy)
1.12 units of Bond C.
Pricing Government Bonds Through No Arbitrage Example
One, Part II
t=0 t=1 t=2

Bond B
(one-year zero)
long 0.12 units 100(0.12) = 12

t=0 t=1 t=2

Bond C
(two-year zero)
long 1.12 units 100(1.12) = 112
12 112

Same cash flows as Bond A

 Pricing Government Bonds Through No Arbitrage Example
One, Part III
Since being long 0.12 units of Bond B and long 1.12 units of Bond C gives the exact same cash
flows as Bond A the price of bond A must be the same price as 0.12 units of Bond B and 1.12
units of Bond C.

0.12 ( £70 ) + 1.12 ( £60 ) = £75.6

Two assets ie, Bond A and the replicating portfolio (0.12 of Bond B and 1.12 of Bond C), which
have exactly the same cash flows in the future must have the same price today.

The no arbitrage price of Bond A has to be £75.6.

Could you make an arbitrage profit if Bond A was priced at £76 in the market? Yes.
 Pricing Government Bonds Through No Arbitrage Example
One, Part IV

How can you make arbitrage profits?

At t = 0 go short on (sell) Bond A and go long on (buy) the replicating portfolio ie, go long on
(buy) 0.12 units of Bond B and go long on (buy) 1.12 units of Bond C, and make at t = 0 an
arbitrage profit of £0.4.

How did I know what strategy to use to make arbitrage profits?

Let’s consider future cash flows when we go long or short an asset today.

If we go long on (buy) Bond A the future cash flows are positive and if we go short on (sell) the
replicating portfolio the future cash flows are negative. Likewise, if we go short on (sell) Bond A
the future cash flows are negative and if we go long on (buy) the replicating portfolio the future
cash flows are positive.
 Pricing Government Bonds Through No Arbitrage Example
One, Part V
t=0 t=1 t=2

Bond A
(long)
£12 £112
t=0 t=1 t=2

Replicating
portfolio
(long) £12 £112

Since the absolute size of the cash flows is the same at every given point in time in the future, if
we go long one and short the other they will always sum to zero. (Note the diagram is showing
being long both Bond A and the replicating portfolio so these are not the cash flows from the
arbitrage strategy).
 Pricing Government Bonds Through No Arbitrage Example
One, Part VI
We know if we go long one of the assets and short the other the future cash flows will sum to
zero.

How do we decide which one to go long and which one to go short?

Buying (going long on) an asset today results in a negative cash flow today.

Selling (going short on) an asset today results in a positive cash flow today.

We want a net positive cash flow today. Buy cheap and sell high.

Buy replicating portfolio (cheap) and sell Bond A (expensive).

The full arbitrage strategy is, therefore, sell 1 unit of Bond A, buy 0.12 units of Bond B and buy
1.12 units of Bond C.
 Pricing Government Bonds Through No Arbitrage Example
One, Part VII
t=0 t=1 t=2
Bond A
(short)
£76 − £12 − £112
t=0 t=1 t=2

Replicating
portfolio
(long) − £75.6 £12 £112
£0.4 0 0
Our investment strategy yields an arbitrage profit of £0.4. It is arbitrage as our investment
strategy yields a guaranteed positive cash flow today and zero cash flows in the future in all
states of nature, ie, this is a money machine.
In reality, we would short much more than one unit of Bond A to maximise the arbitrage profits
before price movements eliminate the arbitrage opportunity.
 Pricing Government Bonds Through No Arbitrage Example
Two, Part I

Bond A is a one-year zero-coupon bond with a price of £98.039. Bond B is a two-year

annual coupon bond with a 5% coupon and price of £102.02. Par values are £100. What
is the no arbitrage price of a two-year zero-coupon bond and the two-year spot rate?

t=0 t=1 t=2

Price £100
 Pricing Government Bonds Through No Arbitrage Example
Two, Part II
Define xA and xB as the number of units of each bond held.
t=0 t=1 t=2
Bond A

98.039 100
t=0 t=1 t=2

Bond B
Cash flows of
102.02 5 two-year zero- 105
coupon bond
t=0 t=1 t=2
Replicating
portfolio

100 x A + 5 xB = 0 0 x A + 105 xB = 100

 Pricing Government Bonds Through No Arbitrage Example
Two, Part III

100xA + 5xB = 0 Equation 1

0 x A + 105xB = 100 Equation 2

Solving the system of equations we find that

1 20
xA = − xB =
20 21

Using a no arbitrage argument the replicating portfolio must have the same price as the
two-year zero-coupon bond.
Pricing Government Bonds Through No Arbitrage Example
Two, Part IV

98.039 x A + 102.02 xB

 1   20 
98.039 −  + 102.02  = 92.49
 20   21 

t=0 t=1 t=2

Price = 92.49 100

 Pricing Government Bonds Through No Arbitrage Example
Two, Part V

100
92.49 =
(1 + r2 )2

1
 100  2
r2 =   − 1 = 0.0398
 92.49 

The two-year spot rate is 3.98%.

The End
Forward Rates
 Forward Rates
The spot interest rate (denoted by rt ) is the interest rate fixed today on a loan that is made
today over a specified time period.

The forward interest rate (denoted by f) is the interest rate fixed today on a loan to be made in
the future over some specified future period agreed today.

(1 + rt ) (1 + t fT ) = (1 + rt +T )
t T t +T

0 t t+T

(1 + rt )
t
(1 + t fT )T

(1 + rt +T )
t +T

The above formula holds through no arbitrage arguments since all rates are known today and
are risk-free.
 Forward Rates Example One, Part I

Given the following spot rates what is 1f1?

Year Spot Rate Remember this is

1 0.25% an annual rate that
2 0.50% applies over two years.

t=0 t=1 t=2

1.0025 (1+ 1f1)

t=0 t =2
(1.005)2

The two strategies above have to have the same return over two years through a no-arbitrage
argument as all rates are known at t = 0 and are risk-free. If they were not equal you could
borrow at the cheap rate and lend at the expensive rate and make arbitrage profits.
 Forward Rates Example One, Part II

(1 + rt ) (1 + t fT )T = (1 + rt +T )
t t +T

(1 + r1 ) (1 + 1 f1 ) = (1 + r2 )
2

(1.0025) (1 + 1 f1 ) = (1.005)
2

(1.005 )
2

f
1 1 = − 1 = 0.0075
1.0025

The one-year forward rate one year from now ie, 1f1 is 0.75%.
 Forward Rates Example One, Part III

What would happen if 1f1 in the market is greater than 0.75%?

t=0 t=1 t=2

1.0025 Greater than 1.0075
Strategy 1

t=0 t =2
(1.005)2
Strategy 2
 Forward Rates Example One, Part IV

Strategy 1 Strategy 2

(1.0025)(1+1f1 )  (1.005)2

If (1+1f1) is greater than 1.0075 then Strategy 1 must produce a higher risk-free return over two
years than Strategy 2.

We would therefore borrow (short bonds) in Strategy 2 (cheaper rate) and invest (go long) in
Strategy 1 (expensive rate).

If (1+1f1) is less than 1.0075 then invest (go long) in Strategy 2 (expensive rate) and borrow (go
short) in Strategy 1 (cheaper rate).
 Forward Rates Example Two

The one-year spot rate is 5%, the two-year spot rate is 4.5%, and the three-year spot rate
is 4%. Which forward rates can you compute based on this information?

✓ Forward rate between years 1 and 2:

(1 + r1 )(1 + 1 f1 ) = (1 + r2 ) (1.05)(1 + 1 f1 ) = (1.045)

2 2

Therefore 1f1 is 4%.

✓ Forward rate between years 2 and 3:

(1 + r2 ) (1 + 2 f1 ) = (1 + r3 ) (1.045) (1 + 2 f1 ) = (1.04 )
2 3 2 3

Therefore 2f1 is 3%.

 Forward Rates Example Two (cont.)

Forward rate between years 1 and 3:

(1 + r1 )(1 + 1 f 2 ) = (1 + r3 ) (1.05)(1 + 1 f 2 ) = (1.04 )

2 3 2 3

Therefore 1f2 is 3.5%.

The End
Term Structure Theories
 Theories of the Term Structure of Interest Rates, Part I

The term structure of spot rates (or yield curve) represents the spot rates as a function of
maturity. Graphically, it is a plot of spot rates on the y-axis against maturities on the x-axis.

Term Structure Shape

 Theories of the Term Structure of Interest Rates, Part II

✓ The term structure can have many shapes.

▪ It generally slopes up, as we have seen in an earlier in the yield curve for the summer of
2016. This means that spot rates for long maturities are generally higher than for short
maturities.

▪ However, it can also be hump shaped, inverted hump shaped, or downward sloping.

✓ Spot rates, both for short and long maturities, move substantially over time.
 Theories of the Term Structure of Interest Rates, Part III

Term structure theories

✓ Unbiased expectations theory

✓ Liquidity preference theory

✓ Market segmentation hypothesis

 Unbiased Expectations Hypothesis

✓ Agents construct forward rates as (unbiased, rational) forecasts of future one-period interest
rates. For example, 1f1=E(1r1), and liquidity premiums are zero​.

✓ Spot rates are then just combinations of forward rates.

✓ A flat term structure indicates that agents expect future one-period spot rates to be close to
today’s spot rate.

✓ An increasing term structure, for example, reflects expected future one-period rates (and
thus forward rates) that are higher than the current one-period spot rate.

▪ For instance, upward sloping term structure, ie, 0r2>0r1 implies 1f1 > 0r1

▪ That is, investors expect future interest rates to increase, E(1r1) > 0r1 with 1f1=E(1r1)

✓ Investing in long-maturity bonds returns the same, on average, as investing in short-maturity

bonds and rolling over.
 Liquidity Preference Theory

✓ Extend the expectations idea. Start from the basic expectations theory (ie term structure
slope reflects expected future interest rate changes).

✓ Add the notion that savers have a preference for short-term securities over long term
securities.

✓ Hence, forward rates comprise expectations about future spot rates and liquidity premium

1f1=E(1r1) + liquidity premium

✓ This means that long term securities must offer a larger average return than short term ones,
leading to long term rates naturally being greater than short term rates. Long term bonds are
more sensitive to interest rate movements than short term bonds. Thus the natural shape of
the term structure is upward-sloping.

✓ Only if interest rates are expected to decline strongly should we see a negatively sloped term
structure.
 Market Segmentation Theory

✓ Different clienteles of investors operate in long- and short-term markets eg, liabilities of
banks in comparison to liabilities of pension funds.

✓ These investors don’t trade across short- and long-term securities.

✓ This implies that a short rate is set through trade amongst those interested in short-term
securities and long rates are set separately among investors with a long horizon.

✓ No link between the two segments means no link between equilibrium long and short rates.

✓ The outcome is that the term structure can look whichever way you want it to.
The End