FIXED INCOME SECURITIES

THE YIELD CURVE

BUDAPEST UNIVERSITY OF TECHNOLOGY AND ECONOMICS

Faculty of Economic and Social Sciences
Department of Finance
2022

Andrea TOTO
toto.andrea@gtk.bme.hu
 Overview

1. the yield curve

a) bond pricing with different yields
2. the yield curve and future interest rates
a) the yield curve under uncertainty
b) forward rates
3. interest rate uncertainty and forward rates
4. yield curve patterns

2
 The Yield Curve
• while yields to maturity on bonds of similar maturities are reasonably
close, they do differ.
• When these bond prices and yields were compiled, long-term bonds sold at
higher yields than short-term bonds.

Prices and yields of U.S. Treasury bonds

Source: The Wall Street Journal Online, May 16, 2016

3
 The Yield Curve

• The yield curve displays the relationship between YTM and

time to maturity. It is a plot of yield to maturity as a function
of time to maturity
• Information on expected future short-term rates can be
implied from the yield curve (it allows investors to gauge
their expectations for future interest rates against those of the
market)
• Such this information is often the starting point in the
formulation of a fixed-income portfolio strategy

4
Treasury Yield Curves

Treasury yield curves

Source: Various editions of The Wall Street Journal

5
 Yield Curve: Bond Pricing

• Yields on different maturity bonds are not all equal

• Consider each bond cash flow as a stand-alone zero-coupon
bond
• Bond stripping and bond reconstitution offer opportunities
for arbitrage
• The value of the bond should be the sum of the values of its
parts

6
 Prices and Yields to Maturities on
Zero-Coupon Bonds ($1,000 Face Value)
Example
• zero-coupon bonds with 1-year maturity sell at a yield to maturity of y1 = 5%, 2-year
zeros sell at yields of y2 = 6%, and 3-year zeros sell at yields of y3 = 7%

Prices and yields to maturity on zero-coupon

Bonds ($1,000 face value)

• we should use all of these rates to discount bond cash flows

• trick: consider each bond cash flow — either coupon or principal payment — as at least
potentially sold off separately as a stand-alone zero-coupon bond

7
 Treasury Stripping
• Stripped Treasuries are zero-coupon bonds created by selling each coupon
or principal payment from a whole Treasury bond as a separate cash flow
• Treasury stripping suggests exactly how to value a coupon bond. If each
cash flow can be (and in practice often is) sold off as a separate security,
then the value of the whole bond should equal the total value of its cash
flows bought piece by piece in the STRIPS market
• What if it weren’t?
bond stripping and bond reconstitution offer opportunities for arbitrage —
the exploitation of mispricing among two or more securities to clear a
riskless economic profit.
Any violation of the Law of One Price, that identical cash flow bundles
must sell for identical prices, gives rise to arbitrage opportunities

8
 Valuing Coupon Bonds
• To value each stripped cash flow, we simply look up its appropriate discount
rate in The Wall Street Journal. Because each coupon payment matures at a
different time, we discount by using the yield appropriate to its particular
maturity — this is the yield on a Treasury strip maturing at the time of that
cash flow
Example:
Suppose the yields on stripped Treasuries are as given in the table in the slide n.7, and
we wish to value a 10% coupon bond with a maturity of three years. For simplicity,
assume the bond makes its payments annually. Then the first cash flow, the $100 coupon
paid at the end of the first year, is discounted at 5%; the second cash flow, the $100
coupon at the end of the second year, is discounted for two years at 6%; and the final
cash flow consisting of the final coupon plus par value, or $1,100, is discounted for three
years at 7%. The value of the coupon bonds therefore

9
 Valuing Coupon Bonds (2/2)

• Price = $1082.17 and YTM = 6.88%

(use the excel spreadsheet for YTM: set n=3, P=108.217,
coupon rate = 0.1, redemption value = 100)
• 6.88% is less than the 3-year rate of 7%
• while its maturity matches that of the 3-year zero in slide n. 7,
its yield is a bit lower
• the 3-year coupon bond may usefully be thought of as a
portfolio of three implicit zero-coupon bonds, one
corresponding to each cash flow. The yield on the coupon bond
is then an amalgam of the yields on each of the three
components of the “portfolio”.

10
 Bond Pricing:
Two Types of Yield Curves

Pure Yield Curve On-the-Run Yield Curve

• Uses stripped or zero- • Uses recently-issued

coupon Treasuries coupon bonds selling at
or near par
• May differ significantly • The one typically
from the on-the-run yield published by the financial
curve press

11
 The Yield Curve and
Future Interest Rates (1 of 6)

Yield Curve Under Certainty

• Suppose you want to invest for 2 years
─ Buy and hold a 2-year zero
or
─ Rollover a series of 1-year bonds
• Equilibrium requires that both strategies provide the
same return

12
 Two 2-Year Investment Programs
• the upward-sloping yield curve is evidence that short-term rates are
going to be higher next year than they are now
• consider two 2-year bond strategies:
− The first strategy entails buying the 2-year zero offering a 2-year yield to
maturity of y2 = 6% and holding it until maturity. The zero has face value
$1,000, so it is purchased today for $1,000/1.06 2 = $890 and matures in two
years to $1,000. The total 2-year growth factor for the investment is therefore
$1,000/$890 = 1.06 2 = 1.1236
− Now consider an alternative 2-year strategy. Invest the same $890 in a 1-year
zero-coupon bond with a yield to maturity of 5%. When that bond matures,
reinvest the proceeds in another 1-year bond

See next slide:

The interest rate that 1-year bonds will offer next year is denoted as r2

13
Two 2-Year Investment Programs

14
 Two 2-Year Investment Programs
both strategies must provide equal returns — neither entails any risk.
Therefore, the proceeds after two years to either strategy must be equal
Buy and hold 2-year zero = Roll over 1-year bonds
$890 × 1.062 = $890 × 1.05 × (1 + r2)
We find next year’s interest rate by solving 1 + r2 = 1.062 / 1.05 = 1.0701,
or r2 = 7.01%

So, while the 1-year bond offers a lower yield to maturity than the 2-year
bond (5% versus 6%), we see that it has a compensating advantage: It allows
you to roll over your funds into another short-term bond next year when
rates will be higher. Next year’s interest rate is higher than today’s by just
enough to make rolling over 1-year bonds equally attractive as investing in
the 2-year bond

15
 The Yield Curve and
Future Interest Rates (2 of 6)

• spot rate: the rate that prevails today for a time period
corresponding to the zero’s maturity
• short rate for a given time interval (e.g., one year): the interest
rate for that interval available at different points in time
• A spot rate is the geometric average of its component short rates

• in our example, the short rate today is 5%, and the short rate next year
will be 7.01%
• the 2-year spot rate is an average of today’s short rate and next year’s
short rate. But because of compounding, that average is a geometric one

16
 The Yield Curve and
Future Interest Rates (3 of 6)
Yield Curve Under Certainty

• Buy and hold vs. rollover:

(1 + y2 ) = (1 + r1 )  (1 + r2 )
2

1 + y2 = (1 + r1 )(1 + r2 ) 
.5

• (r2) is just enough to make rolling over a series of 1-year

bonds equal to investing in the 2-year bond

17
 The Yield Curve and
Future Interest Rates (4 of 6)

Previous equation begins to tell us why the yield curve

might take on different shapes at different times.
• When next year’s short rate, r , is greater than this
2

year’s short rate, r , the geometric average of the

1

two rates is higher than today’s rate, so y > r and the

2 1

yield curve slopes upward.

• If next year’s short rate were less than r , the yield
1

curve would slope downward.

18
 The Yield Curve and
Future Interest Rates (4 of 6)

Short Rates and Yield Curve Slope

• When next year’s short • When next year’s short
rate, r2 > r1, the yield rate, r2 <r1, the yield
curve slopes up curve slopes down

• May indicate rates are • May indicate rates are

expected to rise expected to fall

19
 The Yield Curve and
Future Interest Rates (5 of 6)
Finding a Future Short Rate
compare two 3-year strategies. One is to buy a 3-year zero, with a yield to maturity from
Table in slide n.7 of 7% and hold it until maturity. The other is to buy a 2-year zero
yielding 6% and roll the proceeds into a 1-year bond in year 3, at the short rate r3. The
growth factor for the invested funds under each policy will be:

20
Short Rates versus Spot Rates

21
 The Yield Curve and
Future Interest Rates (6 of 6)
The following equation generalizes our approach to inferring a future short rate from
the yield curve of zero-coupon bonds. It equates the total return on two n-year
investment strategies: buying and holding an n-year zero-coupon bond versus buying
an (n − 1)-year zero and rolling over the proceeds into a 1-year bond

where n denotes the period in question, and yn is the yield to maturity of a zero-
coupon bond with an n-period maturity. Given the observed yield curve, we can
solve the equation above for the short rate in the last period:

22
 Forward Rates
Under Certainty
• The numerator on the right-hand side is the total growth factor of an
investment in an n-year zero held until maturity. Similarly, the
denominator is the growth factor of an investment in an (n − 1)-year zero.
Because the former investment lasts for one more year than the latter, the
difference in these growth factors must be the gross rate of return available
in year n when the (n − 1)-year zero can be rolled over into a 1-year
investment.
Under Uncertainty
• when future interest rates are uncertain, as they are in reality, there is no
meaning to inferring “the” future short rate. It is common to use previous
equation to investigate the implications of the yield curve for future
interest rates. Interest rate that we infer in this matter are named forward
interest rate rather than the future short rate

23
 Forward Rates

• Forward rates

(1 + yn ) n
(1 + f n ) =
(1 + yn −1 ) n −1

• fn = One-year forward rate for period n

• yn = Yield for a security with a maturity of n

(1 + yn )n = (1 + y n−1 )n−1  (1 + f n )

24
 Forward Rates

• In this formulation, the forward rate is defined as

the “break-even” interest rate that equates the
return on an n-period zero-coupon bond to that
of an (n − 1)-period zero-coupon bond rolled
over into a 1-year bond in year n.
• The actual total returns on the two n-year
strategies will be equal if the short interest rate
in year n turns out to equal f
n

25
 Forward Rates
The forward interest rate is a forecast of a future short
rate
• Rate for 4-year maturity = 8%
• Rate for 3-year maturity = 7%

The forward rate for year 4 would be computed as:

1+ f4 =
(1 + y4 )
4
=
1.084
= 1.1106
(1 + y3 )3 1.07 3

f 4 = 11.06%

26
 Forward Rates

• the interest rate that actually will prevail in the

future need not equal the forward rate, which is
calculated from today’s data. Indeed, the forward
rate may not even equal the expected value of the
future short interest rate
• Forward rates equal future short rates in the
special case of interest rate certainty

27
 Interest Rate Uncertainty and
Forward Rates
• The term structure is harder to interpret when future interest
rates are uncertain. In a certain world, different investment
strategies with common terminal dates must provide equal rates
of return.
• For example, two consecutive 1-year investments in zeros
would need to offer the same total return as an equal-sized
investment in a 2-year zero
Therefore, under certainty:

What can we say when r2 is not known today?

28
 Interest Rate Uncertainty and
Forward Rates
• Suppose that today’s rate is 5% and the expected short rate for the
following year is E(r2) = 6%.

• The value (price) of a 2-year zero is:

$1, 000
= $898.47
1.05 1.06

• The value (price) of a 1-year zero is:

$1, 000
= $952.38
1.05

29
 Interest Rate Uncertainty and
Forward Rates

• The investor wants to invest for 1 year

−Buy the 2-year bond today and plan to sell it at the
end of the first year for $1000/1.06 = $943.40
or
−Buy the 1-year bond today and hold to maturity

• What if next year’s interest rate differs from 6%?

−The actual return on the 2-year bond is uncertain!

30
 Interest Rate Uncertainty and
Forward Rates

• the rate of return on the 2-year bond is risky. If next year’s

interest rate turns out to be above expectations, that is,
greater than 6%, the bond price will be below $943.40;
• conversely if r2 turns out to be less than 6%, the bond price
will exceed $943.40.
• Why should this short-term investor buy the risky 2-year
bond when its expected return is 5%, no better than that of
the risk-free 1-year bond? Clearly, she would not hold the 2-
year bond unless it offered a higher expected rate of return.
This requires that the 2-year bond sell at a lower price than
the $898.47 value we derived when we ignored risk

31
 Bond Prices and Forward Rates with
Interest Rate Risk
Let’s consider again the previous example:

32
 Interest Rate Uncertainty and
Forward Rates

•Investors require a risk premium to hold a

longer-term bond

•This liquidity* premium compensates short-

term investors for the uncertainty about future
prices

*Liquidity refers to the ability to sell an asset easily at a predictable price. Because long-
term bonds have greater price risk, they are considered less liquid in this context and
thus must offer a premium.

33
 Yield Curve patterns

• There are different types of yield curves, depending on the

characteristics of the underlying bonds.
• In theory, maturity structure should be analyzed for bonds that
have the same properties other than time-to-maturity:
−denominated in the same currency
−the same credit risk, liquidity, and tax status.
−annual rates should be quoted for the same periodicity
−the same coupon rate so that they each have the same degree
of coupon reinvestment risk.
• In practice, maturity structure is analyzed for bonds for which
these strong assumptions rarely hold

34
 Yield Curve patterns
• The “normal” shape of the yield curve is a curve with a positive slope. This is
because if we lend out our money for a longer period (“deposit” it for longer)
then we usually expect higher interest for that money
• In reality, however, or at least in certain periods, a wide range of forms can be
observed. The yield curve can also take an inverted shape, when the yields at
the front end of the curve are higher than at the long end, i.e., the slope of the
yield curve is negative.

35
 Yield Curve patterns
A Government Bond Spot Curve
The ideal dataset: yields-to-maturity on a series of zero-coupon government bonds for a
full range of maturities (spot rates are interpreted as the “risk-free” yields)
• This spot curve is upward
sloping and flattens for
longer times-to-maturity.
Longer-term government
bonds usually have higher
yields than shorter-term
bonds. This pattern is
typical under normal market
conditions.
• Sometimes, a spot curve is
downward sloping inverted
yield curve in that shorter-
term yields are higher than
longer-term yields.

36
 Yield Curve patterns
A Government Bond
Yield Curve
yield curve for a government
that issues 2-year, 3-year,
5-year, 7-year, 10-year, and
30-year bonds that make
semiannual coupon payments.
Straight-line interpolation is
used between those points on
the yield curve for coupon
bonds

37
 Forward Curve
Equation in slide 24 can be used to construct a forward curve. A forward curve is a
series of forward rates, each having the same time frame. These forward rates might be
observed on transactions in the derivatives market. Often, the forward rates are implied
from transactions in the cash market.

• forward curve that is

calculated from the
government bond spot curve
shown in slide 36.
• These are one-year forward
rates stated on a semiannual
bond basis

38
 Problem set 1

The bond can be viewed as a portfolio of zero-coupon bonds with one- and
two-year maturities.
Therefore:

39
 Problem set 1
We now want to calculate a single rate for the bond (its YTM). We do this by solving for
y in the following equation:

Y = YTM = 9.95%
Using these spot rates, the yield to maturity of a two-year coupon bond whose
coupon rate is 12 % and PV equals $1,036.73 can be determined by:

Two bonds with the same maturity will usually have different yields to maturity if
the coupons differ

40
 Problem set 2

Hint:

41
Problem set 3

42
 Problem set 3

remark:

43
 References

• Bodie, Z., Kane, A., & Marcus, A. J. (2018). Investments 11th

ed. MacGrawHill.
• CFA Program Curriculum 2020 Level I , Volume 5, Reading 44
• Yield Curve: insights

44