Term Structure of Interest Rates

An n-year unit zero coupon bond is an agreement to pay €1 at the end of n

years – it is also called a pure discount bond.

Discrete Time
Discrete Time Spot Rates

The yield on a unit zero coupon bond with term n years, y n, is called the “n-
year spot rate of interest”.

The equation of value for an n-year unit zero coupon bond is:
1
P n= n
(1+ y n)

Hence the yield, yn, is:

−1

( 1+ y n ) =Pnn

The spot rate will vary with the term n and the variation by term is referred to
as the term structure of interest rates.

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Example 1:

The table below shows the price per €100 nominal for some n-year unit zero
coupon bonds and the corresponding spot rates.

Term Price Spot Rate

1 year 94 6.4%

5 years 70 7.4%

10 years 47 7.8%

15 years 30 8.4%

Graphing the spot rates we have:

9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
0 2 4 6 8 10 12 14 16
Duration

This is an example of a yield curve.

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Every fixed interest investment may be regarded as a combination of (perhaps
notional) zero coupon bonds. For example, an n-year bond paying coupons of
D per annum with a final redemption of R may be regarded as a combined
investment of n zero coupon bonds with maturity value D with terms of 1 year,
2 years, 3 years,…, n years plus a zero coupon bond of nominal value R with
term n years.

The price per €100 nominal of the bond is:

1 2 n n
A=D v + D v + …+ D v + R v
−1
Defining v y =(1+ y t )
t
and rewriting in terms of n zero coupon bonds we have:
A=D ( P 1+ P2 +…+ Pn ) + R Pn

¿ D ( v y + v 2y +…+ v ny )+ R v ny
1 2 n n

Example 2:

For a five year fixed interest security with annual coupons of 6% and
redeemable at par calculate:

- The price if the annual term structure of interest rates is:

7%, 7.25%, 7.5%. 7.75%, 8%
- The gross redemption yield for this security

Solution

The price per €100 nominal is:

P=6 ( v 7 % + v 27.25 % + v 37.5 % +v 7.75

4
% + v 8 % ) +100 v 8 %
5 5

 P = €92.25

The gross redemption yield:

92.25=6 a5 ∨¿+100 v ¿ 5

@7.5% = 93.93 and @8% = 92.01

Therefore, by interpolation the gross redemption yield is 7.9%

Discrete Time Forward Rates

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The discrete time forward rate, ft,r, is the annual interest rate agreed at time 0
for an investment made at time t>0 for a period of r years.

If an investor agrees at time 0 to invest €100 at time t for r years the

accumulated investment at maturity (at time t+r) is:
r
100(1+ f t ,r )

The forward rates, spot rates and zero-coupon bond prices are related as
follows:
t r t +r −1
( 1+ y t ) (1+ f t ,r ) =(1+ y t +r ) =P t+r

where:

( 1+ y t ) (1+ f t ,r ) is the accumulation of €1 invested at time 0 for t years and

t r

where the proceeds at time t are immediately re-invested for a further r years
at a rate of interest agreed at time 0 (ie the forward rate ft,r)

and

(1+ y t +r ) =P t+ r follows from the equation of value for a t+r year zero coupon
t +r −1

bond

Rearranging we have:
t +r
r (1+ y t +r ) Pt
(1+ f t , r ) = t
=
(1+ y t ) Pt +r

One period forward rates ft = ft,1

t
(1+ y t ) =( 1+ f 0 ) ( 1+ f 1 ) ( 1+ f 2 ) …(1+ f t−1 )

Where we define f0 = y1.

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The one-year forward rate, ft, is therefore the rate of interest from time t to
t+1 and can be expressed as:
t +1
(1+ y t +1)
( 1+ f t ) = t
(1+ y t )

Example 3:

The 3, 5 and 7-year spot rates are 6%, 5.7% and 5% pa respectively. The 3-year
forward rate from time 4 is 5.2% pa. Calculate:

(i) f3
(ii) f5,2
(iii) y4
(iv) f3,4

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Theories of the Term Structure of Interest Rates
Factors Influencing the Term Structure of Interest Rates

- Supply and Demand

- Base Rates
- Interest rates in other countries
- Expected future inflation
- Tax rates
- Risk associated with changes in interest rates

Patterns of the Term Structure of Interest Rates

Spot Rate Yield Curves

- Decreasing yield curve

- Increasing yield curve
- Humped yield curve

Decreasing Yield Curve

- long term bond yields are lower than short-term bonds

- Since price is a decreasing function of yield this implies that long term
bonds are more expensive than short-term bonds

Increasing Yield Curve

- This implies that long term bonds are cheaper (higher yielding) than
short term bonds

Humped Yield Curve

- Short term bonds are generally cheaper than long term bonds except at
very short terms (< 1 year)

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The three most popular explanations for why interest rates vary according to
the term of the investment are:

- Expectations Theory
- Liquidity Preference
- Market Segmentation

Expectations Theory

The price of short and longer-term investments will vary according to

expectations of future movements in interest rates.

For example, an expectation of a fall in interest rates will make short-term

investments less attractive (the yield on short term investments will rise) and
longer-term investments more attractive (the yield on long term investments
will fall).

Liquidity Preference

Longer dated bonds are more sensitive to interest rate movements that short-
dated bonds. It is assumed that risk averse investors will require compensation
(in the form of higher yields) for the greater risk of loss on longer bonds.

Market Segmentation

Bonds of different terms are attractive to different investors, who will choose
assets that are similar in term to their liabilities.