💡 LOS 55.

a: Define Spot Rates and the Spot Curve, and Calculate the Price of a Bond Using Spot Rates

🔹 Step 1: Understanding Spot Rates

🔸 What is a Spot Rate?

A spot rate is the interest rate used to discount a single cash flow occurring at a specific point in the
future. It’s the rate you'd earn if you invested in a zero-coupon bond that matures at that specific point
in time.

 Zero-coupon bond: A bond that pays no coupon — just one lump sum (face value) at maturity.

 Since a zero-coupon bond only has one cash flow, the rate used to discount it is pure — it’s a
spot rate.

💭 Think of spot rates as “today’s price for future money at time T.” They're the most accurate way to
value a future cash flow of a known amount.

🔸 Why are Spot Rates Important?

When valuing any bond, each cash flow (coupon or face value) occurs at a different time — so it should
be discounted at a rate appropriate for that time. That’s what spot rates do.

In contrast, Yield to Maturity (YTM) simplifies things — it applies one average discount rate to all future
cash flows.

But spot rates are more precise — they reflect the term structure of interest rates (i.e., how interest
rates vary by maturity).

🔹 Step 2: The Spot Rate Curve (aka the Zero Curve)

The spot rate curve is a graphical plot:

 X-axis: Time to maturity (1 year, 2 years, 3 years, etc.)

 Y-axis: Spot rates

It shows what the market requires as the return for each future time horizon assuming zero-coupon
securities.

📌 The spot curve is the foundation of all fixed-income valuation. It's used to value any bond by
discounting each of its cash flows at its corresponding spot rate.

🔹 Step 3: Pricing a Bond Using Spot Rates

Instead of using the same rate (YTM) for every cash flow, you use a different spot rate for each.

Let’s understand this with a clear example.

🧮 EXAMPLE: Valuing a 3-Year, 5% Coupon Bond Using Spot Rates

We are given:

 A 3-year bond

 Face value = $100

 Annual coupon rate = 5% → So annual coupon = $5

 Spot rates:

o 1-year = 3%

o 2-year = 4%

o 3-year = 5%

🔸 What Cash Flows Will This Bond Pay?

Since it's a 3-year annual coupon bond:

 Year 1: $5

 Year 2: $5

 Year 3: $5 + $100 = $105

Now, we discount each of these individual cash flows using their corresponding spot rate.

🔸 Step-by-Step Present Value Calculations:

📅 Year 1:

 Cash flow = $5

 Spot rate = 3% → discount factor = 1 / (1 + 0.03) = 0.97087

 PV = $5 × 0.97087 = $4.854

📅 Year 2:

 Cash flow = $5

 Spot rate = 4% → discount factor = 1 / (1 + 0.04)^2 = 0.92456

 PV = $5 × 0.92456 = $4.623

📅 Year 3:
  Cash flow = $105

 Spot rate = 5% → discount factor = 1 / (1 + 0.05)^3 = 0.86384

 PV = $105 × 0.86384 = $90.703

✅ Total Bond Value = Sum of Present Values

Bond Price=4.854+4.623+90.703=100.180\text{Bond Price} = 4.854 + 4.623 + 90.703 = \boxed{100.180}

That’s the no-arbitrage value of the bond.

📌 Why is it Called the No-Arbitrage Price?

If a bond were priced higher or lower than $100.180 in the market, investors could:

 Buy or sell this bond

 Hedge with zero-coupon bonds

 Lock in a riskless profit — this is called arbitrage

But at this precise value ($100.180), no such arbitrage opportunities exist — so this is called the no-
arbitrage price.

🔹 Step 4: Comparing Spot Rate Pricing vs. Yield to Maturity (YTM)

The YTM is the single discount rate that would make the present value of all future cash flows equal to
the bond’s market price.

Given:

 PV = 100.180

 PMT = 5

 FV = 100

 N=3

Solving using your calculator or Excel:

CPT → I/Y=4.93%

This tells us: If we used a flat 4.93% discount rate for all cash flows, we’d get a bond price of 100.180.

🔍 So spot rates are more accurate; YTM is a simplification that’s weighted by the size and timing of the
bond's cash flows.
🧠 Professor’s Insight (Deep Intuition)

Let’s break down what the professor is saying:

 Think of each cash flow earning a different return (spot rate):

o Year 1 coupon: earns 3%

o Year 2 coupon: earns 4%

o Year 3 big payment ($105): earns 5%

 Most of the money is coming in Year 3 — so 5% spot rate has the most influence on overall
yield.

 The weighted average of all spot rates is around 4.93% — that’s why YTM is slightly below the
5% coupon rate (since the bond’s price is slightly above par).

🔚 Conclusion: What You Should Know Cold

✅ A spot rate is the yield for a single payment at a given maturity (usually from a zero-coupon bond).

✅ The spot curve shows spot rates across different maturities.

✅ To calculate a bond’s price using spot rates:

1. Identify each cash flow

2. Match it with the correct spot rate

3. Discount each cash flow using the correct rate

4. Add them all up → This is the no-arbitrage value

✅ YTM is an average — it's useful, but spot rate pricing is more accurate and prevents arbitrage.

✅ If a bond is priced above par, its YTM < coupon. If below par, YTM > coupon.

✅ LOS 55.b: Define Par and Forward Rates, and Calculate:

🔹 Part 1: What is a Par Yield / Par Rate?

Imagine a bond that's just right — its price is exactly $100 (par). No premium, no discount. The coupon
rate that would make that happen, given the current market interest rates (i.e., spot rates), is called
the par rate or par yield.

Why Is This Important?

 If you know the spot rates (the rate today for a zero-coupon bond maturing at each future
date), then you can compute what coupon rate a bond needs to have to be worth par.
  Alternatively, the par rate is the YTM of a hypothetical bond priced at par.

🔹 EXAMPLE: 3-Year Par Rate Calculation

You’re given:

 S₁ = 1%

 S₂ = 2%

 S₃ = 3%

Let’s assume the bond pays annual coupons and matures in 3 years. We need to find the coupon
payment (PMT) that makes this bond's price = par = $100.

💡 Present Value (PV) of bond cash flows:

PMT(1+S1)1+PMT(1+S2)2+PMT+100(1+S3)3=100

Substitute in the spot rates:

PMT1.01+PMT1.022+PMT+1001.033=100

Now solve for PMT (coupon payment). When you plug in:

 PMT = $2.96, it satisfies the equation

 So, par rate = 2.96%

📌 Think of it this way: If interest rates go up, then coupon rates need to be higher to keep price at par —
because higher interest rates mean future cash flows are worth less.

🧠 Quick Tip: Efficient Calculation on Exams

💬 Professor’s Tip: On CFA exams, they often give you multiple choice answers. Plug the middle one in. If
the result is less than 100, try the higher one. If more than 100, try the lower. Don’t solve algebraically
unless you must — it's time-consuming.

🔹 Part 2: What is a Forward Rate?

Let’s build intuition.

A forward rate is a future interest rate agreed upon today for a loan or investment that will happen at a
future time.

Notation

 2y1y = A 1-year loan starting 2 years from now

  3y2y = A 2-year loan starting 3 years from now

 1y1y = A 1-year loan starting 1 year from now

🔑 So (first number = when it starts), (second number = how long it lasts)

🔸 Forward Rates vs. Spot Rates

Spot rate S₃: Invest today for 3 years at one rate.

Forward rates: Instead, invest 1 year at S₁, then at 1y1y, then at 2y1y.

These two approaches should have the same total return if there's no arbitrage.

The Math:

(1+S3)3=(1+S1)(1+1y1y)(1+2y1y)(1 + S₃)^3 = (1 + S₁)(1 + 1y1y)(1 + 2y1y)

This equation reflects compound returns being equal whether you lock in S₃ now, or roll over yearly
using forward rates.

🔸 EXAMPLE: Compute Spot Rate from Forward Rates

You're given:

 S₁ = 2%

 1y1y = 3%

 2y1y = 4%

Find S₃:

(1+S3)3=(1.02)(1.03)(1.04)(1 + S₃)^3 = (1.02)(1.03)(1.04)

(1+S3)3=1.102224⇒1+S3=1.1022241/3⇒S3=2.997(1 + S₃)^3 = 1.102224

So, the 3-year spot rate is 2.997% — it’s the geometric average of compounding at 2%, then 3%, then
4%.

🔸 Quick Approximation Trick

🔎 Simple average of those 3: (2% + 3% + 4%) / 3 = 3% → Pretty close to the exact 2.997%.

This shortcut works well when rates are small and evenly spaced.

🔹 Part 3: Compute Forward Rate from Spot Rates

This is just rearranging the same formula.

You’re given:

 S₁ = 4%

 S₂ = 8%

You want: 1y1y (1-year forward rate one year from now)

Use:

(1+S2)2=(1+S1)(1+1y1y)(1 + S₂)^2 = (1 + S₁)(1 + 1y1y)

Plug in:

(1.08)2=(1.04)(1+1y1y)⇒ 1.1664 =1.04

(1+1y1y)⇒1+1y1y=1.16641.04=1.12154⇒1y1y=12.154

This tells you: if S₁ is 4% and S₂ is 8%, then the market expects 12.154% interest in the second year.

🔹 Part 4: Forward Rate From S₂ and S₃

Use:

(1+S3)3=(1+S2)2(1+2y1y)(1 + S₃)^3 = (1 + S₂)^2 (1 + 2y1y)

You’re given:

 S₁ = 4%

 S₂ = 8%

 S₃ = 12%

Solve:

(1.12)3=(1.08)2(1+2y1y)⇒1.404928=1.1664

(1+2y1y)⇒1+2y1y=1.4049281.1664=1.2045⇒2y1y=20.45

(1.12)^3 = (1.08)^2 (1 + 2y1y)

✅ So the market expects rates to go way up between year 2 and year 3.

🔸 Approximation Shortcut (Again)

If:

 2-year spot = 8%

 3-year spot = 12%

Then:

 (3 × 12%) − (2 × 8%) = 36% − 16% = 20% ≈ Forward rate

Dividing difference over 1 year gives 20% (exact: 20.45%). So shortcut is very accurate.

🔹 Multi-Period Forward Rate: Example

Given:

 S₁ = 5%

 S₂ = 6%

 S₃ = 7%

 S₄ = 8%

Want: 2y2y (2-year forward starting 2 years from now)

(1+S4)4=(1+S2) 2(1+2y2y) 2(1 + S₄)^4 = (1 + S₂)^2 (1 + 2y2y)^2

(1.08)4=(1.06) 2(1+2y2y) 2(1.08)^4 = (1.06)^2 (1 + 2y2y)^2

1.36049=1.1236(1+2y2y)2⇒(1+2y2y)2=1.360491.1236=1.2108⇒1+2y2y=1.2108=1.1004⇒2y2y=10.041.
36049 = 1.1236 (1 + 2y2y)^2

So a 2-year loan starting 2 years from now would yield 10.04% per year.

🔹 FINAL: Price a Bond Using Forward Rates

Given:

 S₁ = 4%

 1y1y = 5%

 2y1y = 6%

 Bond: 3-year, 5% coupon, $1000 par, annual payments

Break it down year by year:

 Year 1 CF: $50 → discount by 4%

 Year 2 CF: $50 → discount by 5%

 Year 3 CF: $50 + $1000 = $1050 → discount by 6%

PV=501.04+50(1.05)+1050(1.06)=48.08+47.62+990.57=1086

So, bond price = $1086.27

🔁 Same logic as spot rates: Discount each cash flow at the correct rate for that year.

🎓 Core Concepts to Tattoo in Your Brain:

Concept Meaning

Spot Rate (Sₙ) Today’s interest rate for a single cash flow n years in future

Forward Rate Future interest rate agreed today for borrowing/lending in future

Par Rate Coupon rate that prices a bond at par given the spot curve

Spot ↔ Forward Use compounding equations to go back and forth

Bond Price (Spot or Forward) Sum of PVs of all cash flows, each discounted at the right rate

🎯 Learning Outcome Statement 55.c

Compare the spot curve, par curve, and forward curve.

These are three different ways of representing interest rates across different time periods. They're
interrelated and built on one another — and understanding each in the right order will make everything
fall into place logically.

🧭 Step 1: Understand What a Yield Curve Is

A yield curve is just a graph or table that shows interest rates (yields) plotted against time to maturity.

You can think of it like this:

📈 X-axis = time (e.g., 1 year, 2 years, 3 years…)

📉 Y-axis = interest rate (e.g., 2%, 2.5%, 3%…)

But depending on how we define "yield", we get different types of yield curves.

Let’s explore the three curves:

1️⃣ The Spot Rate Curve (aka Spot Curve, Zero Curve, or Strip Curve)

📌 Definition:

The spot curve shows the yields (called spot rates) of zero-coupon bonds for various maturities.

Zero-coupon bonds have only one payment at maturity — no coupons in between. So:

The spot rate for a given year = the yield required today for a single payment in that year.
These spot rates are risk-free, often derived from stripped U.S. Treasury bonds (hence, “strip curve”).

📈 Shape:

Usually upward sloping — longer maturities have higher spot rates because:

 Investors want more return for lending longer (term premium).

 There’s more uncertainty in the distant future → higher required yield.

But it can also slope downward (called inverted) when:

 Investors expect future interest rates to fall (e.g., in a recession).

🔍 Key Points:

 Spot rates are used for discounting individual future cash flows.

 They’re quoted on a semiannual bond basis to match how bond yields are usually presented.

2️⃣ The Par Curve (aka Par Yield Curve)

📌 Definition:

The par curve shows the yields of hypothetical bonds that trade at par (i.e., price = face value).

But here's the twist: In reality, most bonds don't trade exactly at par (they’re at premium or discount).
So we construct the par curve by using spot rates.

So:

Par yield = The coupon rate that would make a bond trade at par, given current spot rates.

🔍 How It Works:

 At each maturity, calculate the coupon rate that sets the bond price = par.

 Use spot rates to discount all cash flows and find the required par coupon.

 Repeat for 1-year, 2-year, 3-year… etc.

🎯 Why Create a Par Curve?

Because real-world yields from traded coupon bonds may be:

 Distorted by liquidity differences

  Affected by tax treatment (interest vs capital gains)

 Biased if using only on-the-run bonds (most recently issued)

So we build a clean curve using par yields, which are theoretical but based on spot rates, and therefore
more consistent.

📈 Shape:

Par curve will usually:

 Slope upward when spot curve is upward sloping

 Be very close to spot rates, but slightly below (we’ll explain why in a bit)

3️⃣ The Forward Curve (aka Forward Rate Curve)

📌 Definition:

The forward curve shows implied future interest rates for specific future periods.

Example: A 1y2y forward rate = the 2-year rate 1 year from now.

Think of this as:

“If I lock in today, what rate will I get for borrowing/lending money starting in the future?”

🧠 Where Do Forward Rates Come From?

They’re implied by current spot rates.

To avoid arbitrage, the return from:

 Investing today to year 3 must equal

 Investing today to year 1, then rolling over from year 1 to year 3 (via forward rate)

So:

(1+S3)3=(1+S1)1⋅(1+1y2y)2(1 + S_3)^3 = (1 + S_1)^1

(1 + 1y2y)^2

Solving gives us the 1y2y forward rate.

📈 Shape:

 If the forward curve is rising, it means future rates are expected to increase
  If falling, future rates are expected to decrease

📊 How They’re All Related (THE CORE OF THIS LOS)

Let’s connect the dots.

🔁 1. Forward Rates → Spot Rates

The spot rate for year nn is a geometric average of all forward rates up to year nn.

If:

 1-year spot = 1%

 1y1y forward = 3%

Then approximate:

2-year spot rate≈1%+3%2=2%

So:

Spot curve moves in the same direction as the forward curve, but not as steeply.

🔁 2. Spot Rates → Par Yields

A par yield is a weighted average of spot rates, based on the bond's cash flow timing.

The last spot rate (for the longest cash flow) carries the most weight, because:

 It discounts the largest/most distant cash flow (e.g., the par repayment)

So:

Par curve also follows the shape of the spot curve, but lies slightly below it in an upward-sloping curve.

🧠 Example Walkthrough (Professor’s Note):

Let’s say:

 S1=1%S_1 = 1\%

 1y1y forward rate=3%\text{1y1y forward rate} = 3\%

Then:

 Approximate S2=(1%+3%)/2=2%S_2 = (1\% + 3\%) / 2 = 2\%

 Spot curve is rising, but more gradually than forward curve.

Par Bond Examples:

  1-year par bond → single payment → yield = spot rate = 1%

 2-year par bond → cash flows at year 1 and 2 → average of 1% and 2%, but weighted toward 2%
(bigger influence)

So the par yield is:

 Higher than 1%

 Slightly below 2%

 Again, par curve is rising, but sits just below the spot curve

🔁 Summary of Relationships (Sticky Version 🧠):

Curve What It Shows Built From Shape (Normal) Role

Raw or Upward-sloping
Spot Curve Zero-coupon bond rates Base for all others
bootstrapped (usually)

Hypothetical yields of par

Par Curve Derived from spot Slightly below spot Cleaner yield curve
bonds

Forward Implied future short-term Market

Derived from spot Steepest when rising
Curve rates expectations

🧩 Final Takeaways:

1. Forward rates drive spot rates

2. Spot rates drive par yields

3. Curves typically slope upward, unless the market expects future rate cuts

4. In a flat yield curve, all three are the same → forward = spot = par