Term structure of interest

rates
 Spot rates and the yield curve

Interest rates on loans depend in part on the time to maturity of the loan.
Anyone who has invested money in a certificate of deposit has observed that
the interest rate paid depends on the term of the CD. Typically, the longer
the term the higher the rate, although this does have to be the case.
For example, individuals looking for mortgage loans will generally find that
they can get a lower rate on a 15 year loan than on a 30 year loan. The
dependence of yield on maturity is referred to as the term structure of
interest rates. The term structure is established by looking at the rates of
zero coupon bonds based on United States government bonds. This requires
a little clarifying discussion.
If a bond has zero coupon, this means there are no coupon payments to the bondholder, the only
payments involved are the original investment and the final repayment of the redemption value at
maturity. A zero coupon bond for two years with redemption value of 1000 and an annual yield of 3%
would have price

In practice, investors buy bonds at prices, which give them the yield they desire, thus, if inventors were
willing to pay 942.60 for a two year zero coupon bond. We could look at this price and calculate the
implied two-year annual interest rate:

Investor require higher interest rates on bonds issued by firms considered risky, because there is a greater
chance of default (i.e., not paying the bond) from a risky firm. Thus if we looked at market prices for two
year zero coupon bonds we would find different annual interest rates for different borrowing firms based
on risk.
 Example
A four year annual $1000 par bond has a coupon rate of 3%. Thus its
payments are.
Year 1 2 3 4
Payment 30 30 30 1030

To value the bond, take the present value of each payment at the
appropriate yield curve rate and sum the present values. Using the
example yield curve in table below, the price is.
Yield curve example Year Spot Rate
1 2.00%
2 3.00%
4 3.50%
5 4.00%
 Example

If you calculate the price of this bond using a single yield-to-maturity ,

that method must give the same price of 965.20. This in turn means
that once we have found the price using the yield curve we can find the
yield to maturity by finding the single yield rate for the cash flow
sequence.
-965.20, 30, 30, 30, 1030.
The yield to maturity is 3.9578%.
 Forward rates
The n-year forward rate is the rate
agreed upon today for one year loan
to be made n year in the future. For
example, the one year forward rate is
the rate that would be agreed upon
now for one year loan to start one
year from now.
The yield curve implies certain values
for the forward rates –which are also
called implied forward rates. We can
calculate the n-1 -year forward rate if
we are given the spot rates sn-1 y sn.
One year forward rate. We are given and . There are two ways to get
an accumulated value for a two year investment.
• Invest for the entire two years at the known rate . The accumulation
factor is .
• Invest for one year at the first year rate of and then reinvest the first
year accumulation at the one year forward rate . The accumulation
factor is .
Equating the two accumulation factors, we have.
Two year forward rate. We are given and . There are two ways to get an
accumulated value for a three year investment.
• Invest for the entire three years at the known rate . The accumulation
factor is .
• Invest for two years at the rate of and then reinvest the accumulation at
the two year forward rate . The accumulation factor is .
Equating the two accumulation factors, we have.

The general pattern should be fairly clear from this example.

, or equivalently
Asset Liability Management
Duration and Immunization
 Duration
The reality of investments for an insurance company or a bank is
much more complex that the previous exact match examples.
There are thousands of claim liabilities, thousands of accounts and
thousands of bonds and other investments to buy. The company
may have to sell bonds to meet unexpected liabilities at various
times, and it also faces interest rate risk. Interest rate risk occurs
because the value of its investments decreases when interest rates
go up and increases when interest rates decline.
The concept of duration gives an investment manager a way of
calculating what his interest rate risk is to control that risk and
match assets and liabilities for his entire portfolio. There are two
closely related types of duration, Macaulay duration and modified
duration. There is a simple way to describe the Macaulay duration
of an investment --it is the weighted average time at which the
investment pays.
For an investment, which has, cash flows at times the duration is
a weighted average of times of payment
 Duration
The weights are based on the terms of the present value sum. The present value
or price of this investment is
.
The weight for the payment is just its term in the expression for divided by.
 

It is clear that .

The Macaulay duration is defined using the weights from the last expression.
 Example
An investment pays 1000 in one year, 2000 at the end of the second year and 3000 at the end
of the third year. An investor has purchased it to yield the annual rate . The present value is

The weights for the duration are

The Macaulay duration is the weighted average time

 Modified duration
The interest rate risk that worries an investment manager is the change
in the value that occurs when interest rates change. We can study the
rate of change in price when interest rates change by looking at the
derivative of price with respect to interest rate .
 Example
An investment pays 1000 in one year, 2000 at the end of the second year
and 3000 at the end of the third year. The price at a rate is

Thus:

The investor purchased this investment to yield . For

 
Note that the derivative is negative, since the price of this investment is a
decreasing function of
 The modified duration DM
The modified duration DM (also referred to as the volatility) is the
negative of derivative by the price-representing the rate of change as o
percent of price.
 Example
The price was P= 4815.92. Thus the modified duration was

The modified duration above is close to the actual Macaulay duration of 2.27925. There is a nice
relationship between and which follows:
 Example

• The following derivation shows why the relationship holds.

• First, note that
• Since the price is given by ,
 Helpful Formulas for Duration
Calculations
When payments are level, it can be shown that
Duration of level payment investment:
 Example
An investment pays 1000 at the end of each year for the next 3 years.
Then at a rate the price is Macaulay durations is given by.

At the rate we have

There is also a similar simplifying formula for the duration of a coupon
bond.
Macaulay duration of a coupon bond with face value and coupon for
periods and redemption value C

Note: when and in the above formula, you can prove that
 Example
An annual par bond has face value of 1000, a coupon rate of 5% and three
years maturity. At a rate of
Using derivatives to approximate change in price
Once we know the duration or modified duration, we can find the derivative from it,
and vice-versa. Derivatives can be used to find the Taylor series for a function . The
basic series formula is

This gives a formula for the change in from to

 
Using derivatives to approximate change in price
 If we just use the first term of the above series we have the familiar
approximation.

Using the first two terms to improve the approximation we have

The price function, , is a function of , and we can use the above formula to
approximate change in price as changes.
 Example
The investment pays 1000 in one year, 2000 at the end of the second year and 3000 at
the end of the third year. The price at rate is

The first two derivatives of the price function are

 Suppose this asset is purchased to yield . We have already seen that the price is

Now suppose that the yield changes by to . The actual new price is
The actual change in price is

Now we will use the two approximation formulas. First, we need to evaluate the
derivatives involved.

 
Using the first derivative approximation (7.21) we have

The first approximation to the true change in price is reasonable and the second is
accurate to the four decimal places.
 The duration of a portfolio

Up to this point, we have concentrated on finding the duration for a

single asset. It is more common for investors to own a portfolio
containing a number of different investments. Since duration is used to
estimate interest rate sensitivity, a portfolio investor would like to know
the duration of his portfolio. We will begin by looking at a simple
example where the portfolio in the question has only two assets, both
price at par.
 Example

An investor can buy two annual payment bonds

• A $1000 annual bond for four years with coupon of 5% priced at
$1000 to yield 5%. Tis modified duration is
• A $1000 annual bond for eight years with coupon of 7% priced at
$1000 to yield 7%. Its modified duration is
The investor buys 3 of a bond a) for $3000 and 2 of bond b) for $2000.
She could estimate the change in price if rates on both bonds increase
by 0.10% by doing separate duration estimates and adding them.
• and

• and
For the entire portfolio with original value , we have

We could look at this sum in a slightly different way.

The value of 4.5161 in parentheses in the last line above is the
weighted average of the durations of two bonds, weighted
according to each bond`s percent of total price. It functions as a
single durations for the entire portfolio, and can be used to
evaluate interest sensitivity for the entire portfolio if the interest
rates on each bond change by the same amount the calculation
above was based on assuming that the same applied to the
interest rate on each bond.

This reasoning works in general. Suppose that there are

investments with present values of in the portfolio, and that the
modified durations of these investments are . Then the present
value (price) of the entire portfolio at the rate is
The modified durations of the portfolio is the weighted average a the modified
durations of the investments with each investment having weigh equal to its
percent of total portfolio value:

The modified durations of a portfolio in which all investment have the same
interest rate shift, , is the weighted average of the individual investment
modified durations, with the weight for each investment equal to its percent
of total portfolio.
• Bibliografía: Hasset, M. J., Coombs T. and Stteeby, A. C. ACTEX Study Manual:
SOA Exam and CAS Exam 2, ACTEX Publications, 2010

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