Introduction to the Term Structure

of Interest Rates

By

Prosper Raynold
 Introduction
• The term structure (TS) of interest rates is the
relationship between yields and time to
maturity on securities or bonds that differ
only w.r.t. length of time to maturity (LTM).
• Measurement and analysis of the TS
relationship requires that we find a class of
bonds that differ only w.r.t. LTM.
• The US gov’t issues nearly identical bonds
over a wide maturity spectrum so there is
significant variation in LTM among US gov’t
bonds, but they are near identical in all other
 Yield Curves
• A yield curve is a graphical representation of
the TS relationship at a given point in time.
• Yield curves may be positively sloped
(normal), negatively sloped (inverted), or flat.
 Empirical facts
• Yield curves are predominantly upward
sloping (about 85 percent of the time). This
means that yields on long-term bonds
typically exceed that on short-term bonds. So
the term premium is positive.
 Empirical facts
• Yield curves tend to shift instead of twist. This
means that short and long-term interest rates
tend to move in the same direction. A
twisting yield curve implies that short and
long-term rates are moving in opposite
directions.
 Basic Definitions
• An investor’s holding period is the period
over which he/she wishes to invest funds.
• Let in,t represent the yield on a security that
currently exists and that will mature in n
periods.
• For example, i2,t is the yield on a bond that
currently exists and that will mature in 2
periods while i2,t+3 is the yield on a bond that is
expected to come into existence 3 periods
from now and will mature in 2 periods.
 Definitions cont’d
• A spot security is currently being traded so
spot rates are known at date t and the second
subscript on spot rates is always t. (ex. i2,t)
• Forward securities do not currently exist but
are expected to come into existence at some
future period. Consequently, investors must
form expectations about rates on forward
securities. As such, the second subscript will
be greater than t. (ex. t+1, t+2, and so on).
 Definitions cont’d
• For example, ien,t+2 represents the expected
yield on a security that does not currently
exist but is expected to commence trading 2
periods from now and that will mature n
periods after it comes into existence.
• Similarly, ien,t+4 represents the expected yield
on a security that does not currently exist but
is expected to commence trading 4 periods
from now and that will mature n periods after
it comes into existence.
 Investment Strategies
• An investor who wishes to transfer current
resources n periods into the future (i.e. the
investor has an n-year holding period) will
have the option to choose among several
alternative strategies to achieve his/her
objective. Characterize these strategies as
investment strategies.
• Available investment strategies may be placed
in one of two categories. These are:
• Buy and hold
• Rollover
 Investment Strategies cont’d
• To illustrate, note that an investor who has a
3-year holding period needs a vehicle or
vehicles to transfer period t resources to
period t+3.
• A simple buy and hold strategy to achieve this
objective is to buy a spot bond (or security)
that will mature in 3 years and hold it to
maturity.
• The expected holding period return (EHPR)
from this strategy (assuming compound
interest) will be equal to: (1+i3,t) (1+i3,t) (1+i3,t)
 Investment Strategies cont’d
• Alternatively, the investor could buy a 1 yr
spot, collect the proceeds when it matures
and invest it in a 2 yr security that he/she
expects to come into existence one period
from now and hold it to maturity. This
rollover strategy’s EHPR will be given by:
• EHPR = (1+i1,t) (1+ie2,t+1) (1+ie2,t+1)
• Alternatively the investor can rollover by
buying a series of 1-year bonds. The EHPR
would be given by:
• EHPR = (1+i1,t) (1+ie1,t+1) (1+ie1,t+2)
Concluding Comments