The Term Structure of Interest Rates CHAPTER 19 The Term Structure of Interest Rates Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

The Yield Curve and the Term Structure Term structure of interest rates the relationship between yield and maturity The graphical depiction of the relationship between the yield on bonds of the same credit quality but of different maturities is the yield curve Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

The Yield Curve and the Term Structure (continued) These curves are typically constructed from U.S. Treasury bonds, since such securities have effectively no default or liquidity risks Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

The Yield Curve and the Term Structure (continued) Using the Yield Curve to Price a Bond At first glance, bond pricing using a yield curve should be a relatively simple But securities with the same maturity can have different yields, depending upon the coupon rate and cash flow pattern Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

The Yield Curve and the Term Structure (continued) A way to think about these bonds is as packages of zero-coupon bonds, wherein the interest paid for each period is the price at maturity To determine the value of each zero-coupon instrument, it is necessary to know the yield on a zero-coupon Treasury with the same maturity. This yield is called the spot rate Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Forward Rates Forward rate, or an implied forward rate, is the rate on a loan at some future period For example, the yield on one-year bonds a year from now is termed the one year forward rate on one-year bonds Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Forward Rates (continued) Knowledge of the implicit forward rates is important. Borrowers must consider whether to utilize short-term liabilities or longer-term ones. The forward rate will indicate whether a short-term renewal will be more or less costly next year. On the other hand, speculators will be interested in knowing whether rates will go up or down in the future Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Forward Rates (continued) Forward Rate as a Hedgeable Rate Forward rates do not do a good job in predicting future interest rates Forward rates indicate how investors expectations must differ from the market consensus to make the correct decision Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Historical Shapes Observed for the Treasury Yield Curve When the yield curve is upward sloped, it is called positively sloped yield curve The convention in the market is to refer to a positively sloped yield curve whose maturity spread as measure by the 6-month and 30-year yields as a normal yield curve when the spread is 300 basis points or less Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Historical Shapes Observed for the Treasury Yield Curve (CONTINUED) When the spread is more than 300 bp, the yield curve is said to be a steep yield curve The markets can also see an inverted yield curve, and a flat yield curve Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

The Main Influences on the Shape of the Yield Curve A comprehensive study of the shape of the yield curve found three main influences: The market’s expectation of the future rate changes Bond risk premium Convexity bias Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Summary The relationship between yield and maturity is referred to as the term structure of interest rates Under certain assumptions, the market’s expectation of future interest rates can be extrapolated from the theoretical Treasury spot rate curve. The resulting forward rate is called the implicit forward rate Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Summary (continued) Several theories have been proposed about the determination of the term structure The fact of price risk in investing in long-term bonds, and that it increases with maturity, gives rise to an alternative liquidity theory of the term structure Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.