T ERM S TRUCTURE O F I NTEREST R ATES

G ROUP 8 03 Tashween Ahluwalia 06 Ayush Bhatia 07 Naresh Bhoravat 11 Amit Das 23 Vinod Iyer 53 Mita Shah 61 Vishal Kalro

Road map Yield Curve Types of Yield Curve Term Structure Theories Current Statistics – Indian Securities Conclusion

T ERM S TRUCTURE OF I NTEREST R ATES Popularly Called “ the yield curve ” Shows how yield to maturity (YTM) is related to term to maturity (TTM) for bonds that are similar in all respects, expecting maturity. Under normal circumstances- - Longer the maturity-high risk-high return (Government securities/Gilts) - Shorter maturity-low risk-low return (Treasury Bills)

B ASICS Coupon Rate: Annual payout as a percentage of the bond's par value Coupon Rate = Annual Interest Par value Current Yield: Annual payout as a percentage of the current market price you'll actually pay Current Yield = Annual Interest Price

B ASICS Yield to maturity (YTM) It is discount rate that makes the present value of the cash flows receivable from owning the bond equal to the price of the bond Calculated as, P = C(1 + r)-1 + C(1 + r)-2 + C(1 + r) n + + M(1 + r) n Where P = price of the bond C = annual interest (Rs.) M = maturity value (Rs.) N= no. of yrs left to maturity

B ASICS Term to Maturity - The remaining life of a financial instrument. Yield to call - Redemption before maturity - Usually at Premium - Yield to call is often compared with Yield to Maturity.

B OND P RICES AND Y IELDS if Bond YTM is… then Bond Price is… (Assume par = $1,000) higher than coupon rate less than $1,000 “discount bond” equal to coupon rate $1,000 “par bond” less than coupon rate more than $1,000 “premium bond”

E XAMPLE Suppose your bond is selling for $950, and has a coupon rate of 7%; it matures in 4 years, and the par value is $1000. What is the YTM? Solution: The coupon payment is $70 (that's 7% of $1000) Current yield is $70/$950 = 7.37% So the equation to satisfy is 2.70(1 + r) (1 + r) (1 + r) (1 + r) (1 + r)-4 = 950 Therefore, r is 8.53%. YTM >current yield, which in turn is greater than the coupon rate. (Always true in case of discount) Bond Selling At...Satisfies This Condition Discount Coupon Rate < Current Yield < YTM Premium Coupon Rate > Current Yield > YTM Par Value Coupon Rate = Current Yield = YTM

T YPES OF Y IELD C URVE T YPES OF Y IELD C URVE 1) Normal/Positive Yield Curve A normal yield curve is one in which longer maturity bonds have a higher yield than do shorter-term bonds because of the risks associated with time..

2) Inverted Yield Curve o An inverted yield curve is one in which the short term yields are higher than the longer term yields. o This can be a sign of an upcoming recession T YPES OF Y IELD C URVE T YPES OF Y IELD C URVE

3) Flat or humped Yield Curve One in which the shorter-term and longer-term yields are very close to each other; this is also a predictor of an economic transition. The slope of the yield curve also is considered important: The greater the slope, The greater the gap between short-term and long-term rates. T YPES OF Y IELD C URVE

T ERM S TRUCTURE T HEORIES Expectations Theory Liquidity Premium Theory Preferred Habitat Theory Segmented Markets Theory

E XPECTATIONS T HEORY Financial market beliefs about future interest rates.i.e (The Expectation) Long-term rate is a function of today’s short-term rate and expected future short-term rates Long-term and short-term securities are perfect substitutes Forward rates that are calculated from the yield on long- term securities are market consensus expected future short-term rates The interest rate on a long-term bond will equal an average of short-term interest rates that are expected to occur over the life of the long-term bond

T HE T ERM S TRUCTURE OF I NTEREST R ATES Expected higher interest rate levels Expansive monetary policy Expanding economy Expected lower interest rate levels Tight monetary policy Recession soon Upward- Sloping Yield Curve Downward- Sloping Yield Curve

S HORTCOMINGS OF EXPECTATIONS THEORY Neglects the risks inherent in investing in bonds (because forward rates are not perfect predictors of future rates) Interest rate risk Reinvestment rate risk Yield Curve Explanation Ascending - Short-Term rates are expected to rise in Future Descending - Short-Term rates are expected to fall in Future Humped - Short-Term rates are expected to rise for a while and then fall Flat - Short-Term rates are expected to remain unchanged in Future

L IQUIDITY P REMIUM T HEORY Investors are Risk averse Long-term bonds are more risky Investors will hold on only for a premium Forward rates contain a liquidity premium and interest rate.

EQ: = Actual long term rate n = term to maturity (in years) =Current one year rate =Expected one-year rate ( i=2,…, n -1) =Risk premium ( i =2,…, n ) L IQUIDITY P REMIUM T HEORY

If liquidity premium is small, then ST rates are expected to rise Maturity Yield yield curve small liquidity premium L IQUIDITY P REMIUM T HEORY

If liquidity premium is larger, then ST rates are expected to stay the same Maturity Yield yield curve large liquidity premium L IQUIDITY P REMIUM T HEORY

P REFERRED H ABITAT T HEORY Long term investors would like to invest in instruments of longer maturities. Short term investors would like to invest in instruments of shorter maturities. Investors may buy bonds that do not have their preferred maturity if there is demand-supply mismatch.

S EGMENTED M ARKETS T HEORY An extreme form of preferred habitat theory. Investors and borrowers are unwilling to shift from their preferred maturity range.

C URRENT S TATISTICS – I NDIAN S ECURITIES

P OLICY – I MPACT ON T ERM S TRUCTURE OF I NTEREST R ATES Monetary Tools – SLR (25%), CRR (5.5%)

I NDIAN G-S EC M ARKET

C ONCLUSION Market Interest Rates Managing the Government/Corporate Debt & Borrowing’s Programs Economic Indicator Managing Growth & Inflation

R EFERENCES Investment Analysis & Portfolio Management – Prasanna Chandra Financial Markets & Institutions – Anthony Saunders & Marcia Millon Cornett RBI Billiton Jan ncedbond4.asp

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