1. The Term Structure of Interest Rates
CHAPTER 19
The Term Structure of Interest Rates
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2. 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
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3. 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
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4. 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
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5. 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
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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
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7. 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
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8. 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
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9. 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
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10. 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
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11. 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
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12. 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
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13. 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
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