TheTermStructureofInterest Rates

TermStructureofInterestRates
Dierentinterestratesprevailinthemarket forborrowingoverdierent=mehorizons. Thetermstructureofinterestratesdescribes therela=onshipbetweenthetermof borrowingandtherateforborrowing. Itcanbeexpressedinmanydierentways.

TermStructureofInterestRates
Adierenttermstructurecanbederivedfor each(typeof)instrument. Wewillfocusonthemarketbenchmarkterm structurederivedfromthetreasurymarket.
Treasurysecuri=esaredefaultfree,sothis representsatermstructurethatisfreefrom considera=onsofcreditworthiness Thetreasurymarketisthemostliquidmarket,so therearenoilliquidityconcerns

TypesofInterestRates
YieldtoMaturity SpotRate ForwardRate ShortRate

YieldtoMaturity
Widelyusedforbonds Givenbytheconstantinterestratethat equatesthediscountedvalueofthefuture cashowsunderthebondanditscurrent marketprice. Alsocalledtheinternalrateofreturn.

YieldtoMaturity
Forabulletbondwithcouponpaymentc,n couponpayments,facevalueFandpriceP,the yield(y)isthesolu=onoftheequa=on:
1 (1 + y ) n P = cF + F (1 + y ) n y

Theyieldcurvegivestheyieldasafunc=onof bondmaturity.

YieldtoMaturity
OQenusedtocomparebondswithdierent maturi=es,issuers,etc. Canbemisleading:
Theyieldonathreeyearbonddependsonthe borrowingrateatthreeyears,aswellasatall previouscoupondates. Thecurvedoesnotrevealyearbyyear informa=onaboutborrowingcosts.

SpotRates
LetP(t,t+k)denotetheprice(at=met)ofa zerocouponbondwithfacevalue1,withk periodsun=lmaturity. Lett=0.Thespotrateforkperiodstomaturity istheyieldtomaturityofazerocouponbond withkperiodstomaturity.Itisthesolu=onsk oftheequa=on:

P (0, k ) = (1 + sk )

Spotratecurvefordierentmaturi=esofCanadianTreasuries. Source:www.bandofcanada.ca

SpotRates
Wecanalsopriceabulletbondbasedon observedspotrates:
n

P = cF (1 + sk ) k + F (1 + sn ) n
k =1

Moregenerally,ifaninstrumentpaysthe (determinis=c)cashowC atthe=mek k periodsinthefuture,k=1,,n,itspriceis:

n

P = Ck (1 + sk ) k
k =1

ForwardRates
Ratesforcontractsmadetodayforborrowing infutureperiods. fj,kisthenota=onfortheforwardratecovering periodjtok Forexample,f3,5istheinterestratefor agreeingtodaytoborrowmoney3yearsfrom nowandrepayit5yearsfromnow.

ForwardRatesandArbitrage
Arbitrageistheopportunitytoearnariskless protbytakingadvantageofmispricinginone ormoremarkets. Innancialtheory,wegenerallyassumethat themarketdoesnotpermitarbitrage opportuni=es.
Otherwise,investorswouldimmediatelyinvestin arbitrageopportuni=esinhugeamounts.
Supplyanddemandwouldalterpricesun=lthe arbitrageopportuni=esnolongerexisted.

ForwardRatesandSpotRates
Topreventarbitrage,wemusthavethe followingrela=onshipbetweenforwardand spotrates:
(1 + f j ,k )
k j

(1 + sk ) k = (1 + s j ) j

Intermsofbondprices:

(1 + f j ,k )
k j

P (0, j ) = P (0, k )

ForwardRatesandSpotRates
Oneperiodforwardratesfk,k+1aresimply denotedbyfk. Itiseasytoseethat: Spotratesaregeometricaveragesofforward rates. Thereisaonetoonerela=onshipbetween thespotcurveandtheforwardcurve.
Spotratesuniquelydetermineforwardratesand viceversa

1 + sk = ((1 + f 0 )(1 + f1 ) (1 + f k 1 ))

1/ k

ShortRates
Oneperiodinterestratesthatapplyfor borrowingatfuture=mes. rkistherateforborrowingbetween=mekand =mek+1thatprevailsinthemarketat=mek. fkrateforborrowingbetween=mekandk+1 agreeduponat-mezero. rkrateforborrowingbetween=mekandk+1 agreeduponat-mek(itisthespotratethat prevailsinthefuture). Viewedfromtoday,rkisrandom.

Bootstrapping
Themostusefulrepresenta=onoftheterm structureofinterestratesisaspotratecurve. Wedontobservespotratesdirectlyinthe market.
Bondprices(oQenforcouponbearingbonds)are observed.

Theprocessofinferringspotratesfrom observedpricesofbondsiscalled bootstrapping.

ShapeoftheTermStructure
Normal sT sT Inverted

T Flat sT

TheoriesoftheTermStructure
Expecta=onTheory(Forwardratesrepresent marketfutureexpecta=onsofinterestrates).
Pure/UnbiasedExpecta=onsTheory LiquidityPreferenceTheory PreferredHabitatTheory

MarketSegmenta=onTheory

Pure/UnbiasedExpecta=onsTheory
Forwardratesrepresentexpectedfuturespot rates:

f k = E [ rk ]

Theslopeofthecurverepresentsexpecta=ons offuturerates:
Upwardslopingmeansthemarketexpectsrates togoup. Downwardslopingmeansthemarketexpects ratestogodown.

LiquidityPreferenceTheory
Investorsfavourliquidity. Forwardratesareexpectedfuturespotratesplus aliquiditypremium. TheliquiditypremiumLkincreaseswithk.

f k = E [ rk ] + Lk , Lk > 0

Reectsthefactthatlendersprefertolendforshort horizons(borrowersprefertoborrowforlong horizons).

Anupwardslopingcurvemayreectonly increasingliquiditypremiums(notnecessarilyan expectedincreaseinrates).

PreferredHabitatTheory
SameasLiquidityPreferenceTheory,exceptthat itallowsforLktobeposi=ve,nega=ve,orzero. Borrowersandinvestorshavepreferredmaturity ranges. Ifsupply/demandforagivenmaturitysector doesnotmatch,borrowers/investorsmaybe drivenoutsidetheirpreferredhabitatiftheyare compensatedbyanappropriateriskpremium/ discount.

f k = E [ rk ] + Lk

MarketSegmenta=onTheory
Neitherinvestorsnorborrowersarewillingto shiQfromonematuritysectortotheotherto takeadvantageofopportuni=esarising betweenexpecta=onsandforwardrates. Theshapeoftheyieldcurveisdeterminedby supplyanddemandforsecuri=eswithineach maturitysector,andindependentlyfromother maturi=es.
Eachsector(orsegment)isaseparatemarket