Spot Rates and Forward Rates

Forward rates: markets expectations of future

short term rates.
Use spot rate to compute forward rates
called implied forward rates

Its possible to use yield curve to calculate the

implied forward rate for any time in the future
18-1

Term-Structure Theories
Expectations Hypothesis
Any long-term interest rate simply represents the geometric
mean of current and future one-year interest rates expected to
prevail over the maturity of the issue
Explains any shape of the yield curve
Expectations for rising future short term rates rising yield curve
Expectations for falling future short term rates falling yield curve
Could also be flat or humped

Consistent Investor Actions

Interest rates expected to fall long term bonds become
attractive, short term bonds less attractive increase demand
and decreasing supply in long term bonds
18-2

Term-Structure Theories
Liquidity Preference Theory
Investor prefer short term bonds due to
uncertainty and volatility of longer maturities
bonds.
Liquidity premium (L) compensates investor in
long-term bonds for the added volatility
Yield curve should slope upward

18-3

Term-Structure Theories
Segmented-Market Hypothesis
Different institutional investors have different
maturity needs
On its strongest form: investors never buy
securities outside their preferred maturities
(effectively segmented).

Yield on a segment depend on supply & demand

within that maturity segment
18-4

World Yield Curve

Source: Thomson Reuters

US Yield Curve

Yield

US Corporate Bond Yield

Curves
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
2yr 2yr 5yr 5yr 5yr 10yr 10yr 10yr 20yr 20yr 20yr
AA A AAA AA A AAA AA A AAA AA A
Maturity

Source: Yahoo! Finance

Indonesia Yield Curve

Source: IBPA (Indonesia Bond Pricing Agency

Source: IBPA (Indonesia Bond Pricing Agency

Trading Implications of the Term

Structure
help formulate yield expectations
bond investors use the prevailing yield curve to
predict the shapes of future yield curves
The maturity segments that are expected to
experience the greatest yield changes give the
investor the largest potential price change
opportunities

18-8

Term-Structure Theories
Yield Spreads: the differences in promised yields
between bond issues or segments of the market at any
point in time.

Major Yield Spreads

Segments: Government bonds, agency bonds, and
corporate bonds
Sectors: Prime-grade municipal bonds versus goodgrade municipal bonds, AA utilities versus BBB utilities
Coupons or seasoning within a segment or sector
Maturities within a given market segment or sector

Indonesia Yield Spread

Source: IBPA (Indonesia Bond Pricing Agency

Price Volatility for Bonds

Interest rate sensitivity

Malkiels bond valuation model: a function of

1. Par value
2. Coupon
3. Years to maturity
4. Prevailing market interest rate

EPB
1
BPB

where:
EPB = the ending price of the bond
BPB = the beginning price of the bond

Price Volatility for Bonds

Malkiels mathematical proofs shows that:
Bond prices move inversely to bond yields
For a given change in yields, longer maturity bonds
post larger price changes
Price volatility increases at a diminishing rate as term
to maturity increases
Price movements resulting from equal absolute
increases or decreases in yield are not symmetrical
Bond price volatility is inversely related to coupon

Price Volatility for Bonds

The Maturity Effect
The longer-maturity bond experienced the
greater price volatility
Price volatility increased at a decreasing rate
with maturity

 The Coupon Effect

inverse relationship between coupon rate and
price volatility

 The Yield Level Effect

If yield changes by a constant percentage, the
change in the bond price is larger when the
yields are at a higher level
If yield changes by a constant basis-point, the
change in the bond price is larger when the
yields are at a lower level

18-15

Trading Strategies
Expecting interest rates to decline select
bonds with maximum interest rate sensitivity
Expecting interest rates to rise select bonds
with minimum interest rate sensitivity