CHAPTER 11

THE TERM STRUCTURE OF INTEREST RATES

THE YIELD CURVE AND THE TERM STRUCTURE

The graphical depiction of the relationship between the yield on bonds of the same credit
quality but of different maturities is called the yield curve. These curves are typically
constructed from U.S. Treasury bonds, since such securities have effectively no default or
liquidity risks.

Using the Yield Curve to Price a Bond

At first glance bond pricing using a yield curve should be a relatively simple matter—just take
the Treasury yield for the comparable maturity and add a risk premium. But securities with the
same maturity can have different yields, depending upon the coupon rate and cash flow pattern.
Because of the different cash flow patterns, the same interest rate cannot be used to discount all
cash flows.

Constructing the Theoretical Spot Rate Curve

A better 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. Determining the value of each zero-coupon
bond can be derived from a theoretical spot rate curve of Treasury bonds (the curve is
theoretical because there are very few zero-coupon Treasuries). This process is called
bootstrapping and employs the basic principle that the value of the Treasury coupon security
should be equal to the value of the package of zero-coupon securities.

Using Spot Rates to Value a Bond

The theory suggests that theoretical price of a bond is equal to the present value of the cash
flows. What economic force will assure that actual price will not depart significantly from its
theoretical price? Since any coupon bond can be viewed as a package of zero-coupon
instrument, the rate on a zero coupon bond is called the spot rate. This is shown by a process
referred to as stripping a security. Each security created has a maturity value and maturity date
equal to the date when the coupon payment of maturity value is due. In this manner, each
security is treated as a zero coupon bond. It is the process of coupon stripping and synthetically
creating a Treasury bond by buying the zero coupon bonds that will drive the price of T-bond
to its value as determined by the spot rates.

FORWARD RATES

A forward rate is the rate on a loan at some future period, e.g. the yield on one-year bonds a
year from now. The implicit forward rate can be calculated from the knowledge of current spot
rates and finding an indifference rate. For example, assume the spot rate of one-year bond is 8%

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and for two-year bonds it is 10%. Suppose now that an investor would consider buying either a
two-year bond (long-term) or two one-year bonds (short-term). The yield for the period must be
the same. To reach that indifference point the investor must obtain 12% next year on his one-
year bond to match the two-year offering. Hence the implicit forward rate becomes 12%. Of
course, due to compounding and semi-annual payment periods, the actual situation is more
complex. The general formula is:

f = (1 + z2)2 / (1 + z1) – 1

where f = the forward rate for the second one period bond
z1 = the bond equivalent yield of the theoretical spot rate for one period
z2 = the bond equivalent yield of the theoretical spot rate for a second period

A future interest rate calculated from either the spot rates or the yield curve is called a forward
rate or an implied forward rate.

Relationship between Spot Rates and Short-Term Forward Rates

In general, the relationship between a T-period spot rate, and implied forward rates is as
follows:

Zt = [( 1+z1 ) ( 1+f1 ) (1+f2 ) (1+f3 ) . . . (1+ft-1 )]1/t – 1

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. 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.

DETERMINANTS OF THE SHAPE OF THE TERM STRUCTURE

Two major theories evolved to account for these observed shapes of the yield curve: the
expectation theory and the market segmentation theory. Several forms of the expectation theory
include the pure expectation theory, the liquidity theory, and the preferred habitat theory. The
pure expectation theory posits that no systematic factors other than the expected future short-
term rate affects forward rates. The other two theories assert that other factors are involved.
The last two forms of the expectation theory are referred to as bias expectations theory.

The Pure Expectations Theory

According to the pure expectation theory, the forward rates represent expected future rates.
The entire term structure at any point in time reflects the market’s current expectations of the
family of future short-term rates. In other words, the long-term rates represent the average of
future and present short-term rates. A rising term structure indicates that the market expects

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short-term rates to rise. If interest rates are expected to increase, investors will lend long-term
only if they are coaxed to do so by higher yields. Hence the curve will tilt upward.

Risks associated with bond investment: The theory neglects the risks inherent in investing in
bonds. Two risks cause uncertainty about the return over some investment horizon: (1) the
uncertainty about the price of the bond at the end of the investment horizon, called the price
risk, and (2) the uncertainty about the rate at which the proceeds from a bond that matures
prior to the maturity date can be reinvested until the maturity date, called the reinvestment risk.

Interpretations of the pure expectation theory: The broadest interpretation of this theory
relies upon the assumption that holding period return must be identical for any investing
strategy that spans the investor's chosen holding period. In other words, all combinations of
bonds that comprise a five-year term should have the same total yield. A modification of this
idea is considered to be more accurate. The local expectations hypothesis says that long-term
bonds will have the same returns when investors have short investment horizons. The final
interpretation, called the return-to-maturity expectations theory, holds that investors will equate
the yield on a package of bonds with a zero-coupon bond which has the same maturity. Only
the second version is thought to hold much promise in describing actual market rates.

The Liquidity Theory

This theory suggests that investors do not like uncertainty, which tends to increase linearly over
time. They prefer to hold liquid assets and must be coaxed out of such holdings and into long-
term assets by higher rates. This is an outgrowth of Keynesian theory and implies that the curve
must have an upward slope. At the very least it assumes that investors demand a liquidity
premium over the average of expected future rates. According to the liquidity theory of the
term structure, the implicit forward rates will not be an unbiased estimate of the market’s
expectations of the future interest rates because they embody a liquidity premium.

The Preferred Habitat Theory

The preferred habitat theory accepts the view that the term structure reflects the expectations
of the future path of interest rates as well as a liquidity risk premium. But it rejects the view
that the risk premium must rise uniformly with maturity. Investors or borrowers are assumed to
prefer certain maturity sectors and they are reluctant to shift out of those sectors unless induced
by a premium to do so. The classic examples of investors with strong maturity preferences are
banks (which by the nature of their liabilities structures prefer short-term investments) and
insurance companies (which for the same reason prefer to stay with long-term securities).

Market Segmentation Theory

The market segmentation theory represents a stronger version of the preferred habitat theory,
wherein shifts are not made out of maturity sectors. Hence the curve can be humped, negative
or positive in slope, depending upon activities in various financial market sectors. Increased
government borrowing in the form of T-notes, would raise rates among medium-term
securities.The actual behavior of the term structure seems to follow characteristics of pure
expectations in that arbitrage between rates of various maturities occurs according to the
mathematical underpinnings that the expectations hypothesis provides. Segmentation represents

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a valid alternative, but it lacks the ability to explain many observed shapes and movements of
the yield curve over time. Some combination of the two theories, as represented by either a
liquidity premium or preferred habitat approach, is probably the most correct view of interest
rate movements over time.

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 ANSWERS TO QUESTIONS FOR CHAPTER 11
(Questions are in bold print followed by answers.)
1.
a. What is a yield curve?
b. Historically, why has the Treasury yield curve been the one that is most closely
watched by market participants?

a. A yield curve is a geographical representation of the term structure (the relationship

between yield to maturity and the term to maturity) of securities having the same credit
rating.
b. Treasury securities are risk-free with respect to credit and liquidity, and their yields serve as
benchmarks for other securities.

2. What is meant by a spot rate?

The spot rate is the yield on a zero-coupon Treasury security with the same maturity as the
security under consideration. Sometimes referred to as the theoretical spot rate, since it must be
derived, as there are few zero-coupon Treasuries outstanding.

3. Explain why it is inappropriate to use one yield to discount all the cash flows of a
financial asset.

Interest rates change over time. Securities should be discounted by interest rates applicable over
the period of each of the cash flows.

4. Explain why a financial asset can be viewed as a package of zero-coupon instruments.

A bond has a series of interest-paying periods and principal. Interest paid at the end of each
period can be likened to a zero-coupon bond. Hence a bond can be valued as the sum of a
package of zero-coupon bonds.

5. Why is it important for lenders and borrowers to have a knowledge of forward rates?

If a borrower knows the forward rate he can decide whether to request a long-term or short-
term loan. E.g. if a borrower knows that future short-term rates will be higher than today, he
may be better off with a long-term loan. In like manner, if an investor knows the forward rate
and it is higher than today’s spot rate, he is better off to invest short-term now and wait for the
benefits of increased yields later.

6. How are spot rates related to forward rates?

Implied forward rates are future short-term rates. If implied rates are realized, the same number
of dollars will be realized as expected. Thus, spot rate is related to the forward rates.

7. You are a financial consultant. At various times, you have heard the following
comments on interest rates from one of your clients. How would you respond to each

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comment?
a. “The yield curve is upward sloping today. This suggests that the market consensus
is that interest rates are expected to increase in the future.”
b. “I can’t make any sense out of today’s term structure. For short-term yields (up to
three years), the spot rates increase with maturity; for maturities greater than
three years but less than eight years, the spot rates decline with maturity; and for
maturities greater than eight years the spot rates are virtually the same for each
maturity. There is simply no theory that explains a term structure with this shape.”
c. “When I want to determine the market’s consensus of future interest rates, I
calculate the implicit forward rates.”

a. This is true if the unbiased expectations theory of the term structure holds. Under the
liquidity theory of the term structure of interest rates, it is possible for expectations to show
a decline, but the liquidity premium demanded may be large enough to make the term
structure still slope upward.
b. The statement is incorrect. It is possible under the preferred habitat and market
segmentation theories for the term structure to have such a shape.
c. The answer here is the same as in (a). The implicit forward rates are the market's consensus
only if the unbiased expectations theory holds.

8. You observe the Treasury yield curve below (all yields are shown on a bond-equivalent
basis):

Year Yield to Maturity Spot Rate

0.5 5.25% 5.25%
1.0 5.50 5.50
1.5 5.75 5.76
2.0 6.00 ?
2.5 6.25 ?
3.0 6.50 ?
3.5 6.75 ?
4.0 7.00 ?
4.5 7.25 ?
5.0 7.50 ?
5.5 7.75 7.97
6.0 8.00 8.27
6.5 8.25 8.59
7.0 8.50 8.92
7.5 8.75 9.25
8.0 9.00 9.61
8.5 9.25 9.97
9.0 9.50 10.36
9.5 9.75 10.77
10.0 10.00 11.20

All the securities maturing from 1.5 years on are selling at par. The 0.5-year and one-year
securities are zero-coupon instruments.
a. Calculate the missing spot rates.

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 b. What should the price of the six-year Treasury security be?
c. What is the implicit six-month forward rate starting in the sixth year?

In answering this question, the student should recognize that the coupon rates are equal to the
yield to maturity since the bonds are selling at par. The solution -- take each cash flow (½ the
coupon rate) and divide by (1 + ½ the spot rate) for each period and set these cash flows equal
to $1000. The only unknown is the last period spot rate, which can then be found algebraically.
e.g. for year 2 (period 4) the spot rate will be:

$1000 = $30/(1.0265) + $30/(1.0275)2 + $30/(1.0287)3 + $1030/(1+y4)4

Y4 = 6.02%

a. The missing spot rates are shown below:

Year Yield to Maturity Spot Rate

2.0 6.00 6.02
2.5 6.25 6.28
3.0 6.50 6.55
3.5 6.75 6.82
4.0 7.00 7.10
4.5 7.25 7.38
5.0 7.50 7.67

b. The price of a six-year Treasury security should be the sum of the present values of the cash
flows, discounting each cash flow at the theoretical spot rate. The coupon rate for the six-
year Treasury is 8%, so the semi-annual coupon per $100 of par is $4. Given the spot rates
for each of the 12 periods and the cash flows, we can determine the theoretical price =
100.0149 or $1000.15
c. The implicit six-month forward rate six years from now (12 semi-annual periods) is found
by using the equation in the book:

(1+ y13 )13

1 + f 13 = - 1=
(1+ y12 )12

=(1.04295)13
-1=.0623x2=12.46%
12
(1.04135)

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9. You observe the following Treasury yield curve (all yields are shown on a bond-
equivalent basis):

Year Yield to Maturity Spot Rate

0.5 10.00% 10.00%
1.0 9.75 9.75
1.5 9.50 9.48
2.0 9.25 9.22
2.5 9.00 8.95
3.0 8.75 8.68
3.5 8.50 8.41
4.0 8.25 8.14
4.5 8.00 7.86
5.0 7.75 7.58
5.5 7.50 7.30
6.0 7.25 7.02
6.5 7.00 6.74
7.0 6.75 6.46
7.5 6.50 6.18
8.0 6.25 5.90
8.5 6.00 5.62
9.0 5.75 5.35
9.5 5.50 ?
10.0 5.25 ?

All the securities maturing from 1.5 years on are selling at par. The 0.5-year and one-year
securities are zero-coupon instruments.
a. Calculate the missing spot rates.
b. What should the price of the four-year Treasury security be?

a. Using the same formulation as in question 8, we can derive the missing spot rates:

Year Yield to Maturity Spot Rate

9.5 5.50 5.07
10.0 5.25 4.80

b. The price of a four-year Treasury should be the sum of the present value of the cash flows,
discounting each cash flow at the theoretical spot rate. The coupon rate is $4.125 on a semi-
annual basis. Given the necessary data, the theoretical price can be calculated as 99.99 or
$999.90.

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10. Using the theoretical spot rates in Table 11-2, calculate the theoretical value of a 7%,
six-year Treasury bond.

PRICE OF A 10-YEAR 13% COUPON TREASURY BASED

ON THE 10-YEAR YIELD OF 12.5%

CASH FLOW REQUIRED SEMIANNUAL PRESENT

MATURITY PER $100 PAR YIELD OF 0.125 YIELD VALUE
0.50 $6.50 0.125 0.0625 6.1176
1.00 $6.50 0.125 0.0625 5.7578
1.50 $6.50 0.125 0.0625 5.4191
2.00 $6.50 0.125 0.0625 5.1003
2.50 $6.50 0.125 0.0625 4.8003
3.00 $6.50 0.125 0.0625 4.5179
3.50 $6.50 0.125 0.0625 4.2522
4.00 $6.50 0.125 0.0625 4.0020
4.50 $6.50 0.125 0.0625 3.7666
5.00 $6.50 0.125 0.0625 3.5451
5.50 $6.50 0.125 0.0625 3.3365
6.00 $6.50 0.125 0.0625 3.1403
6.50 $6.50 0.125 0.0625 2.9555
7.00 $6.50 0.125 0.0625 2.7817
7.50 $6.50 0.125 0.0625 2.6181
8.00 $6.50 0.125 0.0625 2.4641
8.50 $6.50 0.125 0.0625 2.3191
9.00 $6.50 0.125 0.0625 2.1827
9.50 $6.50 0.125 0.0625 2.0543
10.00 $106.50 0.125 0.0625 31.6790
TOTAL 102.8102

THEORETICAL VALUE OF A 10-YEAR, 13% COUPON TREASURY BASED

ON THE THEORETICAL SPOT RATE

CASH FLOW SEMIANNUAL PRESENT

MATURITY PER $100 PAR SPOT RATE SPOT RATE VALUE
0.50 $6.50 0.08000 0.04000 6.25000
1.00 $6.50 0.08300 0.04150 5.99232
1.50 $6.50 0.08930 0.04465 5.70165
2.00 $6.50 0.09247 0.04624 5.42496
2.50 $6.50 0.09468 0.04734 5.15792
3.00 $6.50 0.09787 0.04894 4.88002
3.50 $6.50 0.10129 0.05065 4.59961
4.00 $6.50 0.10592 0.05296 4.30148
4.50 $6.50 0.10850 0.05425 4.04037
5.00 $6.50 0.11021 0.05511 3.80151
5.50 $6.50 0.11175 0.05588 3.57417
6.00 $6.50 0.11584 0.05792 3.30734
6.50 $6.50 0.11744 0.05872 3.09570
7.00 $6.50 0.11991 0.05996 2.87667
7.50 $6.50 0.12405 0.06203 2.63568
8.00 $6.50 0.12278 0.06139 2.50561
8.50 $6.50 0.12546 0.06273 2.31059
9.00 $6.50 0.13152 0.06576 2.06559
9.50 $6.50 0.13377 0.06689 1.89967
10.00 $106.50 0.13623 0.06812 28.50948
TOTAL 102.93036

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11.
a. Using the theoretical spot rates in Table 11-2, calculate the two-year forward rate
four years from now.
b. Verify the answer by assuming an investment of $100 is invested for six years.

a. In terms of the notation, t = 4 and m = 8. Substituting for t and m into the equation for
forward rate, we have,

 =  (1 + z 8 + 4) 8 + 4 / (1 + z 8) 6
4 8
1/4
- 1 =  (1 + z 12) 12 / (1 + z 8) 6 1/4

z 8 = 0.10592/2 = 0.052960
z 12 = 0.11584/2 = 0.057920

 =  (1.057920) 12 / (1.052960) 6
4 8
1/4
- 1 =  1.965323/1.362923  1/4
-1
48 = 0.095824 = 9.58%

b. We can verify the answer by assuming an investment of $100 for six years. Invest $100 for
twelve periods at the semi-annual spot rate of (11.584 / 2) = 5.792% will produce:
$100 (1.0579) 12 = $196.5324. By investing $100 for eight periods at 5.296% and
reinvesting the proceeds for four periods at the forward rate of 9.5824% gives the same
value:
$100 (1.0579) 12 = $196.5324

12. Explain the role that forward rates play in making investment decisions.

If a borrower knows the forward rate he can decide whether to request a long-term or short-
term loan. For example, if a borrower knows that future short-term rates will be higher than
today, he may be better off with a long-term loan. In like manner, if an investor knows the
forward rate and it is higher than today's spot rate, he is better off to invest short-term now and
wait for the benefits of increased yields later.

13. “Forward rates are poor predictors of the actual future rates that are realized.
Consequently, they are of little value to an investor.” Explain why you agree or disagree
with this statement.

I will disagree with the statement. The forward rate may not be realized, but that is irrelevant.
Forward rates are being hedgeable by buying a one-year security, and thus the investor is able
to hedge the six-month rate.

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14. An investor is considering two alternative investments. The first alternative is to invest
in an instrument that matures in two years. The second alternative is to invest in an
instrument that matures in one year and at the end of one year, reinvest the proceeds in a
one-year instrument. The investor believes that one-year interest rates one year from now
will be higher than they are today and, therefore, is leaning in favor of the second
alternative. What would you recommend to this investor?

The answer depends on the several interpretations of the Pure Expectation (PE) Theory.
According to the broadest interpretation, the investor expects the return for any investment
horizon to be the same, regardless of the maturity strategy selected. Therefore, it makes no
difference to invest in two-year security or one year and followed by another year.

15.
a. What is the difference between a normal yield curve and steep yield curve?
b. What is meant by a humped yield curve?

a. A normal yield curve is when the spread between the 6-month and 30-year yield is 300 bp
or less. When the maturity spread is more than 300 bp, the yield is said to be a steep yield
curve.
b. A humped yield curve means that the yields on medium maturity instruments are higher
than the short-term and long-term yields.

16. What is the common hypothesis about the behavior of short-term forward rates shared
by the various forms of the expectations theory?

The expectations theory of the yield structure states that forward rates represent expected
future rates.

17. What are the types of risks associated with investing in bonds and how do these two
risks affect the pure expectations theory?

The expectations theory suggests that rates will change over time in some direction. The
prospect of changing yields creates two risks related to bond investment: (1) the price risk
(value of principal if sold prior to maturity) and the reinvestment risk. Low rates may be good
for price increases, but their favorable impact is partially offset by investors having to reinvest
earnings at these low rates.

18. Give three interpretations of the pure expectations theory.

(1)Investors expect the return for any investment horizon to be the same, regardless of the
maturity strategy selected. Time arbitrage will see to it.
(2) The local expectations interpretation suggests that returns will be the same, but only over a
short-term horizon.
(3) The return-to-maturity expectations interpretation suggests that the returns realized over a
specified time horizon will be the same as from holding a zero-coupon bond with the same
maturity as the investment horizon.

19. What are the two biased expectations theories about the term structure of interest

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rates?

The two biased expectations theories are (1) the liquidity preference hypothesis and the
preferred habitat hypothesis.

20. What are the underlying hypotheses of the two biased expectations theories of interest
rates?

While the above hypotheses allow for expectations they maintain that investors have: (1) A
preference for more liquid assets and will hence demand a liquidity premium on longer-term
securities, and (2) investors have a preferred habitat on the yield curve and demand premiums if
they are to leave that sector for another one.

21.
a. “Empirical evidence suggests that with respect to bond risk premiums that
influence the shape of the Treasury yield curve, there is a linear relationship
between Treasury average returns and duration.” Explain whether you agree or
disagree with this statement. If you disagree, explain the type of relationship that
has been observed.
b. What is meant by the “convexity bias” influence on the shape of the Treasury yield
curve?

a. Disagree. Empirical evidence suggests that the bond risk premiums are not linear in
duration. Instead, at the front end of the yield curve, the bond risk premiums increase
steeply with duration.
b. Convexity bias is the influence of convexity on the shape of the Treasury yield curve.

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