ࡱ> wyv'` bjbjLULU 1.?.? R8<8<8<8p<d<TŽ4>@@@@AAA]N_N_N_NLN8m8$h?BAABB?@@\*HHHB@@]NHB]NHHUKK@(> p|gޢ8<(CmK1L,<ŽuK,jFjKjKA"AHABAAA??HXAAAŽBBBBd48<8< CHAPTER 13 THE TERM STRUCTURE OF INTEREST RATES 1. Expectations hypothesis. The yields on long-term bonds are geometric averages of present and expected future short rates. An upward sloping curve is explained by expected future short rates being higher than the current short rate. A downward-sloping yield curve implies expected future short rates are lower than the current short rate. Thus bonds of different maturities have different yields if expectations of future short rates are different from the current short rate. Liquidity preference hypothesis. Yields on long-term bonds are greater than the expected return from rolling-over short-term bonds in order to compensate investors in long-term bonds for bearing interest rate risk. Thus bonds of different maturities can have different yields even if expected future short rates are all equal to the current short rate. An upward sloping yield curve can be consistent even with expectations of falling short rates if liquidity premiums are high enough. If, however, the yield curve is downward sloping and liquidity premiums are assumed to be positive, then we can conclude that future short rates are expected to be lower than the current short rate. Segmentation hypothesis. This hypothesis would explain a sloping yield curve as an imbalance between supply and demand for bonds of different maturities. An upward sloping yield curve is evidence of supply pressure in the long-term market and demand pressure in the short-term market. According to the segmentation hypothesis, expectations of future rates have little to do with the shape of the yield curve. 2. d. 3. In general, the forward rate can be viewed as the sum of the markets expectation of the future short rate plus a potential risk or liquidity premium. According to the expectations theory of the term structure of interest rates, the liquidity premium is zero so that the forward rate is equal to the markets expectation of the future short rate. Therefore, the markets expectation of future short rates (i.e., forward rates) can be derived from the yield curve, and there is no risk premium for longer maturities. The liquidity preference theory, on the other hand, specifies that the liquidity premium is positive so that the forward rate is less than the markets expectation of the future short rate. This could result in an upward sloping term structure even if the market does not anticipate an increase in interest rates. The liquidity preference theory is based on the assumption that the financial markets are dominated by short-term investors who demand a premium in order to be induced to invest in long maturity securities. 4. True. Under the expectations hypothesis, there are no risk premia built into bond prices. The only reason for long-term yields to exceed short-term yields is an expectation of higher short-term rates in the future. 5. Uncertain. Lower inflation will usually lead to lower nominal interest rates. Nevertheless, if the liquidity premium is sufficiently great, long-term yields may exceed short-term yields despite expectations of falling short rates. 6. Maturity Price YTM Forward Rates 1 $943.40 6.00% 2 $898.47 5.50% 5.00% (1.0552/1.06 1) 3 $847.62 5.67% 6.00% (1.05673/1.0552 1) 4 $792.16 6.00% 7.00% (1.064/1.05673 1) 7. The expected price path of the 4-year zero coupon bond is as follows. (We discount the face value by the appropriate sequence of forward rates implied by this years yield curve.) Beginning of Year Expected Price Expected Rate of Return 1 $792.16 6.00% (839.69/792.16)  1 2  EQ \F(1000,1.05 1.06 1.07)  = 839.69 5.00% (881.68/839.69)  1 3  EQ \F(1000,1.06 ( 1.07)  = 881.68 6.00% (934.58/881.68)  1 4  EQ \F( 1000, 1.07)  = 934.58 7.00% (1000/934.58)  1 8. a. (1+y4)4 = (1+ y3)3 (1 + f4) (1.055)4 = (1.05)3 (1 + f4) 1.2388 = 1.1576 (1 + f4) f4 = .0701, or 7.01% b. The conditions would be those that underlie the pure expectations theory of the term structure: risk neutral market participants who are willing to substitute among maturities solely on the basis of yield differentials. This behavior would rule out liquidity or term premia relating to risk as well as market segmentation based on maturity preferences. c. Under the expectations hypothesis, lower implied forward rates would indicate lower expected future spot rates for the corresponding period. Since the lower expected future rates embodied in the term structure are nominal rates, either lower expected future real rates or lower expected future inflation rates would be consistent with the specified change in the observed (implied) forward rate. 9. You should expect it to lie above the curve since the bond must offer a premium to investors to compensate them for the option granted to the issuer. 10. The present value of each bond's payments can be derived by discounting each cash flow by rates from the spot interest rate (i.e., the pure yield) curve. Bond A: PV =  EQ \F(10,1.05) +  EQ \F(10,1.082) +  EQ \F(110,1.113) = $98.53 Bond A: PV =  EQ \F(6,1.05) +  EQ \F(6,1.082) +  EQ \F(106,1.113) = $88.36 Bond A sells for $.13 (i.e., .13% of par value) less than the present value of its stripped payments. Bond B sells for $.02 less than the present value of its stripped payments. Bond A seems to be more attractively priced. 11. a. We obtain forward rates from the following table: Maturity YTM Forward rate Price (for parts c, d) 1 year 10% 909.09 (1000/1.10) 2 11 12.01% (1.112/1.10 1) 811.62 (1000/1.112) 3 12 14.03% (1.123/1.112 1) 711.78 (1000/1.123) b. We obtain next years prices and yields by discounting each zeros face value at the forward rates for next year that we derived in part (a): Maturity Price YTM 1 year 892.78 [= 1000/1.1201] 12.01% 2 years 782.93 [= 1000/(1.1201 1.1403)] 13.02% Note that this year s upward sloping yield curve implies, according to the expectations hypothesis, a shift upward in next year s curve. c. Next year, the 2-year zero will be a 1-year zero, and will therefore sell at $1000/1.1201 = $892.78. Similarly, the current 3-year zero will be a 2-year zero and will sell for $782.93. Expected total rate of return: 2-year bond:  EQ \F(892.78,811.62)  1 = 1.1000 or 10% 3-year bond:  EQ \F(782.93,711.78)  1 = 1.1000 or 10% d. The current price of the bond should equal the value of each payment times the present value of $1 to be received at the maturity of that payment. The present value schedule can be taken directly fom the prices of zero-coupon bonds calculated above. Current price = 120 (.90909) + 120 (.81162) + 1,120 (.71178) = 109.0908 + 97.3944 + 797.1936 = $1,003.68 Similarly, the expected prices of zeros in 1 year can be used to calculate the expected bond value at that time: Expected price 1 year from now = 120 .89278 + 1120 .78293 = 107.1336 + 876.8816 = $984.02 Total expected rate of return =  EQ \F(120 + (984.02  1003.67),1003.68)  =  EQ \F(120 19.66,1003.68) = .1000 or 10% 12. a. A 3-year zero with face value $100 will sell today at a yield of 6% and a price of $100/1.063 =$83.96. Next year, the bond will have a two-year maturity, and therefore a yield of 6% (reading from next years forecasted yield curve). The price will be $89.00, resulting in a holding period return of 6%. b. The forward rates based on todays yield curve are as follows: Year Forward Rate 2 6.01% (1.052/1.04 1) 3 8.03% (1.063/1.052 1) Using the forward rates, the yield curve next year is forecast as: Maturity YTM 1 6.01% 2 7.02% [(1.0601 1.0803)1/2  1] The market forecast is for a higher YTM on 2 year bonds than your forecast. Thus, the market predicts a lower price and higher rate of return. 13. a. P =  EQ \F(9,1.07 ) +  EQ \F(109,(1.08)2) = $101.86 b. YTM = 7.958%, which is the solution to:  EQ \F(9,1+y ) +  EQ \F(109,(1+y)2) = 101.86 [On your calculator, input n = 2; FV = 100; PMT = 9; PV = ()101.86; compute i] c. The forward rate for next year derived from the zero-coupon yield curve is: 1 + f2 =  EQ \F((1.08)2,1.07) = 1.0901 which implies f2 = 9.01%. Therefore, using an expected rate for next year of r2 = 9.01%, we find that the forecast bond price is P =  EQ \F(109,1.0901) = $99.99 d. If the liquidity premium is 1% then the forecast interest rate is : E(r2) = f2  liquidity premium = 9.01%  1% = 8.01% and you forecast the bond to sell at  EQ \F(109,1.0801) = $100.92. 14. a. The current bond price is 85 .9434 + 85 .87352 + 1085 .81637 = 1040.20 which implies a yield to maturity of 6.97% [since 85 Annuity factor(6.97%, 3) + 1000 PV factor(6.97%, 3) = 1040.20]. b. If next year, y = 8%, then the bond price will be 85 Annuity factor(8%,2) + 1000 PV factor(8%,2) = 1008.92 for a holding period return equal to [85 + (1008.92  1040.20)]/1040.20 = .0516 or 5.16%. 15. Year Forward rate PV of $1 received at period end 1 5% 1/1.05 = $.9524 2 7% 1/(1.05)(1.07) = .8901 3 8% 1/(1.05)(1.07)(1.08) = .8241 a. Price = (60 .9524) + (60 .8901) + (1060 .8241) = 984.10 b. 984.10 = 60 Annuity factor(y, 3) + 1000 PV factor(y, 3) which can be solved to show that y = 6.60% c. Payment Received Will grow by To a future Period at end of period a factor of value of 1 $ 60 (1.07) (1.08) 69.34 2 $ 60 (1.08) 64.80 3 $1060 1 1060.00 1194.14 984.10 (1 + RCY)3 = 1194.14 1 + RCY =  EQ \B\bc\((\F(1194.14,984.10)) 1/3 = 1.0666 RCY = 6.66% d. Next year, the bond will sell for 60 Annuity factor(7%, 2) + 1000 PV factor(7%,2) = $981.92 which implies a capital loss of 984.10  981.92 = $2.18. The holding period return is  EQ \F(60+ ( 2.18),984.10) = .0588 or 5.88% 16. a. The return on the one-year bond will be 6.1%. The price of the 4-year zero today is $1000/1.0644 = $780.25. Next year, if the yield curve is unchanged, the bond will have a 3-year maturity, a YTM of 6.3%, and therefore sell for $1000/1.0633 = $832.53, resulting in a one-year return of 6.7%. The longer-term bond is expected to provide the higher return in this case because its YTM is expected to decline during the holding period. If you believe in the expectations theory, you would not expect that the yield curve next year will be the same as todays curve. The upward slope in today's curve would be evidence that expected short rates are rising and that the yield curve will shift upward, reducing the holding period return on the four-year bond. Under the expectations hypothesis, all bonds have equal expected holding period returns. Therefore, you would predict that the HPR for the 4-year bond would be 6.1%, the same as for the 1-year bond. 17. a. Based on the pure expectations theory, VanHusens conclusion is incorrect. According to this theory, the expected return over any time horizon would be the same, regardless of the maturity strategy employed. b. According to the liquidity preference theory, the shape of the yield curve implies that short-term interest rates are expected to rise in the future. This theory asserts that forward rates reflect expectations about future interest rates plus a liquidity premium that increases with maturity. Given the shape of the yield curve and the liquidity premium data provided, the yield curve would still be positively sloped (at least through maturity of eight years) after subtracting the respective liquidity premiums: 2.90% 0.55% = 2.35% 3.50% 0.55% = 2.95% 3.80% 0.65% = 3.15% 4.00% 0.75% = 3.25% 4.15% 0.90% = 3.25% 4.30% 1.10% = 3.20% 4.45% 1.20% = 3.25% 4.60% 1.50% = 3.10% 4.70% 1.60% = 3.10% 18. The coupon bonds can be viewed as portfolios of stripped zeros: each coupon can stand alone as an independent zero-coupon bond. Therefore, yields on coupon bonds reflect yields on payments with dates corresponding to each coupon. When the yield curve is upward sloping, coupon bonds have lower yields than zeros with the same maturity because the yields to maturity on coupon bonds reflect the yields on the earlier interim coupon payments. 19. The following table shows the expected short-term interest rate based on the projections of Federal Reserve rate cuts, the term premium (which increases at a rate of 0.10% per 12 months), the forward rate (which is the sum of the expected rate and term premium), and the YTM, which is the geometric average of the forward rates. TimeExpected short rateTerm premiumForward rate (annual)Forward rate (semi-annual)YTM (semi-annual)05.00%0.00%5.00%2.500%2.500%6 months4.500.054.552.2752.38712 months4.000.104.102.0502.27518 months4.000.154.152.0752.22524 months4.000.204.202.1002.20030 months5.000.255.252.6252.27136 months5.000.305.302.6502.334This analysis is predicated on the liquidity preference theory of the term structure, which asserts that the forward rate in any period is the sum of the expected short rate plus the liquidity premium. 20 a. Five-year Spot Rate: 1000 =  EQ \F(70,(1 + y1)1) +  EQ \F(70,(1 + y2)2) +  EQ \F(70,(1 + y3)3) +  EQ \F(70,(1 + y4)4) +  EQ \F(1070,(1 + y5)5)  1000 =  EQ \F(70,1.05) +  EQ \F(70,(1.0521)2) +  EQ \F(70,(1.0605)3) +  EQ \F(70,(1.0716)4) +  EQ \F(1070,(1 + y5)5)  1000 = 66.67 + 63.24 + 58.69 + 53.08 +  EQ \F(1070,(1 + y5)5)  758.32 =  EQ \F(1070,(1 + y5)5)  (1 + y5)5 =  EQ \F(1070,758.32) ( y5 =  EQ \R(5,1.411)  1 = 7.13% Five-year Forward Rate:  EQ \F((1.0713)5,(1.0716)4)  1 = 1.0701  1 = 7.01% b. Yield to maturity is the single discount rate that equates the present value of a series of cash flows to a current price. It is the internal rate of return. The spot rate for a given period is the yield to maturity on a zero-coupon bond which matures at the end of the period. A spot rate is the discount rate for each period. Spot rates are used to discount each cash flow of a coupon bond to calculate a current price. Spot rates are the rates appropriate for discounting future cash flows of different maturities. A forward rate is the implicit rate that links any two spot rates. Forward rates are directly related to spot rates, and therefore yield to maturity. Some would argue (as in the expectations theory) that forward rates are the market expectations of future interest rates. Regardless, a forward rate represents a break-even rate that links two spot rates. It is important to note that forward rates link spot rates, not yields to maturity. Yield to maturity is not unique for any particular maturity. In other words, two bonds with the same maturity but different coupon rates may have different yields to maturity. In contrast, spot rates and forward rates for each date are unique. c. The 4-year spot rate is 7.16%. Therefore, 7.16% is the theoretical yield to maturity for the zero coupon Canada bond. The price of the zero coupon discounted at 7.16% is the present value of $1000 to be received in 4 years. Using annual compounding, PV =  EQ \F(1000,(1.0716)4) = $758.35 21. The price of the coupon bond, based on its yield to maturity, is 120 Annuity factor(5.8%, 2) + 1000 PV factor(5.8%, 2) = $1113.99. If the coupons were stripped and sold separately as zeros, then based on the yield to maturity of zeros with maturities of one and two years, the coupon payments could be sold separately for  EQ \F(120,1.05) +  EQ \F(1120,1.062) = $1111.08. The arbitrage strategy is to buy zeros with face values of $120 and $1120 and respective maturities of one and two years, and simultaneously sell the coupon bond. The profit equals $2.91 on each bond. 22. a. The one-year bond has a yield to maturity of 6%: 94.34 =  EQ \F(100, 1+y1)  ( y1 = .0600 The yield on the two-year zero is 8.472%: 84.99 =  EQ \F(100, (1+y2)2)  ( y2 = .08472 The price of the coupon bond is  EQ \F(12,1.06) +  EQ \F(112,(1.08472)2) = $106.51 Therefore its yield to maturity is 8.333% [on your calculator: n = 2; PV = ()106.51; FV = 100; PMT = 12] b. f2 =  EQ \F((1 + y2)2,1 + y1)  1 =  EQ \F((1.08472)2,1.06)  1 = .11 = 11% c. Expected price =  EQ \F(112,1.11) = 100.90. (Note that next year, the coupon bond will have one payment left.) Expected holding period return =  EQ \F(12 + (100.90 106.51),106.51) = .06 = 6% which is the same as the return on the one-year zero. d. If there is a liquidity premium, then E(r2) < f2 E(Price) =  EQ \F(112,1 + E(r2) ) > 100.90 E(HPR) > 6% 23. a. Maturity (years) Price Forward rate 1 925.93 2 853.39 .085 3 782.92 .090 4 715.00 .095 5 650.00 .100 b. For each 3-year zero that you issue today, you can use the proceeds to buy 782.92/715 = 1.095 four-year zeros. Your cash flows are thus as follows: Time Cash flow 0 0 3 (1,000 [The 3-year zero that you issue matures and you pay out face value of $1000.] 4 +1,095 [The 4-year zeros that you bought mature and you collect face value on each one.] This is a synthetic one-year loan originating at time 3, with a rate of .095 = 9.5%, precisely the forward rate for year 3. c. For each 4-year zero that you issue today, you can use the proceeds to buy 715/650 = 1.10 five-year zeros. 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For each three-year zero that you buy today, you need to issue 782.92/650 = 1.2045 five-year zeros to make your time-0 cash flow equal to zero. b. Your cash flows are thus as follows: Time Cash flow 0 0 3 1,000 [The 3-year zero that you issue matures and you pay out face value of $1000.] 5 +1,204.50 [The 5-year zeros that you bought mature and you pay out face value on each one.] This is a synthetic two-year loan originating at time 3. c. The two-year rate on the forward loan is 1,204.50/1,000 ( 1 = .2045 = 20.45% d. The one-year forward rates for years 4 and 5 are 9.5% and 10%, respectively. Notice that 1.095 ( 1.10 = 1.2045, which equals (1 + the two-year forward rate) on the 3-year ahead forward loan. The 5-year YTM is 9.0%. The 3-year YTM is 8.5%. Therefore, another way to derive the 2-year forward rate for a loan starting at time 3 is: 1 + f3(2) =  EQ \F((1 + y5)5,(1 + y3)3) =  EQ \F((1.09)5,(1.085)3) = 1.2045 25. We wish to know what interest rate can be engineered on a loan that initiates in three years with a term of two years. Three-year zero coupon bonds with par value of $1000 sell today for 1000/(1.0619)3 = $835.12. Five-year zeros sell for 1000/(1.0651)5 = $729.54. For each 3-year zero that you sell, you can use the proceeds to buy 835.12/729.54 = 1.14472 5-year zeros. Your cash flows are thus as follows: Time Cash flow 0 0 3 1,000 [The 3-year zero that you issue matures and you pay face value of $1000.] 5 +1,144.72 [The 5-year zeros that you bought mature and you collect face value on each one.] This is a synthetic 2-year loan originating at time 3, with a two-year rate of .14472 = 14.472%. An alternative approach would derive the 2-year forward rate as of year 3 as: 1 + f3(2) =  EQ \F((1 + y5)5,(1 + y3)3) =  EQ \F((1.0651)5,(1.0619)3) = 1.14472 26. a. i. The two-year implied annually compounded forward rate for a deferred loan beginning in 3 years is calculated as follows:  EMBED Equation.3  ii. The expectations theory holds that the shape of the yield curve results from the interest rate expectations of the market. The theory holds that any long-term interest rate simply represents the geometric mean of the current and future one-year interest rates expected to prevail over the maturity of the issue. The equilibrium long-term rate is the rate the long-term bond investor would expect to earn through successive investments in short-term bonds over the term to maturity of the long-term bonds. This implies that forward rates are equivalent to expected future interest rates. Thus, given an expected 3-year rate of 11 % and an expected 5-year rate of 9%, the expected 2-year (implied forward) rate three years from now is 6.07%. b. 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