Investors will demand a premium for the risk associated with long-term bonds.
The yield curve has an upward bias built into the long-term rates because of the risk premium.
15-12
Expectations Theory
Observed long-term rate is a function of today’s short-term rate and expected future short-term rates. Long-term and short-term securities are perfect substitutes. Forward rates that are calculated from the yield on long-term securities are market consensus expected future short-term rates.
9.660 9.993
* $1,000 Par value zero
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Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
15-7
Forward Rates from Observed Long-Term Rates
- Upward bias over expectations
Market Segmentation
- Preferred Habitat
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15-3
Yield Curves
Yields Upward Sloping Flat
Downward Sloping
Maturity
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
The relationship between yield to maturity and maturity.
Information on expected future short term rates can be implied from yield curve. The yield curve is a graph that displays the relationship between yield and maturity.
(1 yn ) (1 f n ) (1 yn 1 ) n 1
n
fn = one-year forward rate for period n yn = yield for a security with a maturity of n
(1 yn ) (1 yn1 ) (1 f n )
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15-1
Chapter 15
The Term Structure of Interest Rates
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15-2
Overview of Term Structure of Interest Rates
=
=
0.063336
0.063008
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15-11
Theories of Term Structure
Expectations
Liquidity Preference
McGraw-Hill/Irwin
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15-13
Liquidity Premium Theory
Long-term bonds are more risky.
PVn = Present Value of $1 in n periods r1 = One-year rate for period 1
r2 = One-year rate for period 2
rn = One-year rate for period n
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McGraw-Hill/Irwin
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15-10
Forward Rates for Downward Sloping Yield Curve
1yr Forward Rates
15-14
Liquidity Premiums and Yield Curves
Yields
Observed Yield Curve
Forward Rates
Liquidity Premium Maturity
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
15-17
Using Spot Rates to Price Coupon Bonds
A coupon bond can be viewed as a series of zero coupon bonds. To find the value each payment is discount at the zero coupon rate. Once the bond value is found, one can solve for the yield. It’s the reason that similar maturity and default risk bonds sell at different yields to maturity.
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15-9
Downward Sloping Spot Yield Curve
Zero-Coupon Rates Bond Maturity 12% 1 11.75% 2 11.25% 3 10.00% 4 9.25% 5
Forward rates contain a liquidity premium and are not equal to expected future short-term rates.
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Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
15-5
Pricing of Bonds using Expected Rates
1 PVn (1 r1 ) (1 r2 )...(1 rn )
15-15
Liquidity Premiums and Yield Curves
Yields
Observed Yield Curve
Forward Rates Liquidity Premium
Maturity
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Three major theories are proposed to explain the observed yield curve.
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3yr = 9.660
fn = ?
(1.0993)4 = (1.0966)3 (1+fn) (1.46373) / (1.31870) = (1+fn) fn = .10998 or 11% Note: this is expected rate that was used in the prior example.