The Term Structure of Interest Rates

[Pages:25]The Term Structure of Interest Rates

What is it?

The relationship among interest rates over different timehorizons, as viewed from today, t = 0.

A concept closely related to this:

The Yield Curve

? Plots the effective annual yield against the number of periods an investment is held (from time t=0).

? Empirical evidence suggests the effective annual yield is increasing in n, i.e. the number of periods remaining until maturity.

y t( n )

>

y (n-1) t

> ... >

y t( 2 )

>

yt(1) ,

where yt(n) refers to the yield at time t over n periods.

We will concern ourselves with possible reasons for this:

? Begin by building simple model that captures essentials. The introduce complexities.

? Assume the future is known with certainty. Then introduce uncertainty

We should note that time is an essential element in our analysis. A period is a portion of time that defined over its beginning and end point.

Spot versus Short Rates Spot rate:

? That rate of effective annual growth that equates the present with the future value.

? Thus, the spot rate is the cost of money over some time-horizon from a certain point in time.

? This is identical with the yield to maturity, or internal rate of return, on a zero coupon bond.

? Denote the yield of a bond at time t with n periods to maturity by yt(n).

Short rate: ? Refers to the interest rate that prevails over a specific time period. ? Only known with certainty ex-post. ? The short rate refers to the (annualised) cost of money between any two dates, thus it may provide us with the correct rate of discount to apply over a

certain time period, e.g. the rate that prevailed between year one and year two.

? Denote the short rate applicable between time t = 1 & t = 2 as r1.

? We (typically) use a combination (i.e. the product) of short rates to discount over a series of timeperiods.

Expectations

If we knew with certainty the short interest rates that will hold over the future periods, we could calculate the effective annual yield that applies for a specific timehorizon.

In reality the future sequence of interest rates is unknown.

Similarly, if we know the spot-rates (the yield to maturity of a zero coupon bond) at which money is lent/borrowed over the various time-periods from now (3 month money, six month money, etc.), we have an idea about what the best guess is, as to the likely development of interest rates over the coming periods. [However, these expectations could change dramatically in the next instant.]

Another distinction we must draw is between interest rates, short or spot, and the yield of an investment.

By taking the interest rates that prevailed over any one period, and forming an average of these (weighted by the amount of time they prevailed for over a given period), we can obtain the effective annual interest rate that prevailed over a specific period, or, equivalently, the yield that accrued to our investment.

We can plot these over time to obtain a yield curve. (Strictly speaking the yield is simply the effective annual rate of growth our investment would have to grow by in each period in order for it to grow from the price paid to the value at maturity).

The yields over n-periods are given by the geometric average of the short rates that prevailed in each period, i.e. it is the single effective annual yield that would have given our investment the same future value as we

obtained from the series of short rates that actually prevailed.

Certainty

If we assume we know the future short rates with certainty, we can calculate the yield of investments locked in at these rates.

E.g. assume r1 = 8%, r2 = 10%, r3 = 10%, r4 = 11%, where r1 is the interest rate that applied in the first year. (N.B.: The short rates in consecutive periods are rising!)

Then the yield on a 3-year investment should be:

(1 + y(3))3 = (1 + r1) (1 + r2) (1 + r3) or

y(3) = [(1 + r1) (1 + r2) (1 + r3)]1/3-1.

In this case of certainty, we will note how the yield actually increases with the length of time an investment is locked in for. This, however, is only because the short rates are rising over time. You can calculate y(i), with i = 1, 2, 3, 4, yourself.

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