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Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1
The Term Structure of Interest Rates
Chapter 11
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall2
The Yield CurveRelationship between yield and
maturity for bonds of the same credit quality but different maturities
Yield curve shapesNormalInvertedFlatHumped
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Shape of the Yield Curve
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Using the Yield Curve to Price a Bond
Any financial asset can be viewed as a package of zero-coupon instrumentsMaturity of an instrument is the
coupon payment date or maturity dateValue of the asset equals the total
value of the component zero-coupon instruments
Spot RateRate on zero-coupon bond
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Theoretical Spot Rate CurveYield curve based on theoretical
spot rates (bootstrapping)Theoretical value of a bond is
equal to the present value of its periodic cash flows discounted at the corresponding theoretical spot rate for each period
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Bond Value
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Forward RatesMarket’s Consensus Prediction of
Future Interest RatesImplied forward rate is calculated from
either spot rates or yield curveThe yield curve can be used to
calculate the implied forward rate for any investment horizon
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Relationship Between Spot Rates and Short-Term Forward Rates
The relationship between the spot rate on an instrument maturing in six months (the current six-month spot rate), and the implied monthly forward rates for the next six months is:
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Forward Rate as a Hedgeable RateForward rates do not predict future
interest ratesForward rates indicate how an
investor’s expectations must differ from the market consensus in order to make the correct decision
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Historical Shapes of Yield CurvesPositively sloped yield curve
Normal yield curve Steep yield curve
Inverted yield curve Flat yield curve
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Historical Shapes of Yield Curves
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Determinants of the Shape of the Term Structure
Pure Expectations Theory
Liquidity Theory
Preferred Habitat Theory
Market Segmentation Theory
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Pure Expectations TheoryYields on different maturities are
based only on expectations of future short-term rates
Term structure might be normal, inverted, humped, or flat
Ignores price risk and reinvestment risk
Interpretations include broad, local and return-to-maturity
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Market Segmentation TheoryYields with different maturities are
based only on demand and supply at each maturity
Term structure might be normal, inverted, humped, or flat
Issuers and buyers of bonds have maturity preferences and will not shift to another maturity because each maturity is a separate market
Yields are completely unrelated to expectations of future rates
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Preferred Habitat TheoryYields with different maturities are
based only on demand and supply at each maturity
Term structure might be normal, inverted, humped, or flat
Issuers and buyers of bonds have maturity preferences but will shift to other maturities if the prices or yields are attractive enough
Yields are completely unrelated to expectations of future rates
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall16
Liquidity TheoryYields on different maturities are based
only on expected future rates plus a liquidity premium that increases with maturity
Term structure might be normal or flatPresupposes that all lenders want to
lend short-term and all borrowers want to borrow long-term
In reality, there are lenders for short and long-terms and borrowers for short and long-terms
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Main Influences on Shape of Yield Curve
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All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.
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