LOS 25.

a: Describe relationships among spot rates, forward rates, yield to maturity,

expected and realized returns on bonds, and the shape of the yield curve
SPOT RATE
The price of a risk-free single-unit payment (e.g., $1, €1, or £1) after N periods is called the discount factor with maturity
N, denoted by PVN. The yield-to-maturity of the payment is called a spot rate, denoted by ZN. (single CF)

e.g. If a 5 years ZCB is trading at 75 (FV-100), then YTM of this bond will be 5.92% Hence 5th year spot rate will be
5.92%.
The N-period discount factor, DFN, and the N-period spot rate, ZN, for a range of maturities in years N > 0 are called the
discount function and the spot yield curve (or, more simply, spot curve), respectively. This spot curve represents the
term structure of interest rates
The spot curve shows, for various maturities, the annualized return on an option-free and default-risk-free zero-coupon
bond (zero for short) with a single payment at maturity. For this reason, spot rates are also referred to as zero-coupon
yields(YTM) or zero rates. The spot rate as a yield concept avoids the need for a reinvestment rate assumption for
coupon-paying securities. The spot curve is a benchmark for the time value of money received on a future date as
determined by the market supply and demand for funds.

FORWARD RATE
A forward rate is an interest rate determined today for a loan that will be initiated in a future period. The set of
forward rates for loans of different maturities with the same future start date is called the forward curve. Forward
rates and forward curves can be mathematically derived from the current spot curve.

The forward pricing model describes the valuation of forward contracts. The no-arbitrage principle, which simply
states that tradable securities with identical cash flow payments must have the same price. can also be given by
equation DFj+k = DFj × FAjk where DF is a discount factor.
solve example 1 from 343
FORWARD RATE MODEL

• This equation suggests that the forward rate f(2,3) should make investors indifferent between buying a five-
year zero-coupon bond versus buying a two-year zero-coupon bond and at maturity reinvesting the principal
for three additional years. In this sense, the forward rate can be viewed as a type of breakeven interest rate.
• Three year rate that can be locked in today by buying an five-year zero-coupon bond rather than investing in
a two-year zero-coupon bond and, when it matures, reinvesting the proceeds in a zero-coupon instrument
that matures in three year

if f1,2 check whether the spot rate

3 is greater then spot rate 1
if greater then - f1,2 > spot rate 3

same goes to forward curve

solve example 2 , 3 & 4 from 346

EXPECTED AND REALIZED RETURNS ON BONDS

Expected return is the ex-ante holding period return that a bond investor expects to earn.
The expected return will be equal to the bond’s yield only when all three of the following are true:
 The bond is held to maturity.
 All payments (coupon and principal) are made on time and in full.
 All coupons are reinvested at the original YTM.
The second requirement implies that the bond is option-free and there is no default risk.
The last requirement, reinvesting coupons at the YTM, is the least realistic assumption. If
the yield curve is not flat, the coupon payments will not be reinvested at the YTM and the
expected return will differ from the yield.
Realized return on a bond refers to the actual return that the investor experiences over the
investment’s holding period. Realized return is based on actual reinvestment rates.The YTM
is generally a realistic estimate of expected return only if the yield curve is flat

YIELD TO MATURITY
As we’ve discussed, the yield to maturity (YTM) or yield of a zero-coupon bond with
maturity T is the spot interest rate for a maturity of T. However, for a coupon bond, if the
SOLVE EX 5
spot rate curve is not flat, the YTM will not be the same as the spot rate
from pg.352
A par rate is the yield to maturity of a bond trading at par. Par rates for bonds with
different maturities make up the par rate curve or simply the par curve. By definition, the
par rate will be equal to the coupon rate on the bond. Generally, par curve refers to the par
rates for government or benchmark bonds.
By using a process called bootstrapping, spot rates or zero-coupon rates can be derived
from the par curve. Bootstrapping involves using the output of one step as an input to the
next step. We first recognize that (for annual-pay bonds) the one-year spot rate (S1) is the
same as the one-year par rate. We can then compute S2 using S1 as one of the inputs.
Continuing the process, we can compute the three-year spot rate S3 using S1 and S2
computed earlier. Let’s clarify this with an example
For an upward-sloping spot curve, the forward rate rises as j increases. (For a downwardsloping yield curve, the
forward rate declines as j increases.) For an upward-sloping spot curve, the forward curve will be above the spot
curve. Conversely, when the spot curve is downward sloping, the forward curve will be below it.
 Consider three zero-coupon bonds:
Maturity (71 1 2 3
Bond A matures in 1 year
Bond B matures in 2 years Spot rates z1 = 9% z2= 10% z3 = 11%
Bond C matures in 3 years. Forward rates / ,1 = 11.01%
1 / ,1 = 13.03%
2

But if the s-pot curve one year f rom today differs from today's forward curve, the returns- on each bond for the o n e -
year
ho lding period will not all be 9%. To show that the returns- on the two-yea r and three-year bonds over the one-yea r
holding period are not 9%, we assume that the spot rate curve at Year 1 is- flat with yields- of 10% for all maturities.

The return on a o ne-ye a r zero-coupon bond over the one-year holding period is

(100 �
100
1 + 0.09
) - 1 = 9%

The return on a bvo-yearzero-coupon bond over the one-year holding period is

= lO%
100 100
( ) l
1+ 0.10 : ( 1+ 0.1 0)2 -

The return on a three-yea r zero-coupon bond over the one-year holding period is

100 100
(
(1 + 0.10)2 : ( 1 + 0.11)
3) - l = 13·0 3%

The bond returns- are 9%, 10%, and 13.03%. The returns- on the two-year and three-,oear bonds differ from the one-year
risk,free interest rate of 9%.

Assumptions
Yield curve is upward sloping
Yield curve does not change over the investment horizon
 In a plain vanilla interest rate swap, one party makes payments based on a fixed
rate while the counterparty makes payments based on a floating rate. The fixed
and floating payments are determined by multiplying the respective rate by a
principal (or notional) amount for each interest period over the swap maturity.
The fixed rate in an interest rate swap is called the swap fixed rate or swap rate.
 The swap rate is analogous to the YTM on government bond,The key difference
between the swap rate and the government bond rate is that the swap rate is
derived using short-term lending rates rather than default-risk-free rates.

 If we consider how swap rates vary for various maturities, we get the swap rate
curve. Because it is based on so-called par swaps, in which the fixed rate is set so
that no money is exchanged at contract initiation—the present values of the fixed-
rate and benchmark floating-rate legs being equal— the swap curve is a type of
par curve. When we refer to the “par curve” here,however, the reference is to the
government par yield curve.

 The swap market is a highly liquid market for two reasons.

First, unlike bonds, a swap does not have multiple borrowers or lenders, only
counterparties who exchange cash flows. Such arrangements offer significant
flexibility and customization in the swap contract’s design.

 Second, swaps provide one of the most efficient ways to hedge interest rate risk.

 In countries where the private sector is much bigger than the public sector, the
swap curve is a far more relevant measure of the time value of money than is the
government’s cost of borrowing
 LOS 25.f: Calculate and interpret the swap spread for a given maturity.

Swap spreads are almost always positive, reflecting the lower credit risk of governments
compared to the credit risk of surveyed banks that determines the swap rate.

While a bond’s yield reflects time value as well as compensation for credit and liquidity
risk, I-spread only reflects compensation for credit and liquidity risks. The higher the Ispread, the
higher the compensation for liquidity and credit risk.

SOLVE EX FROM KAPLAN pg.24

 SOLVE EX FROM KAPLAN pg. 25

An OIS is an interest rate swap in which the periodic floating rate of the swap
equals the geometric average of a daily unsecured overnight rate (or overnight index
rate). The index rate is typically the rate for overnight unsecured lending between banks,
such as the federal funds rate
 Theories of the term structure of interest rates

• Liquidity preference theory asserts that liquidity premiums exist to compensate investors for the added interest
rate risk they face when lending long term and that these premiums increase with maturity. Thus, given an
expectation of unchanging short-term spot rates, liquidity preference theory predicts an upward-sloping yield
curve.

• The forward rate provides an estimate of the expected spot rate that is biased upward by the amount of the
liquidity premium

• Therefore, a positive-sloping yield curve may indicate that either: (1) the market expects future interest rates to
rise or (2) rates are expected to remain constant (or even fall), but the addition of the liquidity premium results
in a positive slope. A downward-sloping yield curve indicates steeply falling short-term rates according to the
liquidity preference theory
• The size of the liquidity premiums need not be constant over time. They may be larger during periods of
greater economic uncertainty when risk aversion among investors is higher, the existence of liquidity
premiums implies that the yield curve will typically be upward sloping.
• Under the segmented markets theory, yields are not • The preferred habitat theory is similar to the
determined by liquidity premiums and expected spot rates. segmented markets theory in proposing that
Rather, the shape of the yield curve is determined by the many borrowers and lenders have strong
preferences of borrowers and lenders, which drives the preferences for particular maturities, but it
balance between supply of and demand for loans of does not assert that yields at different
different maturities. This is called the segmented markets maturities are determined independently of
theory because the theory suggests that the yield at each each other.
maturity is determined independently of the yields at other
maturities; we can think of each maturity to be essentially • The theory contends, however, that if the
unrelated to other maturities expected additional returns to be gained
become large enough, institutions will be
• The theory is consistent with a world in which asset/ willing to deviate from their preferred
liability management constraints exist, either regulatory maturities or habitats
or self-imposed.
• The preferred habitat theory is based on
• The segmented markets theory supposes that various the realistic notion that agents and
market participants only deal in securities of a particular institutions will accept additional risk in
maturity because they are prevented from operating at return for additional expected returns
different maturities. For example, pension plans and
insurance companies primarily purchase longmaturity
bonds for asset-liability matching reasons and are unlikely
to participate in the market for short-term funds

start it with ift video second last video

Curve movements are well desc ribed by a combination of three independent movements:
• Level = The level movement refers to an upward or downward shift in the yield curve.
• Steepness = The steepness movement refers to a non-parallel shift in the yield curve when either short-term rates change more
than long-term rates or long-term rates change more than short-term rates
• Curvature v1e10 (\11,J
The curvature movement is
a reference to movement in
three segments of the yield
curve: The short-term and
long-term segments rise while
the middle-term segment falls,
or vice versa. Level
1
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lt!rm

SOLVE EX 10
from pg 379
KeyDurL = KeyDur1 + KeyDur5 + KeyDur10
KeyDurS = – KeyDur1 + KeyDur10
KeyDurC = KeyDur1 + KeyDur10