Description
The PPT explaining about concept of Interest rates, Concept of YTM, The Credit Spread , Types of Yield Curve, Yield Curve Shifts, Pure Expectations Theory, Liquidity Premium Theory, Segmented Markets Theory, Preferred Habitat Theory
TERM STRUCTURE OF INTEREST RATES
Concept of Interest rates
• Interest rate is the semi annually effective rate payment on borrowed money.
• Importance Of Interest Rates
– The modern fixed income market includes not only bonds but all kinds of derivative securities sensitive to interest rates. – Interest rates are important in pricing all other market securities since they are used in time discounting. – Lastly, on corporate level since most investment decisions are based on some expectations regarding alternative opportunities and the cost of capital— both depend on the interest rates.
Concept of YTM
• The rate of return anticipated on a bond if it is held until the maturity date. YTM is considered a long-term bond yield expressed as an annual rate.
• The calculation of YTM takes into account the current market price, par value, coupon interest rate and time to maturity.
? If a bond's coupon rate is less than its YTM, then the bond is selling at a discount. ? If a bond's coupon rate is more than its YTM, then the bond is selling at a premium. ? If a bond's coupon rate is equal to its YTM, then the bond is selling at par.
• It is also assumed that all coupons are reinvested at the same rate.
Term Structure of Interest Rates
• Constructed by graphing the yield to maturities and the respective maturity dates of benchmark fixedincome securities. • The term structure of interest rates, also known as the yield curve, is a very common bond valuation method. • Yield curves plot the interest rates of same bond with the same characteristics (except maturity) against their corresponding different maturity terms.
How to Construct the Term Structure of Interest Rates?
• The yield on Treasury securities is a benchmark for determining the yield curve on non-Treasury securities.
• Therefore, to construct term structure of interest rates, we need the yield on zero-coupon Treasury securities for different maturities.
• The yield curve, in conjunction with the credit spread, is used for pricing corporate bonds.
The Credit Spread
• The credit spread, or quality spread, is the additional yield an investor receives for acquiring a corporate bond instead of a similar federal instrument. • The spread is demonstrated as the yield curve of the corporate bond and is plotted with the term structure of interest rates. • When inflation rates are increasing (or the economy is contracting) the credit spread between corporate and Treasury securities widens. • When interest rates are declining (or the economy is expanding), the credit spread between Federal and corporate fixed-income securities generally narrows.
Types of Yield Curve
3 main patterns created by Term Structure of Interest rates:
? Normal Yield Curve ? Flat Yield Curve ? Inverted Yield Curve
Yields Upward Sloping
Flat Downward Sloping Maturity
Normal Yield Curve
• As its name indicates, this is the yield curve shape that forms during normal market conditions, wherein investors generally believe that there will be no significant changes in the economy, such as in inflation rates, and that the economy will continue to grow at a normal rate. • The market expects long-term fixed income securities to offer higher yields than short-term fixed income securities. • To invest in one instrument for a longer period of time, an investor needs to be compensated for undertaking the additional risk.
Flat Yield Curve
• A flat yield curve usually occurs when the market is making a transition that emits different but simultaneous indications of what interest rates will do. • In other words, there may be some signals that short-term interest rates will rise and other signals that long-term interest rates will fall. • When the yield curve is flat, investors can maximize their risk/return trade-off by choosing fixed-income securities with the least risk, or highest credit quality.
Inverted Yield Curve
• These yield curves are rare, and they form during extraordinary market conditions wherein the expectations of investors are completely the inverse of those demonstrated by the normal yield curve.
• In such abnormal market environments, bonds with maturity dates further into the future are expected to offer lower yields than bonds with shorter maturities.
Yield Curve Shifts
• Change in the yield curve shapes lead to “yield curve risk”. • Parallel Shift: A shift in the yield curve in which yields change by the same number of basis points for every maturity. • Non-parallel shift: A shift in the yield curve in which yields do not change by the same number of basis points for every maturity.
Characteristics of Term Structure
• There are 3 characteristics of the term structure of interest rates:
? The change in yields of different term bonds tends to move in the same direction. ? The yields on short-term bonds are more volatile than long-term bonds. ? The yields on long-term bonds tend to be higher than short-term bonds.
• The expectations hypothesis has been advanced to explain the 1st and the 2nd characteristics and the premium liquidity theory have been advanced to explain the last characteristic.
Pure Expectations Theory
• Assumption: bonds of different maturities are perfect substitutes.
? Buyers of bonds do not prefer bonds of one maturity over another ? They will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity.
• Implication: The expected returns on bonds with different maturities are equal.
• Yield curve slope reflects market expectations of future interest rates.
• According to the expectations hypothesis
? if future interest rates are expected to rise ? if future interest rates are expected to decline
Upward sloping Yield Curve
Downward sloping Yield Curve
Expectations Theory: 2-Period Example
Strategy 1 : Buy $1 of 1-year bond and when it matures buy another 1-year bond.
Strategy 2 : Buy $1 of 2-year bond and hold it until maturity.
Expectations Theory: 2-Period Example
Expectations Theory: A Numerical Example
• Expected 1-year interest rates over the next 5 years: 5%, 6%, 7%, 8% and 9%.
? ? ? ? ? Interest rate on 1-year bond: 5%. Interest rate on 2-year bond: 5%+6% = 5.5% Interest rate on 3-year bond: 5%+6%+7% = 6% Interest rate on 4-year bond: 5%+6%+7%+8%= 6.5% Interest rate on 5-year bond: 5%+6%+7%+8%+9%= 7%
Liquidity Premium Theory
• Assumption: bonds of different maturities are substitutes, but are not perfect substitutes. • Implication: modifies Expectations Theory with features of Segmented Markets Theory.Investors prefer short-term, more liquid, securities.
• Long-term securities and associated risks are desirable only with increased yields.
? inflation risk ? interest rate risk.
• Explains upward-sloping yield curve.
Liquidity Premium Theory
Liquidity Premium Theory: A Numerical Example
Segmented Markets Theory
• Assumption: bonds of different maturities are not substitutes at all.
• Implication: markets are completely segmented; interest rate at each maturity is determined separately. • Investors have maturity preference boundaries, e.g., short-term vs. long-term maturities. • Explains why rates and prices vary significantly between certain maturities.
Preferred habitat theory
• The Preferred Habitat Theory states that in addition to interest rate expectations, investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their "preferred" maturity, or habitat.
• They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return.
• Proponents of this theory believe that short-term investors are more prevalent in the fixed-income market, and therefore longer-term rates tend to be higher than shortterm rates.
Relationship Between Theories
Uses of the term structure
• Forecast interest rates
? The market provides a consensus forecast of expected future interest rates ? Expectations theory dominates the shape of the yield curve
• Investment and financing decisions
? Lenders/borrowers attempt to time investment/financing based on expectations shown by the yield curve ? Riding the yield curve ? Timing of bond issuance
Uses of the term structure
• Forecast recessions
? Flat or inverted yield curves have been a good predictor of recessions.
Historic Review of the Term Structure
• Yield curves levels and shapes at various times indicate:
? Inflation expectations ? Level of economic activity or phase of business cycle ? Monetary policy at the time
• Usually high positive slope in short-term
? Represents demand for liquidity ? Short-term securities desired; higher prices; lower rates ? Short-term securities provide liquidity with maturity
International Structure of Interest Rates
• Yield differences between countries are related to:
? ? ? ? ? Expected changes in forex rates Varied expected real rates of return Varied expected inflation rates Varied country and business risk Varied central bank monetary policy
doc_804651683.ppt
The PPT explaining about concept of Interest rates, Concept of YTM, The Credit Spread , Types of Yield Curve, Yield Curve Shifts, Pure Expectations Theory, Liquidity Premium Theory, Segmented Markets Theory, Preferred Habitat Theory
TERM STRUCTURE OF INTEREST RATES
Concept of Interest rates
• Interest rate is the semi annually effective rate payment on borrowed money.
• Importance Of Interest Rates
– The modern fixed income market includes not only bonds but all kinds of derivative securities sensitive to interest rates. – Interest rates are important in pricing all other market securities since they are used in time discounting. – Lastly, on corporate level since most investment decisions are based on some expectations regarding alternative opportunities and the cost of capital— both depend on the interest rates.
Concept of YTM
• The rate of return anticipated on a bond if it is held until the maturity date. YTM is considered a long-term bond yield expressed as an annual rate.
• The calculation of YTM takes into account the current market price, par value, coupon interest rate and time to maturity.
? If a bond's coupon rate is less than its YTM, then the bond is selling at a discount. ? If a bond's coupon rate is more than its YTM, then the bond is selling at a premium. ? If a bond's coupon rate is equal to its YTM, then the bond is selling at par.
• It is also assumed that all coupons are reinvested at the same rate.
Term Structure of Interest Rates
• Constructed by graphing the yield to maturities and the respective maturity dates of benchmark fixedincome securities. • The term structure of interest rates, also known as the yield curve, is a very common bond valuation method. • Yield curves plot the interest rates of same bond with the same characteristics (except maturity) against their corresponding different maturity terms.
How to Construct the Term Structure of Interest Rates?
• The yield on Treasury securities is a benchmark for determining the yield curve on non-Treasury securities.
• Therefore, to construct term structure of interest rates, we need the yield on zero-coupon Treasury securities for different maturities.
• The yield curve, in conjunction with the credit spread, is used for pricing corporate bonds.
The Credit Spread
• The credit spread, or quality spread, is the additional yield an investor receives for acquiring a corporate bond instead of a similar federal instrument. • The spread is demonstrated as the yield curve of the corporate bond and is plotted with the term structure of interest rates. • When inflation rates are increasing (or the economy is contracting) the credit spread between corporate and Treasury securities widens. • When interest rates are declining (or the economy is expanding), the credit spread between Federal and corporate fixed-income securities generally narrows.
Types of Yield Curve
3 main patterns created by Term Structure of Interest rates:
? Normal Yield Curve ? Flat Yield Curve ? Inverted Yield Curve
Yields Upward Sloping
Flat Downward Sloping Maturity
Normal Yield Curve
• As its name indicates, this is the yield curve shape that forms during normal market conditions, wherein investors generally believe that there will be no significant changes in the economy, such as in inflation rates, and that the economy will continue to grow at a normal rate. • The market expects long-term fixed income securities to offer higher yields than short-term fixed income securities. • To invest in one instrument for a longer period of time, an investor needs to be compensated for undertaking the additional risk.
Flat Yield Curve
• A flat yield curve usually occurs when the market is making a transition that emits different but simultaneous indications of what interest rates will do. • In other words, there may be some signals that short-term interest rates will rise and other signals that long-term interest rates will fall. • When the yield curve is flat, investors can maximize their risk/return trade-off by choosing fixed-income securities with the least risk, or highest credit quality.
Inverted Yield Curve
• These yield curves are rare, and they form during extraordinary market conditions wherein the expectations of investors are completely the inverse of those demonstrated by the normal yield curve.
• In such abnormal market environments, bonds with maturity dates further into the future are expected to offer lower yields than bonds with shorter maturities.
Yield Curve Shifts
• Change in the yield curve shapes lead to “yield curve risk”. • Parallel Shift: A shift in the yield curve in which yields change by the same number of basis points for every maturity. • Non-parallel shift: A shift in the yield curve in which yields do not change by the same number of basis points for every maturity.
Characteristics of Term Structure
• There are 3 characteristics of the term structure of interest rates:
? The change in yields of different term bonds tends to move in the same direction. ? The yields on short-term bonds are more volatile than long-term bonds. ? The yields on long-term bonds tend to be higher than short-term bonds.
• The expectations hypothesis has been advanced to explain the 1st and the 2nd characteristics and the premium liquidity theory have been advanced to explain the last characteristic.
Pure Expectations Theory
• Assumption: bonds of different maturities are perfect substitutes.
? Buyers of bonds do not prefer bonds of one maturity over another ? They will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity.
• Implication: The expected returns on bonds with different maturities are equal.
• Yield curve slope reflects market expectations of future interest rates.
• According to the expectations hypothesis
? if future interest rates are expected to rise ? if future interest rates are expected to decline
Upward sloping Yield Curve
Downward sloping Yield Curve
Expectations Theory: 2-Period Example
Strategy 1 : Buy $1 of 1-year bond and when it matures buy another 1-year bond.
Strategy 2 : Buy $1 of 2-year bond and hold it until maturity.
Expectations Theory: 2-Period Example
Expectations Theory: A Numerical Example
• Expected 1-year interest rates over the next 5 years: 5%, 6%, 7%, 8% and 9%.
? ? ? ? ? Interest rate on 1-year bond: 5%. Interest rate on 2-year bond: 5%+6% = 5.5% Interest rate on 3-year bond: 5%+6%+7% = 6% Interest rate on 4-year bond: 5%+6%+7%+8%= 6.5% Interest rate on 5-year bond: 5%+6%+7%+8%+9%= 7%
Liquidity Premium Theory
• Assumption: bonds of different maturities are substitutes, but are not perfect substitutes. • Implication: modifies Expectations Theory with features of Segmented Markets Theory.Investors prefer short-term, more liquid, securities.
• Long-term securities and associated risks are desirable only with increased yields.
? inflation risk ? interest rate risk.
• Explains upward-sloping yield curve.
Liquidity Premium Theory
Liquidity Premium Theory: A Numerical Example
Segmented Markets Theory
• Assumption: bonds of different maturities are not substitutes at all.
• Implication: markets are completely segmented; interest rate at each maturity is determined separately. • Investors have maturity preference boundaries, e.g., short-term vs. long-term maturities. • Explains why rates and prices vary significantly between certain maturities.
Preferred habitat theory
• The Preferred Habitat Theory states that in addition to interest rate expectations, investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their "preferred" maturity, or habitat.
• They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return.
• Proponents of this theory believe that short-term investors are more prevalent in the fixed-income market, and therefore longer-term rates tend to be higher than shortterm rates.
Relationship Between Theories
Uses of the term structure
• Forecast interest rates
? The market provides a consensus forecast of expected future interest rates ? Expectations theory dominates the shape of the yield curve
• Investment and financing decisions
? Lenders/borrowers attempt to time investment/financing based on expectations shown by the yield curve ? Riding the yield curve ? Timing of bond issuance
Uses of the term structure
• Forecast recessions
? Flat or inverted yield curves have been a good predictor of recessions.
Historic Review of the Term Structure
• Yield curves levels and shapes at various times indicate:
? Inflation expectations ? Level of economic activity or phase of business cycle ? Monetary policy at the time
• Usually high positive slope in short-term
? Represents demand for liquidity ? Short-term securities desired; higher prices; lower rates ? Short-term securities provide liquidity with maturity
International Structure of Interest Rates
• Yield differences between countries are related to:
? ? ? ? ? Expected changes in forex rates Varied expected real rates of return Varied expected inflation rates Varied country and business risk Varied central bank monetary policy
doc_804651683.ppt