eLearning Course 3: Fixed-Income Analysis
Lesson 1: Bond Prices and Yields (Ch. 14)
Session 1.1: Bond characteristics (14.1)
Session 1.2: Bond pricing (14.2)
Session 1.3: Bond yields (14.3)
Lesson 2: The Term Structure of Interest Rates (Ch. 15)
Session 2.1: The yield curve (15.1)
Session 2.2: Future & forward rates (15.2/15.3)
Session 2.3: Theories of the term structure (15.4)
Lesson 3: Managing Bond Portfolio (Ch. 16)
Session 3.1: Interest rate risk (16.1)
Session 3.2: Convexity (16.2)
Session 3.3: Passive bond management (16.3)
Source: Bodie, Kane, Marcus (BKM), Chapter 14 to 16
Learning Goal
- Undertand the relationship between time to maturity and yield to maturity,
commonly known as the yield curve, and it’s economic implications.
The yield curve
• The relationship between yield and
maturity is summarized in the yield curve,
which is a plot of yield to maturity as a
function of time to maturity.
The yield curve
• The relationship between yield and
maturity is summarized in the yield curve,
which is a plot of yield to maturity as a
function of time to maturity.
• The yield curve is central to bond valuation
and, as well, allows investors to gauge their
expectations for future short-term
interest rates against those of the market.
The yield curve
• The relationship between yield and
maturity is summarized in the yield curve,
which is a plot of yield to maturity as a
function of time to maturity.
• The yield curve is central to bond valuation
and, as well, allows investors to gauge their
expectations for future short-term
interest rates against those of the market.
• A rising yield curve implies long-term
bonds offering yields higher than those
of short-term bonds.
Why care about bond yields?
1. Interest rates and forecasts of interest rates provide basis for investment decisions of firms, saving decisions of
households, and policy decisions.
Why care about bond yields?
1. Interest rates and forecasts of interest rates provide basis for investment decisions of firms, saving decisions of
households, and policy decisions.
2. Monetary policy. Central banks move short rates (policy rate) in response to changes in the economy.
Why care about bond yields?
1. Interest rates and forecasts of interest rates provide basis for investment decisions of firms, saving decisions of
households, and policy decisions.
2. Monetary policy. Central banks move short rates (policy rate) in response to changes in the economy.
3. Close link between interest rates and the state of the economy.
Source: FRED St. Louis FED Interest rates climbed sharply after the Fed Flight to quality in the 2007/2008 financial
instituted a policy of tight money to rein crisis. 10 year US government bonds offer a
inflation. They peaked at 15.8% in the early interest rate of about 2.4% annually while
1980’s. short term rates dropped virtually to zero.
End of Session 2.1
§ After having carefully studied session 2.1, please start with the Review
Questions.
eLearning Course 3: Fixed-Income Analysis
Lesson 1: Bond Prices and Yields (Ch. 14)
Session 1.1: Bond characteristics (14.1)
Session 1.2: Bond pricing (14.2)
Session 1.3: Bond yields (14.3)
Lesson 2: The Term Structure of Interest Rates (Ch. 15)
Session 2.1: The yield curve (15.1)
Session 2.2: Future & forward rates (15.2/15.3)
Session 2.3: Theories of the term structure (15.4)
Lesson 3: Managing Bond Portfolio (Ch. 16)
Session 3.1: Interest rate risk (16.1)
Session 3.2: Convexity (16.2)
Session 3.3: Passive bond management (16.3)
Source: Bodie, Kane, Marcus (BKM), Chapter 14 to 16
Learning Goal
- The learning goal of this session is to understand what’s the information
content of the term structure for future interest rates.
Yields to maturities on zero-coupon bonds and bond valuation
1000
Pt n =
(1 + y )
n n
t
n=years to maturity
Yields to maturities on zero-coupon bonds and bond valuation
1000
Pt n =
(1 + y )n n
t
n=years to maturity
• Valuing a 3 year, 10% coupon bond with a face value of $1’000 (annual coupon payments) using yields to maturity
from the above table (pure yield curve) implies:
100 100 1'100
PB = + 2
+ 3
= 1'082.17
1.05 1.06 1.07
Yields to maturities on zero-coupon bonds and bond valuation
1000
Pt n =
(1 + y )n n
t
n=years to maturity
• Valuing a 3 year, 10% coupon bond with a face value of $1’000 (annual coupon payments) using yields to maturity
from the above table (pure yield curve) implies:
100 100 1'100
PB = + 2
+ 3
= 1'082.17
1.05 1.06 1.07
• It follows that the yield to maturity of this bond is
100 100 1'100
1'082.17 = + + Þ y = 0.0688 = 6.88%
( ) (1 + y ) (1 + y )
1 + y 2 3
• We can think of the coupon bond as a portfolio composed of three «zero coupon bonds» and the YTM on
the coupon bond is a weighted average of the YTMs on the 3 «zero bonds».
The yield curve and future interest rates (1)
• For simplicity assume first that there is no uncertainty in the economy meaning that with no
risk all bonds must offer identical returns or invetors will bid up the price of the high-return
bond until its rate of return is no longer superior to that of other bonds.
• An upward sloping yield curve is evidence that short-term rates are going to be higher next year
than they are now. The interest rate that 1-year bonds will offer next year is denoted as r2.
The yield curve and future interest rates (1)
• For simplicity assume first that there is no uncertainty in the economy meaning that with no
risk all bonds must offer identical returns or invetors will bid up the price of the high-return
bond until its rate of return is no longer superior to that of other bonds.
• An upward sloping yield curve is evidence that short-term rates are going to be higher next year
than they are now. The interest rate that 1-year bonds will offer next year is denoted as r2.
0 1 2
Time line
Alternative 1: Buy and hold
2-year zero.
2-year investment
890 890 ´1.062 = 1'000
The yield curve and future interest rates (1)
• For simplicity assume first that there is no uncertainty in the economy meaning that with no
risk all bonds must offer identical returns or invetors will bid up the price of the high-return
bond until its rate of return is no longer superior to that of other bonds.
• An upward sloping yield curve is evidence that short-term rates are going to be higher next year
than they are now. The interest rate that 1-year bonds will offer next year is denoted as r2.
0 1 2
Time line
Alternative 1: Buy and hold
2-year zero.
2-year investment
890 890 ´1.062 = 1'000
Alternative 2: Buy a 1-year zero,
and reinvest proceeds in another
1-year investment 1-year investment 1-year zero.
890 890 ´ (1.05 ) = 934.5 934.5 ´ (1 + r2 )
The yield curve and future interest rates (2)
• Both strategies must provide equal returns since neither entails any risk. Therefore, the
proceeds after 2 years to either strategy must be equal:
890 ´1.062 = 890 ´1.05 ´ (1 + r2 ) No arbitrage condition under
complete certainty
2-year investment
Þ (1 + y2 ) = (1 + r1 ) ´ (1 + r2 )
2
890 ´1.062 = 1'000
1
1-year investment 1-year investment Þ 1 + y2 = éë(1 + r1 ) ´ (1 + r2 ) ùû 2
890 890 ´ (1.05 ) = 934.5 934.5 ´ (1 + r2 )
The yield curve and future interest rates (2)
• Both strategies must provide equal returns since neither entails any risk. Therefore, the
proceeds after 2 years to either strategy must be equal:
890 ´1.062 = 890 ´1.05 ´ (1 + r2 ) No arbitrage condition under
complete certainty
2-year investment
Þ (1 + y2 ) = (1 + r1 ) ´ (1 + r2 )
2
890 ´1.062 = 1'000
1
1-year investment 1-year investment Þ 1 + y2 = éë(1 + r1 ) ´ (1 + r2 ) ùû 2
890 890 ´ (1.05 ) = 934.5 934.5 ´ (1 + r2 )
• Solving for r2 yields next year’s interest rate:
890 ´1.062 1.062
r2 = -1 = - 1 = 7.01%
890 ´1.05 1.05
Spot rates versus short rates and the slope of the yield curve
• To distinguish between yields on long-term bonds versus short-term rates that will be available in
the future, practitioners use the following terminology:
Spot rate:
The rate that prevails today for a time period corresponding to the zero’s maturity.
Short rate:
The rate for a given time interval (e.g. 1 year) refers to the interest rate for that interval available
at different points in time.
Spot rates versus short rates and the slope of the yield curve
• To distinguish between yields on long-term bonds versus short-term rates that will be available in
the future, practitioners use the following terminology:
Spot rate:
The rate that prevails today for a time period corresponding to the zero’s maturity.
Short rate:
The rate for a given time interval (e.g. 1 year) refers to the interest rate for that interval available
at different points in time.
• A spot rate is the geometric average of its component of short rates. For example the two year
spot rate is the geometric average of the short rate in year 1 and the short rate in year 2.
1
1 + y2 = éë(1 + r1 ) ´ (1 + r2 ) ùû 2
Spot rates versus short rates and the slope of the yield curve
• To distinguish between yields on long-term bonds versus short-term rates that will be available in
the future, practitioners use the following terminology:
Spot rate:
The rate that prevails today for a time period corresponding to the zero’s maturity.
Short rate:
The rate for a given time interval (e.g. 1 year) refers to the interest rate for that interval available
at different points in time.
• A spot rate is the geometric average of its component of short rates. For example the two year
spot rate is the geometric average of the short rate in year 1 and the short rate in year 2.
1
1 + y2 = éë(1 + r1 ) ´ (1 + r2 ) ùû 2
• When next year’s short rate, r2, is greater than this year’s short rate, r1, the geometric average of
the two rates is higher than today’s rate, so y2 > r1 and the yield curve slopes upward.
• When next year’s short rate, r2, is smaller than this year’s short rate, r1, the geometric average of
the two rates is lower than today’s rate, so y2 < r1 and the yield curve slopes down.
The yield curve and forward rates
• We can generalize the approach of inferring a future
short rate from the yield curve of zero-coupon
bonds.
(1 + yn ) = (1 + yn -1 ) ´ (1 + rn )
n n -1
(1 + yn )
n
Þ (1 + rn ) =
(1 + yn-1 )
n -1
(1.07 ) Þ r = (1.07 ) - 1 = 9.025%
3 3
( n)
1 + r =
(1.06 ) (1.06 )
2 n 2
The yield curve and forward rates
• We can generalize the approach of inferring a future
short rate from the yield curve of zero-coupon
bonds.
(1 + yn ) = (1 + yn -1 ) ´ (1 + rn )
n n -1
(1 + yn )
n
Þ (1 + rn ) =
(1 + yn-1 )
n -1
(1.07 ) Þ r = (1.07 ) - 1 = 9.025%
3 3
( n)
1 + r =
(1.06 ) (1.06 )
2 n 2
• Since interest rates are uncertain we call the inferred interest rate the forward interest rate fn rather than the
future short rate since we don’t know if this will be the interest rate that actually will prevail at the future date. The
forward rate is a forecast of the future short rate.
(1 + yn )
n
(1 + f n ) =
(1 + yn-1 )
n -1
Þ (1 + yn ) = (1 + yn -1 ) (1 + f n )
n n -1
End of Session 2.2
§ After having carefully studied session 2.2, please start with the Review
Questions.
eLearning Course 3: Fixed-Income Analysis
Lesson 1: Bond Prices and Yields (Ch. 14)
Session 1.1: Bond characteristics (14.1)
Session 1.2: Bond pricing (14.2)
Session 1.3: Bond yields (14.3)
Lesson 2: The Term Structure of Interest Rates (Ch. 15)
Session 2.1: The yield curve (15.1)
Session 2.2: Future & forward rates (15.2/15.3)
Session 2.3: Theories of the term structure (15.4)
Lesson 3: Managing Bond Portfolio (Ch. 16)
Session 3.1: Interest rate risk (16.1)
Session 3.2: Convexity (16.2)
Session 3.3: Passive bond management (16.3)
Source: Bodie, Kane, Marcus (BKM), Chapter 14 to 16
Learning Goal
- The learning goal of this session is to get an understanding of theories used
to explain the term structure of interest rate.
Term structure of interest rates
• There are two main theories to explain the term structure of interest rates.
• Expectations hypothesis
• Liquidity preference theory
• Both theories argue that long term interest rates depend on:
• Short term interest rates
• Expected future short term interest rates
• The difference is that according to the expectations hypothesis investors are risk neutral whereas according to
the liquidity preference theory investors are risk averse and have short investment horizons.
Expectations hypothesis
• The simplest theory of the term structure of interest rates is the expectations hypothesis which
assumes that investors are risk neutral.
Expectations hypothesis
• The simplest theory of the term structure of interest rates is the expectations hypothesis which
assumes that investors are risk neutral.
• A common version of this hypothesis states that the forward rate equals the market consensus
expectation of the future short rate; that is, f2=E(r2), and liquidity premiums are zero.
Expectations hypothesis
• The simplest theory of the term structure of interest rates is the expectations hypothesis which
assumes that investors are risk neutral.
• A common version of this hypothesis states that the forward rate equals the market consensus
expectation of the future short rate; that is, f2=E(r2), and liquidity premiums are zero.
• The yield to maturity would thus be determined solely by current and expected future one-period
interest rates.
(1 + y2 ) = éë(1 + y1 ) ´ éë1 + E ( r2 ) ùû ùû
2
• An upward sloping yield curve would be
clear evidence that investors anticipate
increases in future short term interest
rates and vice versa.
• However, this also implies that bonds of
different maturities are perfect
substitutes.
Expectations hypothesis
• The simplest theory of the term structure of interest rates is the expectations hypothesis which
assumes that investors are risk neutral.
• A common version of this hypothesis states that the forward rate equals the market consensus
expectation of the future short rate; that is, f2=E(r2), and liquidity premiums are zero.
• The yield to maturity would thus be determined solely by current and expected future one-period
interest rates.
(1 + y2 ) = éë(1 + y1 ) ´ éë1 + E ( r2 ) ùû ùû
2
Expectations hypothesis
• The simplest theory of the term structure of interest rates is the expectations hypothesis which
assumes that investors are risk neutral.
• A common version of this hypothesis states that the forward rate equals the market consensus
expectation of the future short rate; that is, f2=E(r2), and liquidity premiums are zero.
• The yield to maturity would thus be determined solely by current and expected future one-period
interest rates.
(1 + y2 ) = éë(1 + y1 ) ´ éë1 + E ( r2 ) ùû ùû
2
• An upward sloping yield curve would be
clear evidence that investors anticipate
increases in future short term interest
rates and vice versa.
• However, this also implies that bonds of
different maturities are perfect
substitutes.
Liquidity preference theory (1)
• The liquidity preference theory is based on two key assumptions:
• Investors are risk averse
• Most investors have a short time horizon (exposure to price risk)
Liquidity preference theory (1)
• The liquidity preference theory is based on two key assumptions:
• Investors are risk averse
• Most investors have a short time horizon (exposure to price risk)
• These two assumptions imply that long-term bonds are considered riskier relative to short term
bonds and investors require a risk premium to be willing to invest in long-term bonds.
Liquidity preference theory (1)
• The liquidity preference theory is based on two key assumptions:
• Investors are risk averse
• Most investors have a short time horizon (exposure to price risk)
• These two assumptions imply that long-term bonds are considered riskier relative to short term
bonds and investors require a risk premium to be willing to invest in long-term bonds.
• This is consistent with the view that in a well functioning market higher risk implies a higher
expected return.
Liquidity preference theory (1)
• The liquidity preference theory is based on two key assumptions:
• Investors are risk averse
• Most investors have a short time horizon (exposure to price risk)
• These two assumptions imply that long-term bonds are considered riskier relative to short term
bonds and investors require a risk premium to be willing to invest in long-term bonds.
• This is consistent with the view that in a well functioning market higher risk implies a higher
expected return.
• In the context of the liquidity preference theory this means that the forward rate exceeds the
expected short rate, f2>E(r2).
• The excess of f2 over E(r2) is the liquidity premium and is predicted to be positive.
Liquidity preference theory (1)
• The liquidity preference theory is based on two key assumptions:
• Investors are risk averse
• Most investors have a short time horizon (exposure to price risk)
• These two assumptions imply that long-term bonds are considered riskier relative to short term
bonds and investors require a risk premium to be willing to invest in long-term bonds.
• This is consistent with the view that in a well functioning market higher risk implies a higher
expected return.
• In the context of the liquidity preference theory this means that the forward rate exceeds the
expected short rate, f2>E(r2).
• The excess of f2 over E(r2) is the liquidity premium and is predicted to be positive.
• The liquidity preference theory argues that forward rates are not a perfect measure for
expected future interest rates because they are the sum of the expectations of future
interest rates and the liquidity premium.
Liquidity preference theory (2)
• Recall due to risk aversion the liquidity preference theory implies a risk premium.
• In order to attract short term investors the expected holding period return of a two year bond must exced the
holding period return of a one year bond.
Liquidity preference theory (2)
• Recall due to risk aversion the liquidity preference theory implies a risk premium.
• In order to attract short term investors the expected holding period return of a two year bond must exced the
holding period return of a one year bond.
P1
HPR = -1
P2
Liquidity preference theory (2)
• Recall due to risk aversion the liquidity preference theory implies a risk premium.
• In order to attract short term investors the expected holding period return of a two year bond must exced the
holding period return of a one year bond.
1000
P 1 + E ( r2 )
HPR = 1 - 1 = -1
P2 1000
(1 + y2 )
2
Liquidity preference theory (2)
• Recall due to risk aversion the liquidity preference theory implies a risk premium.
• In order to attract short term investors the expected holding period return of a two year bond must exced the
holding period return of a one year bond.
1000
Holding period return
1 + E ( r2 ) (1 + y2 )
2
P1 1 year bond (YTM)
-1 = -1 = - 1 > y1
P2 1000 1 + E ( r2 )
(1 + y2 )
2 Holding period return
of a 2 year bond
Liquidity preference theory (2)
• Recall due to risk aversion the liquidity preference theory implies a risk premium.
• In order to attract short term investors the expected holding period return of a two year bond must exced the
holding period return of a one year bond.
1000
Holding period return
1 + E ( r2 ) (1 + y2 )
2
P1 1 year bond (YTM)
-1 = -1 = - 1 > y1
P2 1000 1 + E ( r2 )
(1 + y2 )
2 Holding period return
of a 2 year bond
• Rewriting implies
Þ (1 + y2 ) > (1 + y1 ) éë1 + E ( r2 ) ùû
2
(1 + y2 )
2
Þ - 1 > E ( r2 )
(1 + y1 )
Liquidity preference theory (2)
• Recall due to risk aversion the liquidity preference theory implies a risk premium.
• In order to attract short term investors the expected holding period return of a two year bond must exced the
holding period return of a one year bond.
1000
Holding period return
1 + E ( r2 ) (1 + y2 )
2
P1 1 year bond (YTM)
-1 = -1 = - 1 > y1
P2 1000 1 + E ( r2 )
(1 + y2 )
2 Holding period return
of a 2 year bond
• Rewriting implies
Þ (1 + y2 ) > (1 + y1 ) éë1 + E ( r2 ) ùû
2
(1 + y2 ) - 1 > E r
2
Þ ( 2)
(1 + y1 )
Þ f 2 > E ( r2 ) Þ f 2 = E ( r2 ) + liquidity premium
and proves the implication of the liquidity preference theory that the forward rate exceeds the expected short rate.
Yield Curve examples
Yield Curve examples
End of Session 2.3
§ After having carefully studied session 2.3, please start with the Review
Questions.