Fixed Income Securities

Spot Rates and Forward Rates

Estimating the ZCYC: Functional form
• Nelson-Siegel (1987) form for the spot rate function

R(m) = 0 + (1+2)[1 - exp(-m/)]/(m/) - 2exp(- m/)

• o - Represent long run levels of interest rates

• 1 - Slope parameter (short term component)
• 2 - Curvature parameter (medium term component)
>0 means hump and <0 means a trough
• ’ - decay factor (small values produce slow decay)
– 2 and  control the location and height of the
hump in the yield curve
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Nelson-Siegel Parameters

Date 1 Date 2
beta 0 7.5660 7.7941
beta 1 -1.3694 -2.1969
beta 2 -2.3341 -0.0175
tau 2.8686 8.1058

• R(m) = 0 + (1+2)[1 - exp(-m/)]/(m/) - 2exp(- m/)

• Spot rate on date 2 for 10yr ZCB

• r(10) = 7.7941+(-2.1969-0.0175)*(1-exp(-10/8.1058))/(10/8.1058)–
(-0.0175) *exp(-10/8.1058) = 6.5270%

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Estimating the ZCYC : Steps Involved
• Numerical optimization procedures to estimate 0, 1, 2
and  that minimize the sum of squared price errors,
• 0, 1, 2 and  are used to determine the spot rate
function and hence the ‘model’ prices of securities
• Filtering Data
– Outliers given least weight (dropped)
– Market lot trades considered
– NDS-OM trades given more weight as they go through price
discovery process
• Inclusion Criteria
– 3 trades
– Rs.25crores

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Estimating the ZCYC: Functional form
• Nelson-Siegel Svensson (1995) form for the spot rate
function
• Svensson added one additional curvature factor

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Theories Explaining The Term Structure
• The actual shape of the yield curve depends on:
– Economic conditions (e.g., economic growth or recession)
– Investors' and borrowers' expectations about future rates,
inflation
– Quality of bonds under consideration (e.g., AAA bond
versus B bond)
– The maturity preferences of investors and borrowers

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Theories Explaining The Term Structure
• There are three popular explanations of the term
structure of interest rates (i.e., why the yield curve is
shaped the way it is):
– The expectations hypothesis
– The liquidity preference hypothesis
– The market segmentation hypothesis (preferred habitats)
•

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The (Pure) Expectations Hypothesis
• PEH: Shape of the yield curve is explained by
expectations of interest rates
– Forward rates exclusively represent expected future rates
– If interest rates are expected to rise, the yield curve slopes
upward
– If interest rates are expected to fall, the yield curve slopes
downward
• PEH posits that the yield curve is governed by the
condition that the implied forward rate is equal to the
expected sport rate

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The Expectations Hypothesis…Cont’d
• Consider a market consisting of only two bonds: a risk-
free one-year zero-coupon bond and a risk-free two-year
zero-coupon bond, both with FV of $100

• Suppose that supply and demand conditions are such that

both the one-year and two-year bonds are trading at 8%
YTM

• Assume the market is risk-neutral

• Suppose that the market expects the yield curve to shift

up to 10% next year, but, as yet, has not factored that
expectation into its current investment decisions

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The Expectations Hypothesis…Cont’d
• What will be the impact of the expectation on the current yield
curve?
• Consider investors with investment horizon = 2 years
• Alternatives:
– Buy 2-year bond at 8% (Scenario – I)
– Buy a series of 1-year bonds: 1-year bond today at 8% and 1-year bond
one year later at E(r12) = 10%. The expected return from the series
would be 9%: (Scenario – II)

YTM 2:Series = (1.08)(1.10)

1/ 2
−1 = .09
In a risk-neutral world, investors with investment horizon 2 years would prefer
the series of 1-year bonds (Scenario -II) over the 2-year bond (Scenario -I)
Investors will buy or sell debt assets of different maturities until the expected
yields on all assets are equal over the planning period.

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The Liquidity Preference Hypothesis
– What if investors are averse to risk
– Which strategy would appear more risky?
• Invest in a one year bond
• Invest in a two year bond and sell it after one year
– Investors can choose second strategy only if the
returns are higher than in strategy 1
– If Forward price> spot rate expected over period 2
• Note: Implies an always upward sloping yield curve
• There is good evidence that such premiums exist

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The Market Segmentation Hypothesis (MSH)
• Market segmentation (preferred habitat) Hypothesis-
– Different groups of investors have different maturity needs
and they confine their selection of bands to certain
segments of yield curve. Thus, shape of yield curve is
dependent on relative supply/demand in each segment.
– MSH assumes that investors and borrowers are willing to
give up their desired maturity segment and assume market
risk if rates are attractive
S

D
S
Insurance
Companies
D
Banks

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The Market Segmentation Hypothesis
• Example: The yield curve for high quality corporate
bonds could be segmented into two markets:
• (1) Sort-Term Market
– The supply of short-term corporate bonds, such as
commercial paper would depend on business demand for
short-term assets such as inventories, accounts receivables
– The demand for short-term corporate bonds would
originate from investors looking to invest their excess cash
for short periods

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The Market Segmentation Hypothesis
• Example: The yield curve for high quality corporate
bonds could be segmented into two markets:
• (2) Long-Term Market
– The supply of long-term bonds would come from
corporations trying to finance their long-term assets
(plant expansion, equipment purchases, acquisitions, etc.)
– The demand for such bonds would come from investors,
either directly or indirectly through institutions (e.g.,
pension funds, mutual funds, insurance companies, etc.),
who have long-term liabilities and horizon dates

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Spot Rates
• Yield on zero coupon bond is called the spot rate

• But ZCBs for all maturities are not available for trade
– Linear Interpolation technique can be useful to fill the gaps
– Bootstrapping method is used to arrive at the spot rates for
different maturities
– By long/short position in coupon bonds, similar CFs to
ZCB can be obtained.

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Spot Interest Rates : Linear Interpolation
– Suppose 2-year 4.52%, 5-year 4.66%, 10-year 4.80%, 30-
year 5.03% zero coupon bonds are available

– Using the above information, 3- and 4-year Treasury rates

can be computed by using following interpolation of
.0466%:

(4.66% – 4.52%)
3 years

Then the interpolated 3-year rate would be:

4.52% + .0466% = 4.567%
The interpolated 4-year rate would be:
4.567% + .0466% = 4.614%
– In this way we can have the continuous yearly time series

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Spot Interest Rates: Using STRIPS
• Let St = spot rate on a bond with a maturity of t
• Assume: S1 = 7%, S2 = 8%, and S3 = 9%
• The equilibrium price, P0*, of a 3-year, 8% coupon
bond (paid annually) with F = 100 is:
C1 C2 C3 + F
P =
*
0 + +
(1 + S1 )1
(1 + S2 ) 2
(1 + S3 ) 3
$8 $8 $108
P =
*
0 1
+ 2
+ 3
= $97.73
(1.07) (1.08) (1.09)

• Suppose the market prices of the 3-year, 8% bond is

95

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Spot Interest Rates : Equilibrium Price…Cont’d
• Arbitrage Strategy
– Buy the bond for 95
– short ZCBs (strips) :
– 1-Year ZCB with F = 8: Selling Price = 8/1.07 = 7.4766
– 2-Year ZCB with F = 8: Selling Price = 8/(1.08)^2 = 6.8587
– 3-Year ZCB with F = 108: Selling Price = 108(1.09)^3 = 83.3958
– Sale of strips/ZCBs = 97.73
• Risk-free profit = 97.73-95.00 = 2.73

• Arbitrageurs would implement this strategy of buying and

stripping the bond until the price of the coupon bond reached
to its equilibrium price i.e., $97.73

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Estimating Spot Rates: Bootstrapping
• One problem in getting spot rates from strips
– Not enough longer-term pure discount bonds (or STRIPS) available

• Sequential process commonly referred to as

bootstrapping may be used
– (1) The approach requires having at least one pure discount bond
– (2) Given this bond's rate, a coupon bond with the next higher maturity
is used to obtain an implied spot rate
– (3) Then, another coupon bond with the next higher maturity is used to
find the next spot rates, and so on

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Estimating Spot Rates: Bootstrapping
Maturity Annual Coupon Principal Price
1 Year 7% 100 100
2 Years 8% 100 100
3 Years 9% 100 100
S1 = .07 :
107 107 
100 =  S1 =   − 1 = .07
(1 + S1 )1 100 
S2 = .08042 :
8 108
100 = +
1.07 (1 + S2 ) 2
1/ 2
108  108 
95.52 =  S 2 =  95.52  − 1 = .08042
(1 + S2 ) 2  
S3 = .0912 :
9 9 109
100 = + +
1.07 (1.08042) 2 (1 + S3 ) 3
1/ 3
109  109 
83.88 =  S3 =  83.88  − 1 = .0912
(1 + S3 ) 3
Spot Rates: long/short coupon bonds
• Assume you observe the following three coupon bond prices
and remaining cash flows.

• Bond A is currently trading at a price of 114.51, has a face

value of 100 and 25% coupon and three years to maturity.

• Bond B is currently trading at a price of 117.42, has a face

value of 100 and 25% coupon and two years to maturity.

• Finally, Bond C is currently trading at a price of 113.63, has a

face value of 100 and 25% coupon and 1 year to maturity.

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Forward Rates
• Suppose that a firm would like to commit to a rate for
a loan due in future, can a bank offer such a rate?
– Yes, this is the forward rate
• Forward interest rates are the spot rates expected to
rule on future dates as implied by the term structure

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Spot Rates and Forward Rates
• Notation: 1f2

When issued Time to maturity

• A spot rate is a rate agreed upon today, for a loan that is to be
made today. (e.g. r1 = 5% indicates that the current rate for a
one-year loan is 5%)
• A forward rate is a rate agreed upon today, for a loan that is to
be made in the future. (e.g. 2f3 = 7% indicates that we could
contract today to borrow money at 7% for one year, starting
two years from today)
• When the beginning subscript is omitted, it is understood that the
forward rate is for one period only: 3f4 = f4

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 Forward Rates
• Forward rates of interest are implicit in the term structure of interest rates

t=0 1 2 3 4…
r1 1f2

r2 2f3

r3 3f4

• Note the notation: 3f4 means “the forward rate from period 3 to period 4.”
Forward Rates: Example
• Suppose today is March 4, 2001 and a firm sold a piece of
equipment to a client for $100 million
• The client will pay in six months, i.e. on T1 = September 4,
2001
• Suppose the firm does not need that cash immediately, but it
will need it six month later, at T2 = March 4, 2002,to fund
some capital investment
• Today, the firm would like to fix the interest rate to be applied
on the receivable of $100 million for the six month period
from T1 to T2
• The firm calls up its bank to ask for a quote, and the bank
quotes the (semi-annually compounded) annualized rate of f2
= 4.21%

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Forward Rates: Example…Cont’d
• That is, the bank is ready to commit today to receive in six
months (at T1) $100 million from the firm, and return six
months later (at T2) the amount $102.105 = $100 × (1 + f2/2)
million
• The rate, f2, which the bank commits to today is called
forward rate
• How does the bank determine the forward rate f2?
– By no arbitrage
• Suppose, on March 4, 2001 (today), the value of 6-months
Treasury bills is $97.728 and the value of 1-year Treasury bills
is $95.713

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Forward Rates: Example…Cont’d
• In order to guarantee the rate f2 to the client, the bank can
perform the following strategy:
• Today the bank:
• Borrows T-bills with maturity T1 = 6 months and sells them
for $97.728 million
• This amount of cash is then invested in 1-year T-bills expiring
in T2
• Given the price of the latter of $95.713 the bank can now
purchase M = 1.02105 = $97.728/$95.713 million of 1-year T-
bills (for $100 of face value)
• The net cash flow remaining to the bank is zero, as all the cash
obtained from the sale of the T1 T-bill has been used to
purchase T2 T-bills
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Forward Rates: Example…Cont’d
• At time T1 the bank:
• Pay back $100 million to the counterparty it borrowed the T1
T-bills from
• At T1 the net cash flow is zero, as the bank receives $100
million from the firm and uses it to close the short position
• At time T2:
• The M = 1.02105 T-bills mature
• The bank receives M × $100 = $102.105 million
• This is the cash flow promised to the firm in return on the
investment of $100 million at T1
• Indeed, the return for the firm from T1 to T2 is 2.105% =
($102.105−$100)/$100, which implies the annualized interest
rate of f2 = 2.105%×2 = 4.21%
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Deriving Forward Rates
• To compute forward rate, yield curve and the corresponding
spot rate curve is utilized

• The following 2 investments should have the same value:

– 2-year ZCB and
– 2 one-year Treasury bills (one purchased now and the other after one year)

• An investor should be indifferent

– since they should produce the same investment income over the same
investment horizon

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6-Month Forward Rate, six month from now
• The value of first one-year T-bill is: X(1 + z1)
• The value of the total investment following the second one-year T-bill is:
X(1 + z1)(1 + f)

• The value of alternative investment (a 2-year ZCB) is computed as:

= X(1 + z2)2
• Because the two alternatives should generate identical returns:
=X(1 + z1)(1 + f) = X(1 + z2)2

• Multiplying f by 2 to get the forward rate on a bond-equivalent yield basis

• Forward rates can be computed on various combinations of short- and
longer-term interest rates

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General Formula for Forward Rates
• One-period forward rates:
(1 + rn )n  (1+ rn−1 ) n−1 (1 + fn )1
implying tha t ...

(1 + rn ) n
fn = n−1
−1
(1+ rn−1 )
• n-period forward rates:

(1 + rk +n )k + n  (1 + rk ) k (1 + k
f k + n) n
implying tha t...

1
 (1 + r )k + n  n
fk + n =  k+ n  −1
k
 (1 + rk ) 
k

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Example: Forward Rates
• Compute one-year implied forward rates from the following
spot rates?
Maturity Year Spot Rate (rt) Forward Rate (ft)

1 4.0% –

2 5.0% ?

3 5.5% ?

(1 + r2 )2 = (1+ r1 )(1+ f2 ) (1 + r3 )3 = (1 + r2 )2 (1 + f3 )
(1.05)2 = (1.04)(1 + f2 ) (1.055)3 = (1.05)2 (1 + f3 )
f2 = 6.01% f3 = 6.507%

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Valuation of bonds using Forward Rates

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Valuation of bonds using Forward Rates
• Compute the price of a bond having four years of maturity and paying
annual coupon of 6.5%.
• Using Spot Rates

• Using Forward Rates

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Thank You!

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