term structure of interest rates

The term structure of interest rates, also called the yield curve, is a graph that plots the yields of similar-quality bonds against their maturities, from shortest to longest. How It Works/Example: The term structure of interest rates shows the various yields that are currently being offered on bonds of different maturities. It enables investors to quickly compare the yields offered on short-term, medium-term and long-term bonds. Note that the chart does not plot coupon rates against a range of maturities -- that graph is called thespot curve. The term structure of interest rates takes three primary shapes. If short-term yields are lower than long-term yields, the curve slopes upwards and the curve is called a positive (or "normal") yield curve. Below is an example of a normal yield curve:

If short-term yields are higher than long-term yields, the curve slopes downwards and the curve is called a negative (or "inverted") yield curve. Below is example of an inverted yield curve:

Finally, a flat term structure of interest rates exists when there is little or no variation between short and long-term yield rates. Below is an example of a flat yield curve:

It is important that only bonds of similar risk are plotted on the same yield curve. The most common type of yield curve plots Treasury securities because they are considered risk-free and are thus abenchmark for determining the yield on other types of debt. The shape of the curve changes over time. Investors who are able to predict how term structure of interest rates will change can invest accordingly and take advantage of the corresponding changes inbond prices.

Why It Matters: In general, when the term structure of interest rates curve is positive, this indicates that investors desire a higher rate of return for taking the increased risk of lending their money for a longer time period. Many economists also believe that a steep positive curve means that investors expect strong future economic growth with higher future inflation (and thus higher interest rates), and that a sharply inverted curve means that investors expect sluggish economic growth with lower future inflation (and thus lower interest rates). A flat curve generally indicates that investors are unsure about future economic growth and inflation.

Bond indenture
Bond indenture means legal agreement for issuing the bond. This agreement is done between bondholder and company who issues the bond. This is also called trust indenture. This bond indenture is based on different terms. Following may be the terms. 1. When will the bond mature. Bond is just like loan taken by company from investor. Maturity is the date when company repay your loan. This will be written in bond indenture. 2. What will be the interest rate on the bond? This rate will be written in the bond and it will be paid by company to the buyer at the end of year. 3. In the bond indenture, it should be written whether bond are convertible or not. 4. Terms relating to collateral assets as security of bonds.

Zero coupon bond and example

A zero-coupon bond is a bond that makes no periodic interest payments and is sold at a deep discount from face value. The buyer of the bond receives a return by the gradual appreciation of the security, which is redeemed at face value on a specified maturity date. How It Works/Example: The price of a zero-coupon bond can be calculated by using the following formula: P = M / (1+r)
n

where: P = price M = maturity value r = investor's required annual yield / 2 n = number of years until maturity x 2 For example, if you want to purchase a Company XYZ zero-coupon bond that has a $1,000 face valueand matures in three years, and you would like to earn 10% per year on the investment, using the formula above you might be willing to pay: $1,000 / (1+.05) = $746.22 When the bond matures, you would get $1,000. You would receive "interest" via the gradualappreciation of the security. The greater the length until a zero-coupon bond's maturity, the less the investor generally pays for it. So if the $1,000 Company XYZ bond matured in 20 years instead of 3, you might only pay: $1,000 / (1+.05)
40 6

= $142.05

Zero-coupon bonds are very common, and most trade on the major exchanges. Corporations, state and local governments, and even the U.S. Treasury issue zero-coupon bonds. Corporate zero-coupon bonds tend to be riskier than similar coupon-paying bonds because if the issuer defaults on a zero-coupon bond, the investor has not even received coupon payments -- there is more to lose.

Why It Matters: Zero-coupon bonds are usually long-term investments; they often mature in ten or more years. Although the lack of current income provided by zero-coupons bond discourages some investors, others find the securities ideal for meeting long-range financial goals like college tuition. The deep discount helps the investor grow a small amount of money into a sizeable sum over several years.

Floating rate bond

Bond whose interest amount fluctuates with the market interest rates, or some other external measure. Price of floating rate bonds remains relatively stable because neither a capital gain nor a capital loss occurs as market interest rates go up or down.

The advantage of floating debt is that there is a chance to benefit from reductions in interest rates. In addition, interest rates on long-term debt are often higher than interest rates on shortterm debt, so the company might be saving itself money by refinancing short-term debt as opposed to borrowing long-term. However, the downside is that the company might suffer if interest rates rise and they have to refinance at a higher cost.

InterestRateCollars
Acollarisalongpositioninacapandashortpositioninaoor. Theissuerofaoatingratenotemightusethistocaptheupsideofhisdebtservice,andpa yforthecapwithaoor. Collarsaregenerallyfixedinaoatingratenote,butcouldalsobepurchasedseparatelfrom adealer.

InterestRateFloors
Aoorprovidesaguaranteetotheownerofaoatingnotethatthecouponpaymenteachp eriodwillbenolessthanacertainoorrateorstrikerate. Floorsaregenerallyfixedinaoatingratenote,butcouldalsobepurchasedseparatelyfrom adealer

InterestRateCaps
Acapprovidesaguaranteetotheissuerofaoatingorvariableratenoteoradjustablerate mortgagethatthecouponpaymenteachperiodwillbenohigherthanacertainamount. Inotherwords,thecouponratewillbecappedatacertainceilingorcaprateorstrikerate. Capsareeitheroeredoverthecounterbydealersorfixedinasecurity.

The fixed coupon bond:

Fixed rate bonds are what the name implies, they provide a fixed coupon interest payment at each period (monthly, quarterly, semi-annually or annually) for a certain # of years up until maturity. Upon maturity, fixed rate bonds pay back the entire original principal amount.

The most common agreement is that of a loan. If the loan can be freely traded it is called a fixed coupon bond. The agreement is the following: On the start date the lender pays the borrower an agreed amount, the notional. The borrower in turn does regular interest rate payments, and at the end of the agreement returns the notional amount.

Fig. 2: Cash flows of a coupon bond

See figure 2 for a graphic representation of the cash flows. The length of the loan is called the maturity. The termination date of the loan, i.e. the date on which the borrower returns the notional amount along with his last interest payment, is the maturity date.

The spot price

The spot price is the current market price at which an asset is bought or sold for immediate payment and delivery. It is differentiated from the forward price or the futures price, which are prices at which an asset can be bought or sold for delivery in the future.

Definition of 'Forward Rate'

A rate applicable to a financial transaction that will take place in the future. Forward rates are based on the spot rate, adjusted for the cost of carry and refer to the rate that will be used to deliver a currency, bond or commodity at some future time. It may also refer to the rate fixed

for a future financial obligation, such as the interest rate on a loan payment.

Spot Rate
The rate of a foreign-exchange contract for immediate delivery. Also known as "benchmark rates", "straightforward rates" or "outright rates", spot rates represent the price that a buyer expects to pay for a foreign currency in another currency.

Forward rate
Forward rate is the rate at which a bank is willing to exchange one currency for another at some specified future date Multinational Corporations often use the forward market to hedge future payables or receivables denominated in a foreign currency against foreign exchange risk by using a forward contract to lock in a forward exchange rate.
Quotation for customers are Rs. 43.22/42.93 (Bank quotes best rate to itself and worst rate to customer)

Yield to Maturity (YTM)

What It Is: Yield to maturity (YTM) measures the annual return an investor would receive if he or she held a particular bond until maturity.

How It Works/Example: To understand YTM, one must first understand that the price of a bond is equal to the present value of its future cash flows, as shown in the following formula:

Where: P = price of the bond n = number of periods C = coupon payment r = required rate of return on this investment F = maturity value t = time period when payment is to be received To calculate the lien, the investor then uses a financial calculator or software to find out what percentage rate (r) will make the present value of the bond's cash flows equal to today's selling price. For example, let's assume you own a Company XYZ bond with a $1,000 par value and a 5% coupon that matures in three years. If this Company XYZ bond is selling for $980 today on the market, using the formula above we can calculate that the YTM is 2.87%. Note that because the coupon payments are semiannual, this is the YTM for six months. To annualizethe rate while adjusting for the reinvestment of interest payments, we simply use this formula:

[Use our Yield to Maturity (YTM) Calculator to measure your annual return if you plan to hold a particular bond until maturity.] Why It Matters: YTM allows investors to compare a bond's expected return with those of other securities. Understanding how yields vary with market prices (that as bond prices fall, yields rise; and as bond prices rise, yields fall) also helps investors anticipate the effects of market changes on their portfolios. Further, YTM helps investors answer questions such as whether a 10-year bond with a high yield is better than a 5-year bond with a high coupon. Although YTM considers the three sources of potential return from a bond (coupon payments, capital gains, and reinvestment returns), some analysts consider it inappropriate to assume that the investor can reinvest the coupon payments at a rate equal to the YTM. It is important to note that callable bonds should receive special consideration when it comes to YTM.Call provisions limit a bond's potential price appreciation because when interest rates fall, the bond's price will not go any higher than its call price. Thus, a callable bond's true yield, called the yield to call,at any given price is usually lower than its yield to maturity. As a result, investors usually consider the lower of the yield to call and the yield to maturity as the more realistic indication of the return on a callable bond.

Definition of 'Arbitrage'
The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair

value for long periods of time.

Definition of 'Valuation'
The process of determining the current worth of an asset or company. There are many techniques that can be used to determine value, some are subjective and others are objective.

Definition of 'Arbitrage-Free Valuation'

1. The theoretical future price of a security or commodity based on the relationship between spot prices, interest rates, carrying costs, convenience yields, exchange rates, transportation costs, etc. 2. The theoretical spot price of a security or commodity based on the futures price interest rates, carrying costs, convenience yields, exchange rates, transportation costs, etc. When the actual futures price does not equal the theoretical futures price, arbitrage profits may be made.

Definition of 'Interest Rate Future'

A futures contract with an underlying instrument that pays interest. An interest rate future is a contract between the buyer and seller agreeing to the future delivery of any interest-bearing asset. The interest rate future allows the buyer and seller to lock in the price of the interestbearing asset for a future date.

Investopedia explains 'Interest Rate Future'

Interest rate futures can be based on underlying instruments such as:

Treasury Bills in the case of Treasury Bill Futures traded on the CME Treasury Bonds in the case of Treasury Bond Futures traded on the CBT Other products such as CDs, Treasury Notes and Ginnie Mae's are also available to trade as underlying assets in an interest rate future

Because interest rate futures contracts are large in size (i.e. $1 million for Treasury Bills), they are not a product for the less sophisticated trader.

Yield to Call (YTC)

What It Is: Yield to call is a measure of the yield of a bond if you were to hold it until the call date. How It Works/Example: To understand yield to call, one must first understand that the price of a bond is equal to the present value of its future cash flows, as calculated by the following formula:

where: P = price of the bond n = number of periods C = coupon payment r = required rate of return on this investment F = principal at maturity t = time period when payment is to be received To calculate the yield to call, the investor then uses a financial calculator or software to find out what percentage rate (r) will make the present value of the bond's cash flows equal to today's selling price. The big distinction with yield to call, however, is that the investor assumes that the bond is called at the earliest possible date rather than held to maturity. (To run the calculations assuming the bond is held to maturity would be to calculate the yield to maturity). For example, say you own a Company XYZ bond with a $1,000 par value and a 5% zero-coupon bondsthat matures in three years. Also suppose this bond is callable in two years at 105% of par. To calculate the yield to call, you simply pretend that the bond matures in two years rather than three, and calculate the yield accordingly. You should also consider the call price (105% of $1,000, or $1,050) as the principal at maturity (F). Thus, if this Company XYZ bond is selling for $980 today, using the formula above we can calculate that the yield to call is 4.23%. [Use our Yield to Call (YTC) Calculator to measure your annual return if you hold a particular bond until its first call date.] Why It Matters: Although the yield to call calculation considers the three sources of potential return from a bond(coupon payments, capital gains, and reinvestment returns), some analysts consider it inappropriate to assume that the investor can reinvest the coupon payments at a rate equal to the yield to call. The yield to call makes two other tenuous assumptions: it assumes the investor will hold the bond until it is called, and it assumes the issuer will call the bond on one of the exact dates used in the analysis. The true yield of a callable bond at any given price is usually lower than its yield to maturity because the call provisions limit the bond's potential price appreciation -- when interest rates fall, the price of a callable bond will not go any higher than its call price. This is because the issuer should act in the best interests of the company and call the bond as soon as it is favorable to do so. As a result, investors usually consider the lower of the yield to call and the yield to maturity as the more realistic indication of the return an investor will actually receive on a callable bond. Some investors go a step further and calculate the yield to call not just for the first call date, but for all possible call dates. Then the investor compares all the calculated yields to call and yields to maturity and relies on the lowest of them, called the yield to wors

Tracking error is a measurement of how much the return on a portfolio deviates from the return on its benchmark index. It is a very important metric for index trackers.

1. Interest Rate Risk Interest rates and bond prices carry an inverse relationship; as interest rates fall, the price of bonds trading in the marketplace generally rises. Conversely, when interest rates rise, the price of bonds tends fall. This happens because when interest rates are on the decline, investors try to capture or lock in the highest rates they can for as long as they can. To do this, they will scoop up existing bonds that pay a higher rate of interest than the prevailing market rate. This increase in demand translates into an increase in bond price.On the flip side, if the prevailing interest rate were on the rise, investors would naturally jettison bonds that pay lower rates of interest. This would force bond prices down. 2. Reinvestment Risk Another risk that bond investors face is reinvestment risk, which is the risk of having to reinvest proceeds at a lower rate than the rate the funds were previously earning. One of the main ways this risk presents itself is when interest rates fall over time and callable bonds are exercised by the issuers. The callable feature allows the issuer to redeem the bond prior to maturity. As a result, the bondholder receives the principal payment, which is often at a slight premium to the par value. However, the downside to a bond call is that the investor is then left with a pile of cash that he or she may not be able to reinvest at a comparable rate. This reinvestment risk can have a major adverse impact on an individual's investment returns over time. In order to compensate for this risk, investors receive a higher yield on the bond than they would on a similar bond that isn't callable. Active bond investors can attempt to mitigate reinvestment risk in their portfolios by staggering the potential call dates of their differing bonds. This limits the chance that many bonds will be called at once. (For more on callable bonds, read Callable Bonds: Leading A Double Life.) 3. Inflation Risk When an investor buys a bond, he or she essentially commits to receiving a rate of return, either fixed or variable, for the duration of the bond or at least as long as it is held. But what happens if the cost of living and inflation increase dramatically, and at a faster rate than income investment? When that happens, investors will see their purchasing power erode and may actually achieve a negative rate of return (again factoring in inflation).
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Put another way, suppose that an investor earns a rate of return of 3% on a bond. If inflation grows to 4% after the purchase of the bond, the investor's true rate of return (because of the decrease in purchasing power) is -1%. 4. Credit/Default Risk When an investor purchases a bond, he or she is actually purchasing a certificate of debt. Simply put, this is borrowed money that must be repaid by the company over time with interest. Many investors don't realize that corporate bonds aren't guaranteed by the full faith and credit of the U.S. government but are dependent on the corporation's ability to repay that debt. Investors must consider the possibility of default and factor this risk into their investment decision. As one means of analyzing the possibility of default, some analysts and investors will determine a company's coverage ratio before initiating an investment. They will analyze the corporation's income statement and cash flow statement, determine its operating income and cash flow, and then weigh that against its debt service expense. The theory is the greater the coverage (or operating income and cash

flow) in proportion to the debt service expenses, the safer the investment. 5. Rating Downgrades A company's ability to operate and repay its debt (and individual debt) issues is frequently evaluated by major ratings institutions such as Standard & Poor's or Moody's. Ratings range from 'AAA' for high credit quality investments to 'D' for bonds in default. The decisions made and judgments passed by these agencies carry a lot of weight with investors. (To learn more, read What Is A Corporate Credit Rating?) If a company's credit rating is low or its ability to operate and repay is questioned, banks and lending institutions will take notice and may charge the company a higher rate of interest for future loans. This can have an adverse impact on the company's ability to satisfy its debts with current bondholders and will hurt existing bondholders who might have been looking to unload their positions. 6. Liquidity Risk While there is almost always a ready market for government bonds, corporate bonds are sometimes entirely different animals. There is a risk that an investor might not be able to sell his or her corporate bonds quickly due to a thin market with few buyers and sellers for the bond. Low interest in a particular bond issue can lead to substantial price volatility and possibly have an adverse impact on a bondholder's total return (upon sale). Much like stocks that trade in a thin market, you may be forced to take a much lower price than expected to sell your position in the bond.

Definition of 'Bond Rating'

A grade given to bonds that indicates their credit quality. Private independent rating services such as Standard & Poor's, Moody's and Fitch provide these evaluations of a bond issuer's financial strength, or its the ability to pay a bond's principal and interest in a timely fashion.

Definition of 'Mortgage-Backed Security (MBS)'

A type of asset-backed security that is secured by a mortgage or collection of mortgages. These securities must also be grouped in one of the top two ratings as determined by a accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution. Also known as a "mortgage-related security" or a "mortgage pass through."