The Yield Curve

The yield curve can be obtained daily from the US Treasury here Yield Curve, with the last 10
days of yield curves being reported:

The yield curve is simply the Yield to Maturity (YTM) for various US Government Treasuries (yaxis), plotted against their maturity (x-axis). The yield curve on 7/15/11 then look like this:

US Treasury Yield Curve (7/15/11)

4.5%
4.0%
3.5%
3.0%
Yield

2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
-0.5%

10

15
20
Maturity (Years)

25

30

35

This is a normal upward sloping yield curve because it fits the general rule that the longer the
maturity, the more yield will be required to compensate the lender for foregoing their immediate
use of their capital, plus to overcome inflation because a dollar today is not worth the same as
it is tomorrow, and also to compensate for default risk which increases with maturity.

2011 Ben Etzkorn

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US Government Treasuries typically come in 30, 90 and 180-day T-Bills, 1 through 10-year TNotes, and 20-year and 30-year T-Bonds. All of these treasuries may be purchased directly
from Treasury Direct.

Spot Rates & Term Structure

The Expectations Hypothesis theory tells us that the yield curve is comprised of a series of
compounded spot rates. Spot rates are the rates for a T-Bill or zero coupon T-Note or T-Bond
You can purchase any T-Bill up to a year at their spot rate, but when you go beyond one year
you must now deal with the coupons associated with T-Notes and T-Bonds. Treasury auctions
(i.e., the US Treasury selling their treasuries) are reported on Treasury Direct, and pictured
below is an example of how these are listed:

T-Bills work on simple interest and the following formula. For a 13-week T-Bill on 7/14/11:
Discount Rate

Investment Yield

DR = [(FV PP)/FV][360/M]

IR = [(FV PP)/PP][365/M]

Face/Future Value (FV) = $100

Purchase Price (PP) = $99.992417
Maturity (M) = 91 Days
DR = [(100-99.992417)/100][360/91]
DR = 0.030%

FV = $100
PP = $99.992417
M = 91 Days
IR = [(100-99.992417)/99.992417][365/91]
IR = 0.031%

IR is a more realistic return, and is equivalent to the spot rate for the T-Bill.

2011 Ben Etzkorn

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For the T-Notes and T-Bonds, the standard TVM formulas work as shown below for the 3-Year
T-Note issued on 7/15/11 (note, semi-annual coupons thus PMT/2, n2, and i/2):
FV = 100
PV = -99.866569
PMT = (0.625%100)/2 = 0.3125
n = 32 = 6
Solving for i = 0.335%2 = 0.670%
The actual formula that is being solved is as follows:
EQ #1 99.866569

0.3125 0.3125 0.3125 0.3125 0.3125 100.3125

(1 i) (1 i) 2 (1 i)3 (1 i) 4 (1 i)5
(1 i) 6

And the i in the above example is thus the T-Notes period yield which must then be
multiplied by two (i.e., 2 periods per year for a semi-annual coupon) to obtain the T-Notes
YTM.
If the T-Note or T-Bond are zero coupon, then their i is the spot rate. Lets assume that the
T-Note just modeled has a zero coupon equivalent that is selling for 98.013358, its spot rate is
thus:
FV = 100
PV = -98.013358
PMT = 0
n = 32 = 6
Solving for i = 0.335%2 = 0.670%
And the i (0.670%) is now the spot rate (SR3) for year three , and is derived from the formula
below:
100
(1 SR3 )3

EQ #2 98.013358

If the Expectations Hypothesis theory is correct, then the semi-annual coupon bonds price is
equal to a series of coupons and a final principal payment discounted at their various
corresponding spot rates, as pictured below. Note that SR3 in Eq #3 would equal SR3 derived
in Eq. #2:
EQ #3 99.866569

0.3125
0.3125
0.3125
0.3125
0.3125
100.3125

2
3
4
5
(1 SR1 ) (1 SR2 ) (1 SR3 ) ( SR4 i) (1 SR5 ) (1 SR6 )6

Valuing a coupon-based T-Note and/or T-Bond using the appropriate spot rate for each cash
flow is technically the correct way to value the treasury since this takes into account the
reinvestment risk of the coupon payment that is received, whereas using a constant YTM as
the discount rate does not account for reinvestment risk.
2011 Ben Etzkorn

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For another example, lets look at the 2-year T-Note on 6/30/11 which has a YTM of 0.395%,
and a coupon rate of 0.375, and is selling for $99.960197. The classic T-Note DCF solution
using YTM as the discount rate is thus (note: the PMT and i are divided by two since the
coupons are semi-annual):

$99.960197

$0.375 / 2
$0.375 / 2
$0.375 / 2
$100 $0.375 / 2

2
3
1 0.395% / 2 1 0.395% / 2 1 0.395% / 2 1 0.395% / 2 4

We know from the 180 day T-Bill on 6/30/11 that the spot rate SR1 is 0.096% since we receive
$100 in 26 weeks for buying the T-Bill at $99.951972 (IR formula shown below).
SR1 = [($100-$99.951972)/$99.951972](365/182)100 = 0.096%
And we know from the 1-year T-Bill on 6/30/11 that the spot rate SR2 is 0.203% since we
receive $100 in 52 weeks for paying $99.797778.
SR2 = [($100-$99.797778)/$99.797778](365/365)100 = 0.203%
Lets say that we also know that SR4 is equal to 0.395% based upon a 2-year zero coupon
bond that just sold on 6/30/11 for 98.435480.
We can then solve for the spot rate for SR3 by setting up the Discounted Cash Flow (DCF) for
the 2-year T-Note and backing out SR3. Note that we can do this for the cash flows within an
individual bond, and that these are then spot rates, not forward rates:

$99.960197

$0.375 / 2
$0.375 / 2
$0.375 / 2
$100 $0.375 / 2

2
3
1 0.096% / 2 1 0.203% / 2 1 SR3 / 2 1 1.312% / 2 4

Solving for SR3 we obtain 0.312%

We now have the following spot rates, which can be plotted to create the Term Structure.
Term (years)
0.5
1.0
1.5
2.0

Spot Rate
0.096%
0.203%
0.312%
0.395%

Using this same approach, and assuming the spot rates are annual versus semi-annual, I have
derived the spot rates based upon the treasury auctions listed at the start of this article. See
the attached Excel workbook. Where treasuries did not exist year after year, the same spot
rate was assumed over the time range that was spanned between treasuries.
Spot Rates.xlsx

2011 Ben Etzkorn

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Forward Rates
Now that we have the spot rates, we can use them to derive what are called Forward rates. A
forward rate is the return (also then the discount rate) that can be expected (applied) in the
future. Unlike spot rates that are derived within an individual treasury, forward rates are
derived between treasuries. Here are a few examples that will explain the math involved.
Lets say that we know that the spot rate for year 5 is 1.636%, and for year 1 is 0.202%, and
we want to know the forward rate for an investment made one year from now, and for which
we will hold for 4 years, the formula would be:

(1+SR 5 )5 1+SR1 1+FR 2,5

Where:
SR1 = Current Spot Rate today for a 1-Year T-Bill (0.202%)
FR2,5 = Forward Rate for a zero coupon 4-Year T-Note issued one year from today
SR5 = Current Spot Rate for a zero coupon 5-Year T-Note (1.636%)
Solving for FR2,5 = 1.998%
Various combinations of spot rates can then be used to determine forward rates for any range
of years, and beginning any time period in the future, which are only limited to the longest term
spot rate available.

1+SR 5

= 1+FR1,2 1+SR 3 1+SR 4 1+SR 5

Etc.
As stated earlier, this is powerful because the discount rate used in a DCF model should be
term specific, and spot rates and forward rates provide a means for accomplishing this.

2011 Ben Etzkorn

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