Fixed Income Analysis

Lecture 3: Term Structure of Interest Rates:

Empirical Properties and Classical Theories
Jolle Miffre

Term Structure of Interest Rates:

Empirical Properties and Classical Theories

Empirical Properties of the Term Structure (TS)

Shapes of the TS
Dynamics of the TS
Stylized Facts

Theories of the Term Structure

Pure Expectations
Pure Risk Premium
Liquidity Preference Theory
Preferred Habitat

Market Segmentation
Biased Expectations
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Types of Term Structures

The term structure of interest rates is the series of interest rates ordered
by term-to-maturity at a given time

The nature of interest rate determines the nature of the term structure
The term structure of yields to maturity
The term structure of zero-coupon rates
The term structure of forward rates

TS shapes

Quasi-flat
Increasing
Decreasing
Humped
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Shape of the TS: Quasi-Flat

US YIELD CURVE AS ON 11/03/99

7.00%

6.50%

6.00%

par yield

5.50%

5.00%

4.50%

4.00%
0

10

15

20

25

30

maturity

Quasi-Flat
4

Shape of the TS: Increasing

JAPAN YIELD CURVE AS ON 04/27/01

2.50%

2.00%

par yield

1.50%

1.00%

0.50%

0.00%
0

10

15

20

25

30

maturity

Increasing
5

Shape of the TS: Decreasing

UK YIELD CURVE AS ON 10/19/00

6.00%

par yield

5.50%

5.00%

4.50%
0

10

15

20

25

30

maturity

Decreasing (or
inverted)
6

Shape of the TS: Humped (1)

EURO YIELD CURVE AS ON 04/04/01

5.50%

par yield

5.00%

4.50%

4.00%
0

10

15

20

25

30

maturity

Humped (decreasing then increasing)

7

Shape of the TS: Humped (2)

US YIELD CURVE AS ON 02/29/00

7.00%

par yield

6.50%

6.00%

5.50%
0

10

15

20

25

30

maturity

Humped (increasing then decreasing)

8

Dynamics of the Term Structure

The term structure of interest rates changes in response to

Wide economic shocks
Market-specific events

Example
On 10/31/01, Treasury announces that there will not be any further issuance
of 30-year bonds
Price of existing 30-year bonds is pushed up (buying pressure)
30-year rate is pushed down

Dynamics of the Term Structure

Example US YTM TS

10

Stylized Facts (1): Mean Reversion

Mean reversion: high (low) values tend to be followed by low (high) values
Example: Fed Fund Rate versus S&P500 Composite Index

Source: Federal Reserve Bank of St Louis and Datastream

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Stylized Facts (2): Correlation

Rates with different maturities are

Positively correlated to one another
Not perfectly correlated (more than one factor)
Correlation decreases with difference in maturity

Example: France (1995-2000)

1M
3M
6M
1Y
2Y
3Y
4Y
5Y
7Y
10Y

1M
1
0.999
0.908
0.546
0.235
0.246
0.209
0.163
0.107
0.073

3M
1
0.914
0.539
0.224
0.239
0.202
0.154
0.097
0.063

6M

1
0.672
0.31
0.384
0.337
0.255
0.182
0.134

1Y

1
0.88
0.808
0.742
0.7
0.617
0.549

2Y

1
0.929
0.881
0.859
0.792
0.735

3Y

4Y

5Y

7Y

1
0.981
1
0.936 0.981
1
0.867 0.927 0.97
1
0.811 0.871 0.917 0.966

10Y

1
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Stylized Facts (3): 3 Main Factors Explain the QuasiTotality of Rates Changes

The evolution of the interest rate curve can be split into 3 standard
movements
Shift movements (changes in level), which account for more than 60% of
observed movements on average
A twist movement (changes in slope), which accounts for 5% to 30% of
observed movements on average
A butterfly movement (changes in curvature), which accounts for 1% to 10% of
observed movements on average

That 3 factors can account for more than 90% of the changes in the TS is
valid
Whatever the time period
Whatever the market

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Shift Movements: Change in Level

Upward -Downward Shift Movements
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yield (in %)

0
0

10

15

20

25

30

maturity

14

Twist Movements: Change in Slope

Flattening - Steepening Twist Movements
8

yield (in %)

0
0

10

15

20

25

30

maturity

15

Butterfly Movements: Change in Curvature

Concave - Convex Butterfly Movements
6

5.5

yield (in % )

4.5

3.5

2.5

2
0

10

15

20

25

30

maturity

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Term Structure of Interest Rates:

Empirical Properties and Classical Theories

Empirical Properties of the Term Structure (TS)

Shapes of the TS
Dynamics of the TS
Stylized Facts

Theories of the Term Structure

Pure Expectations
Pure Risk Premium
Liquidity Preference Theory
Preferred Habitat

Market Segmentation
Biased Expectations
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Theories of the Term Structure

Term structure theories attempt to account for the relationship between

interest rates and their maturity

They fall within the following categories

Pure expectations
Pure risk premium
Liquidity premium
Preferred habitat

Market segmentation

To these main types, we can add

The biased expectations theory, that combines the first two theories
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Theories of the Term Structure

Remember

(1 + r (0,2 ))2 = (1 + r (0,1))(1 + f (1,2))

(1 + r (0 , t )) = [(1 + r (0 ,1))(1 + f (1, 2 ))(1 + f (2 ,3 ))...(1 + f (t 1, t ))]1 t

r(0,t) = Current spot rate of a bond with a maturity t

f(t, t+1) = Forward rate from year t to year t+1

The pure expectations theory postulates that forward rates exclusively represent
future short term rates as expected by the market

The pure risk premium theory postulates that forward rates exclusively represent
the risk premium required by the market to hold longer term bonds

The market segmentation theory postulates that

Each of the two main market investor categories (the one preferring short bonds, the
other long bonds) is invariably located on a given curve portion (short, long)
As a result, short and long curve segments are segmented
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Pure Expectations

TS reflects market expectations of future short-term rates

An increasing (resp. flat, resp. decreasing) structure means that the market expects an
increase (resp. a stagnation, resp. a decrease) in future short-term rates

Example: Change from a flat curve to an increasing curve

The current TS is flat at 5%
Investors expect a 100bp increase in rates within one year
For simplicity, assume that the short (resp. long) segment of the curve is the one-year
(resp. two-year) maturity
Then, under these conditions, the interest rate curve will not remain flat but will be
increasing
Why?
Year 1
r (0,1) = 5%
r (0,2) = 5%

Year 2
E (r (1,2)) = 6%
r (0,2) = 5%
20

10

Pure Expectations

Consider a long-term investor (2-year horizon) who wants to maximize his return.
He contemplates two alternatives
Maturity strategy: Invests in 1 security with a long 2-year maturity
Roll-over strategy: Invests in a short 1-year security then reinvests in one year the
proceeds in another 1-year security at the then-prevailing spot rate

Before interest rates adjust at the 6% level,

Investor will thus buy short bonds (one year) rather than long bonds (two years)

Annual return on maturity strategy: 5% over two years: $1 (1.05)2 = $1.1025 in 2 years
Roll-over strategy returns 5% in the first year and, according to expectations, 6% in the
second year: $1 (1.05) (1.06) = $1.1130 in 2 years

The price of the one-year bond will increase (its yield r(0,1) will decrease)
The price of the two-year bond will decrease (its yield r(0,2) will increase)
The curve will steepen

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Pure Expectations

Vice versa, if the market expects interest rates to fall, the yield curve will not
remain flat but will become downward-sloping
Year 1
r (0,1) = 5%
r (0,2) = 5%

Year 2
E (r (1,2)) = 4%
r (0,2) = 5%

Maturity strategy in 2 years: $1 (1.05)2 = $1.1025

Roll-over strategy in 2 years: $1 (1.05) (1.04) = $1.092
Investors will buy LT bonds (r(0,2) will fall) and sell ST bonds (r(0,1) will rise)
Yield curve will become downward-sloping

If the market expects interest rates to remain constant, the yield curve will be flat

If the market expects interest rates to first rise (fall) and then fall (rise), the yield
curve will be humped
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Pure Expectations

Investors are collectively indifferent between the different maturities as in

equilibrium the returns from holding short bonds over and over again is
the same as the returns from holding long bonds

If so, the forward rates are perfect predictors of future spot rates
f (1,2 ) = E (r (1,2 ))

The pure expectations theory has important limitations

Investors are assumed to be risk-neutral
They do not take reinvestment risk into account
They do not take price risk into account

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Pure Risk Premium

Both the roll-over and maturity strategies are risky
Future interest rates are unknown (reinvestment risk)
Future bond prices are unknown (market risk)

Example: An investor with a 3-year horizon

May invest in a 3-year zero-coupon bond and hold it until maturity
May invest in a 5-year zero-coupon bond and sell it in 3 years
May invest in a 10-year zero-coupon bond and sell it in 3 years

What would you prefer?

Return of the 1st investment is known ex-ante with certainty
Not the case for the 2nd and 3rd
We dont know the prices of these instruments in 3 years
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12

Pure Risk Premium

Long bonds are more risky than short bonds: A 1% increase in IR decreases
the price of a long bond more than it decreases the price of a short bond

Assume interest rates increase from 5% to 6%. What is the impact on the
price of 1-year and the 2-year 5% coupon bonds?

Initially both bonds trade at par

The long bond price will fall to 5 1.06 + 105 1.062 = 98.17
The short one will fall to 105 1.06 = 99.06
Decrease in 2-year bond price nearly twice as big as decrease in 1-year bond
price

Pure risk premium theory: TS reflects risk premium required by the market
for holding long bonds

The two versions of this theory (liquidity and preferred habitat) differ
about the shape of the risk premium
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Pure Risk Premium Liquidity

Theory takes into account

the preferences of investors for short bonds and
the substantial liquidity risk premium L = L2 + + Lt they require to invest in
long bonds (i.e., to offset price risk)

(1 + r (0 , 2 ))2 = (1 + r (0 ,1))(1 + L 2 )
(1 + r (0, t ))t = (1 + r (0 ,1))(1 + L2 )(1 + L3 )...(1 + Lt )
with 0 < L2 < L3 < < Lt

Limitations
Since 0 < L2 < L3 < < Lt, the TS is either increasing or quasi-flat Cannot
explain decreasing and humped curves
Does not take into account reinvestment risk
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13

Pure Risk Premium Preferred Habitat

Postulates that risk premium is not uniformly increasing

Indeed, investors have a preferred investment horizon dictated by the nature of

their liabilities (shorter is not always better)
Pension funds and life-insurance companies prefer to invest LT
Commercial banks prefer ST investments

Similarly, borrowers have their preferred habitats that match the maturity of their
assets (e.g., firms finance LT projects with LT bonds and ST projects with ST funds)

Nevertheless, depending on bond supply and demand on specific segments

Some lenders and borrowers are ready to move away from their preferred habitat
Provided that they receive a risk premium that offsets their price or reinvestment risk
aversion

Thus, all curves shapes can be accounted for

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Market Segmentation

Extreme version of pure risk premium theory

Investors never move away from preferred habitat
Assumes complete rigidity on behalf of investors

Examples
Commercial banks invest on a short/medium term basis
Life-insurance companies and pension funds invest on a long to very long term basis
Custom, preferences of some people who are used to lending ST and would not lend LT
even for an infinite risk premium

The shape of the yield curve is determined by supply and demand on short and
long term bond markets
Quasi-flat: r(0,1) r(0,2); so P(0,1) P(0,2) because banks have slightly more funds to
invest than insurance companies
Upward-sloping: r(0,1) << r(0,2); so P(0,1) >> P(0,2) because banks have far more funds
to invest than insurance companies
Downward-sloping: r(0,1) >> r(0,2); so P(0,1) << P(0,2) because banks have far less
funds to invest than insurance companies
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14

Biased Expectations Theory

Biased expectations theory is an integrated approach

Combines pure expectations theory and risk premium theory
TS reflects market expectations of future interest rates AND permanent
liquidity premia that vary over time

The forward rate is an upward-biased estimate of the future spot rate; it

also includes a positive liquidity risk premium required by investors to
invest in long bonds
f (1,2 ) = E (r (1,2 )) + L2

All curve shapes can be accounted for

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Biased Expectations Theory

How does the biased expectations theory explain the shapes of the yield
curve?

Example: Assume a liquidity risk premium of 0.5% and an upward-sloping

yield curve
Year 1
r (0,1) = 5%
r (0,2) = 6%

Year 2
E (r (1,2)) = ?%
r (0,2) = 6%

Maturity strategy: $1 (1.06)2 = $1.1236

f(1,2) = 7.01% = E(r(1,2)) + L2 E(r(1,2)) = 6.51%
The market expects ST interest rates to rise from 5% to 6.51%
Note that the pure expectations theory predicts a sharper rise (7.01%)
Roll-over strategy: $1 (1.05) (1 + E(r(1,2)) = $1.11835 < $1.1236
30

15

Biased Expectations Theory

If instead the yield curve is downward-sloping,

Year 1
r (0,1) = 5%
r (0,2) = 4%

Year 2
E (r (1,2)) = ?%
r (0,2) = 4%

Maturity strategy: $1 (1.04)2 = $1.0816

f(1,2) = 3.01% = E(r(1,2)) + L2 E(r(1,2)) = 2.51%
The market expects ST interest rates to fall sharply (from 5% to 2.51%)
Note that the pure expectations theory predicts a smaller fall (to 3.01%)
Roll-over strategy: $1 (1.05) (1 + E(r(1,2))) = $1.07635 < $1.0816

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Biased Expectations Theory

Now assume a quasi-flat yield curve

Year 1
r (0,1) = 4%
r (0,2) = 4.3%

Year 2
E (r (1,2)) = ?%
r (0,2) = 4.3%

Maturity strategy: $1 (1.043)2 = $1.0878

f(1,2) = 4.6% = E(r(1,2)) + L2 E(r(1,2)) = 4.1%
The market expects ST interest rate stability (from 4% to 4.1%)
Note the pure expectations theory predicts IR to rise slightly (to 4.6%)
Roll-over strategy: $1 (1.04) (1 + E(r(1,2))) = $1.0826 < $1.0878

A humped yield curve is due to interest rates expected to rise slightly and
then fall sharply
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