Debt Markets

Yield Curves and Term Structure of Interest Rates

Topicstobecovered
CurrentYield YieldtoMaturity y RelationshipbetweenBondPrices,TimetoMaturity&

InterestRates Interest Rates TheYieldCurve TheoriesofTermStructureofInterestRates UsesofYieldCurve NumericalQuestions

CurrentYield
Thecurrentyieldonabondistheannualinterestdue

onitdividedbythebondsmarketprice
CurrentYield=AnnualInterestorCoupon/MarketPrice

This measure of yield does not consider the time value Thismeasureofyielddoesnotconsiderthetimevalue

ofmoney,orthecompleteseriesofexpectedfuture cashflows cash flows

YieldtoMaturity
YieldtoMaturity(YTM)referstotheinternalrateofreturn

ofthebond,i.e.discountrateatwhichpresentvalueof inflowsisequaltooutflows. Inflowsreferstointerestreceivedonbondsandthe redemptionpriceonmaturity Outflowsrefertothepriceatwhichthebondscanbe p purchasedfromthemarket,i.e.thecurrentmarketprice YTM represents the yield on the bond, provided the bond YTMrepresentstheyieldonthebond,providedthebond isheldtomaturityandtheintermittentcouponsarere investedatthesameYTMrate YTM=(((MaturityValue PurchasePrice)/Yearsto Maturity) Coupon)/ (Maturity Value*0.4 Purchase Maturity) +Coupon)/(MaturityValue 0.4+Purchase Price*0.6)

RelationshipbetweenBondPrices,Time toMaturity&InterestRates
Priceyieldrelationshipbetweenbondsisnotastraightline,but

isconvex.Thismeansthatpricechangesforyieldchangesare notsymmetrical,forincreaseanddecreaseinyield t ti l f i dd i i ld Thesensitivityofpricetochangeinyieldisnotuniformacross bonds.Therefore,forasamechangeinyield,dependingonthe bonds Therefore for a same change in yield depending on the kindofbondoneholds,thechangesinpricewillbedifferent Higher the term to maturity of the bond greater the price Higherthetermtomaturityofthebond,greatertheprice sensitivity.Pricesensitivitiesarehigherforlongertenorbonds, whileintheshorttermbond,onecanexpectrelativeprice while in the short term bond, one can expect relative price stabilityforawiderangeofchangesinyield Lower the coupon, higher the price sensitivity. Other things Lowerthecoupon,higherthepricesensitivity.Otherthings remainingthesame,bondswithhighercouponexhibitlower pricesensitivitythanbondswithlowercoupons

TheYieldCurve
GraphicalrepresentationbetweenYTMandtermtomaturityis

calledtheyieldcurve The relationship is also called the term structure of interest Therelationshipisalsocalledthe termstructureofinterest ratesbecauseitrelatesyieldstotheterm(maturity)ofeach bond Ithelpstheinvestorstounderstandthecurrentandfuture markettrendsandthushelpsthemindecisionmaking Typesofyieldcurves:
Risingyieldcurve itindicatesthatlongtermbondsgenerallyhave

higherinvestorexpectationsandthushigheryield higher investor expectations and thus higher yield Downwardslopingyieldcurve(invertedyieldcurve) itindicates thatbondswithlongermaturityhaveloweryield.Thisyieldcurveis attributedtotheexpectationoffallinshortterminterestrates Humpshapedyieldcurve Flat yield curve Flatyieldcurve

TheoriesofTermStructureofInterest Rates
Themostcommonlyknowntheoriesthatattemptan

interpretationoftheshapeoftheyieldcurveare:
The expectation hypothesis This theory predicts that over any Theexpectationhypothesis Thistheorypredictsthatoverany

holdingperiod,returnswillbeequalforallbonds.Thenotionthat assertsthattheslopeoftheyieldcurveisattributabletoexpectations ofchangesinshortterminterestrates.Relativelyhighyieldsonlong of changes in short term interest rates Relatively high yields on long termbondsareattributedtoexpectationsoffutureincreaseinrates, whilerelativelylowyieldsonlongtermbonds(downwardsloping curve)areattributedtoexpectationsoffallingshorttermrates curve) are attributed to expectations of falling short term rates Theliquiditypreferencehypothesis Thereasonforupwardslopingin thecurveisinvestordemandforhigherexpectedreturnsonassetsthat areperceivedasriskier.Thepreferenceofinvestorsforgreaterliquidity makesthemwillingtoholdtheseshorterbondseveniftheydonot offerexpectedreturnsashighasthoseoflongtermbonds.Therisk premiumrequiredtoholdlongertermbondsiscalledaliquidity premium.Evenifratesareexpectedtoremainunchanged,theyield curvewillslopeupwardsduetoliquiditypremium

TheoriesofTermStructureofInterest Rates
Thepreferredhabitathypothesis thishypothesisrecognizesthat

themarketissegmentedandthatexpectationsofinvestorsarenot uniformacrossvarioustenors.Thehypothesisopinesthatdistinct uniform across various tenors The hypothesis opines that distinct categoriesofinvestorsexist,andthateachofthesecategories preferstoinvestatcertainsegmentsoftheyieldcurve.Thistheory suggeststhatdependingondemandandsupplyatvaryingtenorsof theyieldcurve,investorswillhavetoreceiveorpay,premiumsor discountstoshiftawayfromapreferredhabitat discounts to shift away from a preferred habitat

TheoriesofTermStructureofInterest Rates Summary

TermStructure Hypothesis Expectations p Hypothesis FlatYieldCurve Shortterm interestratesare notexpectedto change Upward Sloping Curve Shortterm interestratesare expectedto increase Downward Sloping Curve Shortterm interestratesare expectedto decrease Humped Shortterm interestratesare expectedto initiallyincrease andthendecrease Liquiditypremium ispositiveupto is positive up to certaintermafter whichit turns g negative Excessofsupply overdemandin the intermediate intermediate term

Liquidity Preference Preference Hypothesis

Thereisno Liquiditypremium Liquiditypremium liquiditypremium ispositivewith liquidity premium is positive with isnegativewith is negative with increaseinterm onlong termrates increaseinterm ascomparedto shorttermrates Demandand supplyare matchedatall matched at all maturities Excessofsupply overdemandin shortermaturities shorter maturities Excessofsupply overdemandin longermaturities longer maturities

PreferredHabitat Hypothesis

UsesofYieldCurve
ForecastingInterestRates UsefultoFinancialIntermediaries Detectingoverpricedandunderpricedsecurities Indicating tradeoff between maturity and yield Indicatingtrade offbetweenmaturityandyield

NumericalQuestions
Example1 AGOIbondofINR100eachhasacouponrateof

8%p.a.andmaturityperiodis10years.Ifcurrentmarketpriceis INR110,findYTM? INR 110 find YTM? Solution YTM=(((MaturityPrice PurchasePrice)/Yearsto

Maturity)+Coupon)/(MaturityPrice*0.4+PurchasePrice*0.6) YTM=(((100110)/10)+8)/(100*0.4+110*0.6) YTM=6.60%
Example2 AbondoffacevalueINR1000(couponrate10%

p.a.)andmaturityperiod20yearshascurrentmarketpriceof p a ) and maturity period 20 years has current market price of INR1050.DetermineYTM? Solution YTM=(((MaturityPrice PurchasePrice)/Yearsto ((( y )/
Maturity)+Coupon)/(MaturityPrice*0.4+PurchasePrice*0.6) YTM=(((10001050)/20)+100)/(1000*0.4+1050*0.6) YTM=9.47% YTM 9 47%

NumericalQuestions
E Example3 M V l 3 Mr.Verma i isconsideringinvestinginabondwhich id i i i i b d hi h

iscurrentlysellingforINR8,785.07.Thebondhas4yearsto maturity,aINR10,000facevalueand8%couponrate.Thenext annualinterestpaymentisdue1yearfromtoday.Thediscount factorforinvestmentofsimilarriskis10%. a)Calculateintrinsicvalueofthebond.ShouldMr.Verma a) Calculate intrinsic value of the bond Should Mr Verma purchasethisbondatitscurrentmarketprice? b)CalculateYTMofthebond?Basedonthiscalculation,should Mr.Verma purchasethisbond? M V h thi b d? Solution a)IntrinsicValueofabondisequaltothediscountedvalueof a) Intrinsic Value of a bond is equal to the discounted value of thecashflows,Thus, IntrinsicValue=800/(1.10^1)+800/(1.10^2)+800/(1.10^3)+ 10800/(1.10^4) 10800/(1 10^4) IntrinsicValue=9,366.03.Sinceitsintrinsicvalueishigherthan p p themarketprice,thebondisunderpricedandMr.Verma shouldpurchasethisbondatthecurrentmarketprice

NumericalQuestions
Solution

b)YTM=(((MaturityPrice PurchasePrice)/YearstoMaturity) ) ((( y ) y)

+Coupon)/(MaturityPrice*0.4+PurchasePrice*0.6) YTM=(((100008785.07)/4)+800)/(10000*0.4+8785.07*0.6) YTM=11.91%.SinceYTMisgreaterthanthediscountrate,Mr. Verma shouldpurchasethisbond

NumericalQuestions
Example4
Particulars MarketPrice Face Value Maturity Coupon BondA 95 100 5years 10% BondB 95 100 10years 10%

a)CalculateYTM? b)Ifyieldincreasesby1%,calculatethebondpriceofbondA andbondB?

NumericalQuestions
Example5 Letusconsidertwobonds BondA(coupon

12.5%)andBondB(zerocouponbond).BondAandBond Bhasmaturityof7yearswithYTMof15%. a)Calculatethemarketpriceofthesebonds? b)Alsoanalysetheimpactofchangeininterestratesby1% onthemarketpriceofthesebonds? p