FINS2624 Lecture Notes - Lecture 2: Spot Contract, Iterative Method, Yield Curve
2 – Term Structure of Interest Rates
T-period spot rate – interest rate today for a t-period investment & no cash flows over
investment period eept for at aturit (also ko as zero rate’)
Use t-period spot rate to determine price of a t-period bond
• Use this price to determine the YTM of the t-period bond
• Values only the same in the case of zero-coupon bonds
Term Structure: Relationship between spot rates & horizons (aka pure’ yield curve)
Price of a t-year zero coupon bond is given by:
Iteratie ethod for solig spot rates oer ultiple periods is ko as bootstrapping’
• Using y1 to find y2, y2 to find y3 etc
Forward Rates: Interest rates for investments agreed upon today but take place in future
Determining multi-period forward rate:
Expectations Hypothesis: Market expectations on future interest rates determine the
spot rates over different horizons
• Term structure is typically upward sloping
• Unlikely to be true most of the time – EH explains only part of term structure
Liquidity Preference Hypothesis: Issuers prefer longer-term bonds than investors
• Liquidity premium necessary to induce short-term investors to hold long-term bonds
• Results in higher yields for long-term bonds – upward-sloping term structure
• Could also e geeralized as the preferred haitat theor
Assuming investor preferences could go either way
Likely that both theories are at work, so that:
• If investors prefer longer horizon, L should be negative to induce investment in
shorter horizons
find more resources at oneclass.com
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Document Summary
T-period spot rate interest rate today for a t-period investment & no cash flows over investment period e(cid:454)(cid:272)ept for at (cid:373)aturit(cid:455) (also k(cid:374)o(cid:449)(cid:374) as (cid:858)zero rate") Use t-period spot rate to determine price of a t-period bond: use this price to determine the ytm of the t-period bond, values only the same in the case of zero-coupon bonds. Term structure: relationship between spot rates & horizons (aka (cid:858)pure" yield curve) Price of a t-year zero coupon bond is given by: Iterati(cid:448)e (cid:373)ethod for sol(cid:448)i(cid:374)g spot rates o(cid:448)er (cid:373)ultiple periods is k(cid:374)o(cid:449)(cid:374) as (cid:858)bootstrapping": using y1 to find y2, y2 to find y3 etc. Forward rates: interest rates for investments agreed upon today but take place in future. Expectations hypothesis: market expectations on future interest rates determine the spot rates over different horizons: term structure is typically upward sloping, unlikely to be true most of the time eh explains only part of term structure. Assuming investor preferences could go either way.
