1. V: Bonds 14: Term Structure of Interest Rates

2. Chapter 14: Term Structure of Interest Rates Term Structure  $1000  (1 Year CDs)@ 3%  (2 Year CD)@ 4%  $1000  (1.03)(1+X) = ??  (1.04) 2 = $1081.60 © Oltheten & Waspi 2012

3. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Decreasing Rates  Let x = 4% 2 (1 Year CDs) < 2 Year CD $1000(1.03)(1.04)<$1000(1.04) 2 < $1081.60 Increase in demand increases price and decreases yield on 2.year CDs

4. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Increasing Rates  Let x = 6% 2 (1 Year CDs) > 2 Year CD $1000(1.03)(1.06)>$1000(1.04) 2 > $1081.60 Decrease in demand decreases price and increases yield on 2.year CDs

5. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Equilibrium  The market predicts 2 (1 Year CDs) = 2 Year CD $1000 (1.03)(1+X)=$1000 (1.04) 2 X = 5.0097% Half the smart money is on lower rates and half the smart money is on higher rates

6. Chapter 14: Term Structure of Interest Rates Term Structure Yield Curve Theoretical Predictions © Oltheten & Waspi 2012

7. Chapter 14: Term Structure of Interest Rates Yield Curve 1999-2013 © Oltheten & Waspi 2012

8. Chapter 14: Term Structure of Interest Rates Normal Yield Curves © Oltheten & Waspi 2012

9. Chapter 14: Term Structure of Interest Rates Flat Yield Curves © Oltheten & Waspi 2012

10. Chapter 14: Term Structure of Interest Rates Inverted Yield Curve © Oltheten & Waspi 2012

11. Chapter 14: Term Structure of Interest Rates Yield Curve 2007-2013 © Oltheten & Waspi 2012

12. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Deriving the Yield Curve  Yield is a function of  Term to maturity  Coupon rate  Call provisions  Liquidity  Risk of Default  Tax implications

13. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Treasury Securities  Represents debt of the US Department of the Treasury  Largest most liquid capital market in the world  Trade in terms from 1 day to 30 years

14. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Deriving Term Structure  Yield is a function of  Term to maturity  Coupon rate  Call provisions  Liquidity  Risk of Default  Tax implications Don’t have to worry about these any more

15. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Treasury Securities  T-Bills  < 1 year  Discount paper  T-Notes  2years to 10 years  Semi-annual coupon  T-Bonds  >10 years  Semi-annual coupon

16. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Observation #1: 6 month rate  Bloomberg shows  6 month T-Bill trading at a yield of 8%* *hypothetical data

17. Chapter 14: Term Structure of Interest Rates Yield Curve © Oltheten & Waspi 2012

18. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Observation 2: 12 month rate  Bloomberg shows  12 month T-Bill trading at a yield of 8.3%* *hypothetical data

19. Chapter 14: Term Structure of Interest Rates Yield Curve © Oltheten & Waspi 2012

20. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Observation #3: 18 month rate  Bloomberg shows  18 month 8.5% T-Note trading at a yield of 8.9%*  Is the 0.6% increase in yield because the bond is 6 months longer or because it has coupon payments? 18 month 8.5% Yield: 8.9% 12 month 0% Yield: 8.3%

21. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Coupon Rate 8.9% ?% 8.5% Yield Curve

22. Chapter 14: Term Structure of Interest Rates Buy the Note … Department of the Treasury Principal Sum of $10,000 due April 15, 2015 with interest calculated at 8.5% $425 April 15, 2014 $425 October 15, 2014 $425 April 15, 2015 © Oltheten & Waspi 2012

23. Chapter 14: Term Structure of Interest Rates 1.... for a total of $9,944.97 © Oltheten & Waspi 2012

24. Chapter 14: Term Structure of Interest Rates 2. Remove the coupons Department of the Treasury Principal Sum of $10,000 due April 15, 2015 with interest calculated at 8.5% $425 April 15, 2015 $425 April 15, 2014 $425 October 15, 2014 © Oltheten & Waspi 2012

25. Chapter 14: Term Structure of Interest Rates 3. Sell the coupons separately $425 April 15, 2014 $425 October 15, 2014 © Oltheten & Waspi 2012

26. Chapter 14: Term Structure of Interest Rates 4. Sell the final coupon and principal … Department of the Treasury Principal Sum of $10,000 April 15, 2015 with interest calculated at 8.5% $425 April 15, 2015 © Oltheten & Waspi 2012

27. Chapter 14: Term Structure of Interest Rates … for $9,144.51 Price of the 18 month note Proceeds from 6 month coupon Proceeds from 12 month coupon Required proceeds from the 18 month coupon and principal © Oltheten & Waspi 2012

28. Chapter 14: Term Structure of Interest Rates 5. Which determines the zero coupon yield $10,425 April 15, 2015 © Oltheten & Waspi 2012

29. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Coupon Rate 8.9% Yield Curve

30. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Yield Curve

31. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Observation #4: 24 month rate  Bloomberg shows  24 month 9% T-Note trading at a yield of 8.92%  Calculate the 24 month zero-coupon yield *hypothetical data

32. Chapter 14: Term Structure of Interest Rates © Oltheten & Waspi 2012 Yield Curve

33. Bonds III