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

2. Term Structure Predict X $1000 $1000 (1 Year CDs) @ 3%
(1.04) = $
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3. Increase in demand increases price and decreases yield on 2.year CDs
Decreasing Rates
Let x = 4%
2 (1 Year CDs) < 2 Year CD $1000(1.03)(1.04) < $1000(1.04) $ < $
Increase in demand increases price and decreases yield on 2.year CDs

4. Decrease in demand decreases price and increases yield on 2.year CDs
Increasing Rates
Let x = 6%
2 (1 Year CDs) > 2 Year CD $1000(1.03)(1.06) > $1000(1.04) $ > $
Decrease in demand decreases price and increases yield on 2.year CDs

5. Equilibrium The market predicts
2 (1 Year CDs) = 2 Year CD $1000 (1.03)(1+X) = $1000 (1.04) X = %
Half the smart money is on lower rates and half the smart money is on higher rates

6. Term Structure Theoretical Predictions Yield Curve
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7. Normal Yield Curves
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8. Flat Yield Curves
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9. Inverted Yield Curve
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10. Deriving Term Structure
Yield is a function of
Term to maturity
Coupon rate
Call provisions
Liquidity
Risk of Default
Tax implications

11. 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

12. Deriving the Yield Curve
Yield is a function of
Term to maturity
Coupon rate
Call provisions
Liquidity
Risk of Default
Tax implications

13. Treasury Securities T-Bills T-Notes T-Bonds < 1 year Discount paper
2years to 10 years
Semi-annual coupon
T-Bonds
>10 years

14. Observation #1: 6 month rate
Bloomberg shows
6 month T-Bill trading at a yield of 8%*
*hypothetical data

15. Yield Curve
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16. Observation 2: 12 month rate
Bloomberg shows
12 month T-Bill trading at a yield of 8.3%*
*hypothetical data

17. Yield Curve
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18. 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%
12 month 0%
Yield: 8.9%
Yield: 8.3%

19. Yield Curve
8.9% ?%
Coupon Rate
8.5%
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20. Department of the Treasury Principal of $10,000 due .
Buy the Note …
Department of the Treasury Principal of $10,000 due
with interest calculated at 8.5%
$425
August 20, 2019
August 20, 2018
February 20, 2019
August 20, 2019
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21. ... for a total of $9,944.97
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22. Department of the Treasury Principal of $10,000 due .
2. Remove the coupons
Department of the Treasury Principal of $10,000 due
with interest calculated at 8.5%
$425
August 20, 2019
$425
$425
August 20, 2018
August 20, 2019
February 20, 2019
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23. 3. Sell the coupons separately
$425
August 20, 2018
$425
February 20, 2019
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24. 4. Sell the final coupon and principal …
Department of the Treasury Principal of $10,000 due with interest calculated at 8.5%
$425
August 20, 2019
August 20, 2019
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25. … for $9,144.51 Price of the 18 month note -$9,944.97
Proceeds from 6 month coupon
$408.65
Proceeds from 12 month coupon $
Required proceeds from the 18 month coupon and principal
$9,144.51
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26. 5. Which determines the zero coupon yield
$10,425
August 20, 2019
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27. Yield Curve
8.9%
Coupon Rate
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28. Yield Curve
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29. 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

30. Bonds III