FIXED-INCOME SECURITIES

Chapter 3

Term Structure of Interest

Rates: Empirical Properties
and Classical Theories
 Outline

• Types of TS
• Shapes of the TS
• Dynamics of the TS
• Stylized Facts
• Theories of the TS
 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
 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 5 10 15 20 25 30
maturity

Quasi-Flat
 Increasing
JAPAN YIELD CURVE AS ON 04/27/01

2.50%

2.00%

1.50%
par yield

1.00%

0.50%

0.00%
0 5 10 15 20 25 30
maturity

Increasing
 Decreasing
UK YIELD CURVE AS ON 10/19/00

6.00%

5.50%
par yield

5.00%

4.50%
0 5 10 15 20 25 30
maturity

Decreasing (or
inverted)
 Humped (1)
EURO YIELD CURVE AS ON 04/04/01

5.50%

5.00%
par yield

4.50%

4.00%
0 5 10 15 20 25 30
maturity

Humped
(decreasing then
increasing)
 Humped (2)
US YIELD CURVE AS ON 02/29/00

7.00%

6.50%
par yield

6.00%

5.50%
0 5 10 15 20 25 30
maturity

Humped
(increasing then
decreasing)
 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
 Example – US YTM TS
US term structure of government YTM

YTM

0
4
8 4
J-01
12 S-00
16 M-00
maturity 20 J-00

24 S-99 time
M-99
28
J-99
 Stylized Facts (1) : Mean Reversion

• Mean reversion: high (low) values tend to be

followed by low (high) values
• Example: 10 Y swap rate versus Dow Chemical
50

45

40

35

30
D o w C h e m ic a l e n U S $
25
T a u x d e sw ap 10 an s en %
20

15

10

0
01/01/1990

01/01/1991

01/01/1992

01/01/1993

01/01/1994

01/01/1995

01/01/1996

01/01/1997

01/01/1998

01/01/1999
 Stylized Facts (2) : Correlation

• Rates with different maturities are

– Positively correlated one another
– Not perfectly correlated though (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
3M 0.999 1
6M 0.908 0.914 1
1Y 0.546 0.539 0.672 1
2Y 0.235 0.224 0.31 0.88 1
3Y 0.246 0.239 0.384 0.808 0.929 1
4Y 0.209 0.202 0.337 0.742 0.881 0.981 1
5Y 0.163 0.154 0.255 0.7 0.859 0.936 0.981 1
7Y 0.107 0.097 0.182 0.617 0.792 0.867 0.927 0.97 1
10Y 0.073 0.063 0.134 0.549 0.735 0.811 0.871 0.917 0.966 1
 Stylized Facts (3)

• The evolution of the interest rate curve can be split

into three standard movements
– Shift movements (changes in level), which account for 70 to 80% of
observed movements on average
– A twist movement (changes in slope), which accounts for 15 to 30% of
observed movements on average
– A butterfly movement (changes in curvature), which accounts for 1 to 5% of
observed movements on average

• That 3 factors account for more than 90% of the

changes in the TS is valid
– Whatever the time period
– Whatever the market
 Shift Movements

Upwar -Downward Shift Movements

4
yield (in %)

0
0 5 10 15 20 25 30
maturity
 Twist Movements
Flattening - Steepening Twist Movements

5
yield (in %)

0
0 5 10 15 20 25 30
maturity
 Butterfly Movements
Concave - Convex Butterfly Movements

5.5

4.5
yield (in %)

3.5

2.5

2
0 5 10 15 20 25 30
maturity
 Theories of the Term Structure

• Studying the TS boils down to wondering about the

preferences of participants' for curve maturities
– Investors
– Borrowers

• Indeed, if they were indifferent in terms of maturity

– Interest rate curves would be invariably flat
– Notion of TS would be meaningless

• Market participants' preferences can be guided

– By their expectations
– By the nature of their liability or asset
– By the level of the risk premiums they require
 Theories of the Term Structure

• Term structure theories attempt to account for the

relationship between interest rates and their residual
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
 Theories of the Term Structure

• Remember:
1+R0,t = [(1+ R0,1)(1+ F1,2)(1+ F2,3)…(1+ Ft-1,t)]1/t
• 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 is invariably located on a
given curve portion (short, long)
– As a result, short and long curve segments are perfectly impermeable
 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: 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?
 Pure Expectations (Cont’)

• Consider a long-term investor (2-year horizon)

– His objective is maximizing his return on the period
– Either invests in a long 2-year security or invests in a short 1-year security,
then reinvests in one year the proceeds in another 1-year security
• Before interest rates adjust at the 6% level
– First option returns an annual return of 5% over two years
– Second option returns 5% the first year and, according to his expectations,
6% the second year, i.e., 5.5% on average per year over two years
• Investor will thus buy short bonds (one year) rather
than long bonds (two years)
– Similar behavior for the short-term investor (return on 2-y bond after 1 year
is 4.05%=(5+105/1.06-100)/100 < 5% (return on 1 year bond)
– As a result
• The price of the one-year bond will increase (its yield will decrease)
• The price of the two-year bond will decrease (its yield will increase)
– The curve will steepen
 Pure Expectations (Cont’)

• In summary, market participants behave collectively

to let the relative appeal of one maturity compared to
the others disappear
• In other words, they neutralize initial preferences for
some curve maturities
• The pure expectations theory has an important
limitation
– Investors behave in accordance with their expectations for the unique
purpose of maximizing their investment return
– They are risk neutral - They do not take into account the fact that their
expectations may be wrong
– The pure risk premium theory includes this contingency
 Pure Risk Premium

• Indeed, if forward rates were perfect predictors of

future rates, future bond prices would be known with
certainty
• Unfortunately, it is not the case
– Future interest rates are unknown (re-investment risk)
– Future bond prices are unknown (market risk)
• Example: an investor with a 3 years horizon
– May invest in a 3-year zero coupon bond and holding it until maturity
– May invest in a 5-year zero coupon bond and selling it in 3 years
– May invest in a 10-year zero coupon bond and selling it in 3 years
• What would you prefer?
– Return of the first investment is known ex-ante with certainty
– Not the case for the 2nd and 3rd
– We don’t know the price of these instruments in three years
 Pure Risk Premium (con’t)

• However, we know something about their risk

(volatility)
• A bond price risk measured by price volatility
– Tends to increase with maturity (P’(r)>0)
– In a decreasing proportion (P’’(r)<0)
• Assume interest rates increase to 6%
– 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 differ about the shape
of the risk premium
 Pure Risk Premium - Liquidity

• Risk premium increases with maturity in a

decreasing proportion
• Formally
1+Ro,t = [(1+ R0,1) (1+ E(R1,2)+ L2) (1+ E(R2,3)+ L3)… (1+ E(Rt-1,t)+ Lt)]1/t
• Lk is the liquidity (actually risk) premium required by
the market to invest in a bond maturing in k years
0 = L1 < L2 < L3 < ... < Lt
L2 -L1 > L3 -L2 > L4 -L3 > ... > Lt -Lt-1
• Hence, an investor will be interested in holding all
the longer bonds as their return contains a high risk
premium, offsetting their higher volatility
• Implies that a “normal” TS is increasing
 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)
• 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
 Market Segmentation

• Extreme version of pure risk premium theory

– Investors never move away from preferred habitat (infinite risk premia)
– Commercial banks invest on a short/medium term basis
– Life-insurance companies and pension funds invest on a long term basis
• Shape of the curve determined
– By supply and demand on short and long-term bond markets
– Insurance comp., pension funds are structural buyers of long-term bonds
– Commercial banks' behavior is more volatile: banks prefer to lend money
directly to corporations and individuals than invest in bond securities
• Their demand for short-term bonds is influenced by
business conditions
– During growth periods, sell bonds to meet corporations' and individuals'
demand for loans => relative increase in short-term yields
– During slow-down periods, corporations and individuals pay back their
loans, thus increasing bank funds; then banks invest in short-term bonds
=> relative decrease in short-term yields compared to long-term yields
 Biased Expectations Theory and
Stochastic Approach

• All these theories are not mutually exclusive

• Biased expectations theory is an integrated
approach
– Combines pure expectations theory and risk premium theory
– Postulates that TS reflects market expectations of future interest rates as
well as permanent liquidity premia that vary over time
• Thus, all curve shapes can be accounted for
• Stochastic Approach
– Uncertainty about future interest rates is not implicit in current TS
– Difficult to correctly anticipate future interest rates driven by surprise effects
– TS modeled as a predictible term plus a stochastic process
– This theory represents an alternative to traditional theories generally used
for pricing and hedging contingent claims
 Synthesis – Explanation of TS
Shapes

Curve type Pure expectations Risk premium Biased expectations Market segmentation
Quasi-flat curve The market expects The risk premium rises The market expects a relative Banks have slightly more funds to
a moderate increase with maturity in a interest rate stability; the risk premium invest than insurance companies.
in interest rates. decreasing proportion. rises with maturity in a decreasing
proportion.
Rising curve The market expects The risk premium rises The market expects a great increase Banks have much more funds to
a great increase in with maturity. in interest rates ; the risk premium invest than insurance companies.
interest rates. rises with maturity in a decreasing
proportion.
Falling curve The market expects The liquidity premium The market expects a great decrease Banks have far less funds to
a great decrease in cannot explain it; in interest rates ; the risk premium invest than insurance companies.
interest rates. according to the preferred rises with maturity in a decreasing
habitat, the risk premium proportion.
decreases with maturity.
Humped curve The market expects The liquidity premium The market expects a decrease followed Banks and insurance companies
first an increase or cannot explain it; or not by an increase in interest rates; have the same amount of funds to
decrease in interest rates, according to the preferred the risk premium rises with maturity invest; their investment segments
and then a decrease or habitat, the risk premium in a decreasing proportion. are disjoint.
increase in interest rates. increases or decreases
with maturity, and then
decreases or increases
with maturity.