15.

433 INVESTMENTS
Class 14: The Fixed Income Market
Part 2: Time Varying Interest Rates and Yield Curves

Spring 2003
 T-Bill Rates (monthyly, %)
Ju
n-

0
2
4
6
8
10
12
85

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86

Ju
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87

Ju
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88

Ju
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89

Ju
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90

Ju
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91

Ju
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92

Ju
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93

Figure 1: Time varying interest rates, Source: Bloomberg.

US0001M
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94

Ju
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95
US0003M

Ju
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96

Ju
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97

Ju
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98

Ju
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99
Time-Varying Interest Rates

Ju
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00

Ju
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01
 A Model for Stochastic Interest Rates

Let rt be the time-t one-period interest rate:

rt+1 = rt = k (r̄ − rt ) + σ · εt+1 (1)

To be consistent with our earlier notation, rt = rt,1 !

Important:

• εt is the random shock that occurs at time t.

• The shocks follow a standard normal distribution.

• The shocks are independent across time.

• k, r, and σ are constant coefficients.

 • The Coefficients and the Moments

r is the long-run mean of the interest rate.

E (rt ) =? (2)

σ is related to the volatility of the interest rate.

var(rt ) =? (3)

k captures the rate at which the interest rate reverts to its long-run
mean, r̄, 0 < k <:

cov(rt , rt+1 ) =? (4)

 The Risk of Rolling Over

At time t, let rt be zero-coupon interest rate with maturity n. Consider

the value of dollar by following the two investment strategies:

1. Long-term: invest in the (2) two-period bond.

e2·rt,2 (5)

2. Short term: invest in the (1) one-period bond and roll over at time t
+ 1.

ert,1 ·rt+1,1 (6)

The long-term investment is riskless, while the short-term investment is

risky. In particular, it is exposed to the random shock εt that is unknown
at time t.
 Implication for the Yield Curve

The time-t value of $ 1 to be collected at t + 2:

1. The short-term strategy:

� �
−[rt,1 ·rt+1,1 ]
E e (7)

2. The long-term strategy:

e−2·rt,2 (8)

If investors are risk-neutral, then they are indifferent between the two
strategies, implying

1 1
rt,2 − rt,1 = k (r̄ − rt,1 ) − σ 2 (9)
2 4

When do we have an upward/downward sloping term structure?

 Term Structure of Interest Rates

0
1/1/1991

7/1/1991

1/1/1992

7/1/1992

1/1/1993

7/1/1993

1/1/1994

7/1/1994

1/1/1995

7/1/1995

1/1/1996

7/1/1996

1/1/1997

7/1/1997

1/1/1998

7/1/1998

1/1/1999

7/1/1999

1/1/2000

7/1/2000

1/1/2001

7/1/2001
FOMC 3 Month LIBOR

Figure 2: Term-structure of Fed-Rates and 3-month Libor-interest rates, source: Bloomberg Professional.

0
3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr 15 Yr 20 Yr 30 Yr

1.1.1995 1.1.1996 1.1.1997 1.1.1998

1.1.1999 1.1.2000 1.1.2001 1.1.2002

Figure 3: Term-structure of interest rates across time, source: Bloomberg Professional.

 Forward Rates

A forward interest rate is the interest rate implied by current zero rates
for a specified future time period.

Let rt,n1 and rt,n2 be the zero rates for maturities n1 , and n2 , respec­
tively. The forward rate for the period of time between t + nl and t + n2 :

n2 · rt,n2 − n1t,n1
ftn1 ,n2 = (10)
n2 − n 1

It is important to note that the forward rate ftn1 ,n2 is known at time t.
 Yield Curve and Expectations Hypothesis

The expectations hypothesis can be stated in the following two equiva­

lent ways:

1. The N-period yield is the average of expected future one-period yields:

1 � �
rt,N = · Et rt,(1) + rt+1,(1) + · · · + rt+N −1,(1) (11)
N

2. The forward rate equals the expected future spot rate:

ftN,N +1 = Et rt+N,(1)
� �
(12)

Implications: a positive yield spread must be associated with rising in­

terest rates.
 Liquidity Preference and Yield Curve

Investors prefer to preserve their liquidity and invest funds for short pe­
riods of time.

Borrowers, on the other hand, usually prefer to borrow at fixed rates

for long periods of time.

In practice, to match depositors with borrowers and avoid interest rate

risk, financial intermediaries raise long-term interest rates relative to ex­
pected future short-term interest rates.

This strategy reduces the demand for long-term fixed-rate borrowing

and encourages investors to deposit their funds for the long-term.
 Market Segmentation and Yield Curve

Different institutions invest in bonds of different maturities and do not

switch maturities.

The short-term interest rate is determined by supply and demand in

the short-term bond market; the medium-term interest rate is deter-
mined by supply and demand in the medium-term bond market; . . .

There need be no relationship between short-, medium-, and long-term

interest rates.
 Repo Market

Repurchase agreement - a sale of a security with a commitment to buy

the security back at a specified price at a specified date.

• overnight repo (1 day)

• term repo (longer)

Repo Example: You are a dealer and you need $ 10 mio. to purchase
some security.
Your customer has $ 10 mio. in his account with no use. You can offer
your customer to buy the security for you and you will repurchase the
security from him tomorrow. Repo rate 6.5%.

Compute: What is the profit for the client allowing such a transaction?

Solution: Then your customer will pay $ 9’998’185 for the security and
you will return him $ 10 mio. tomorrow.

0.065
$9� 998� 185 · = $1� 805 (13)
360
This is the profit of your customer for offering the loan.
Note that there is almost no risk in the loan since you get a safe security
in exchange.
Focus:
BKM Chapter 15

• p. 456-460

• p. 461-469

Style of potential questions: Concept check questions, p. 474 ff. ques­

tion 8, 10, 14
 Preparation for Next Class

Please read:

• BKM Chapter 16, 22 & 23.