Page 3 - PowerPoint Presentation
P. 3

LOS 34.a: Describe relationships among spot rates,                                        READING 34: THE TERM STRUCTURE AND
    forward rates, yield to maturity, expected and realized                                                    INTEREST RATE DYNAMICS
    returns on bonds, and the shape of the yield curve.
                                                                                        MODULE 34.1: SPOT AND FORWARD RATES, PART 1

     SPOT RATES
     If a zero-coupon bond pays no coupon, then it must promise a single sum
     (FV) that is higher than par (PV) to attract investment: the implied rate
     separating PV and FV is ‘interest / YTM’ (called spot rate, S in this case).
                                                                    T



                                                                       Term structure of spot rates (spot yield curve) is a graph of all
                                                                       short-term zero-coupon bonds for different securities (spot rate S )
                                                                                                                                           T
                                                                       against their maturity, T. Its shape changes continuously with the
                                                                       market prices of spot curve bonds.


                                                                       FORWARD RATES
                                                                       Annualized interest rate on a bond/loan to be initiated in future. The
                                                                       term structure of forward rates is called the forward curve.

                                                                        Forward curves and spot curves are mathematically related: Say:


                                                                        • f(j,k) = the annual interest rate on a k-year loan starting in j years.








     F (j,k)  = the forward price of a $1 par zero-coupon bond maturing at time j+k delivered at time j.
     F (j,k)  = the discount factor associated with the forward rate.

                                                                                                      We got to try a non-zero
                                                                                                      coupon bond this time…
   1   2   3   4   5   6   7   8