FIN-2Lecture 9-The Term Structure of Interest Rates and Yield Derivation

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Unformatted text preview: ent maturities will sell at different yields – long-term bonds = higher yield; and vice versa Consider the following zero-coupon bonds with face value Maturity Years Yield Price FVn x [(1+y)-n] (RRR) €1,000 1 5% 1000 x 1.05-1 €952.38 2 6% 1000 x 1.06-2 €889.99 3 7% 1000 x 1.07-3 €816.30 §We 4 borrow this 8% concept and apply€it to coupon bonds 1000 x 735.03 1.08-4 §Investors consider each coupon payment (cash flow) as at least potentially sold off separately as a stand-alone zerocoupon bond The Computation Consider a two-year bond strategy: § Strategy 1: buy a 2-year zero offering a 2-year yield of 6% 2 § Face Value €1,000 1 § § Strategy 2: invest €890 in a 1-yr Zero with y=5%; on 2 maturity re-invest the proceeds in another 1-yr Zero 1 The Computation 2 2 The Computation Consider a 3-year bond strategy: § Strategy 1: buy a 3-year zero offering a 3-year yield of 7%; Face Value €1,000 and hold it until maturity. § 1 § 2 3 Strategy 2: invest €816.30 in a 2-yr Zero with y=6%; on maturity re-invest the proceeds in another 1-yr Zero at 9.025% The Computation This tells us why the yield curve may take on different shapes at different times When next year’s short rate r2 &gt; r1, the average of the two rates will be higher than today’s rate = upwardsloping curve 1 2 3 Initial Interpretation § The yield curve reflects the Market’s assessment of coming interest rates. § It helps us read investors’ expectations of future interest rates and the general economic trend. § The forward rate is that interest rate that would need to prevail in the future to make the long and short-term investments equally attractive – ignoring Risk § Short-term investors will shy away from long-term bonds unless they offer expected returns than that offered by short-term bonds – investor’s will require a premium (liquidity premium). Bond Premiums §Liquidity Premium – which compensates short-term investors for the uncertainty about the price at which they will be ab...
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