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

05 1 95238 2 6 1000 x 106 2 88999 3 7 1000 x 107 3

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

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 > 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...
View Full Document

Ask a homework question - tutors are online