Tutorial 4 – Analysis of the Yield Curve

Problems

13-15 This question requires calculations relating to the

yield curve and the expectations theory.
(Note that the text uses the notation nik where:
n = the number of periods until the future rate starts
k = the number of periods over which the future rate
applies)

(a) If an investor possesses the following information,

and expectations on Treasury bond yields are:
0 𝑖1 = 4.25% p.a.
𝐸1 𝑖1 = 5.20% p.a.
calculate the yield on a two-year bond (0i2) that would
result in the investor being indifferent between placing
funds in a one-year bond now, to be followed by a one-
year bond in a year’s time, or placing the funds in a two-
year bond now.

ANSWER
Calculation using geometric average:
0.5
0𝑖2 = [(1 + 0𝑖1 )(1 + 𝐸 1𝑖1 )] – 1
= [(1.0425)(1.0520)]0.5 – 1
= [1.09671]0.5 – 1
= 4.723923 %

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(b) You are given the following data:
0 𝑖1 = 4.00% p.a.
𝐸1 𝑖1 = 5.00% p.a.
𝐸2 𝑖1 = 5.75% p.a.
𝐸3 𝑖1 = 6.20% p.a.
On the basis of the expectations theory of the yield
curve, complete the following.

(i) Calculate the 0i2, 0i3 and 0i4 rates.

ANSWER
1/𝑛
𝑓𝑜𝑟𝑚𝑢𝑙𝑎: 0 𝑖𝑛 = [(1 + 0 𝑖1 ) (1 + 𝐸1 𝑖1 ) (1 + 𝐸2 𝑖1 ) ⋯ (1 + 𝐸 𝑛−11𝑖 1)] −1

(𝑖) 0 𝑖2 = [(1 + 0.04) (1 + 0.05)]1/2 – 1

= 4.498804%

(𝑖𝑖) 0 𝑖3 = [(1 + 0.04) (1 + 0.05) (1 + 0.0575]1/3 – 1

= 4.914216%

(𝑖𝑖𝑖) 0 𝑖4 = [(1 + 0.04) (1 + 0.05) (1 + 0.0575) (1 + 0.0620]1/4 – 1

= 5.234195%

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(ii) Explain what is meant by implicit forward rates of
interest.

ANSWER
Expectations theory, proposes that the a yield curve
reflects market participants’ collective expectations
about future interest rates.

That is, implicit in the yield curve there are indicators,

or information, on a series of expectations about
future interest rates.

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(iii) List the full range of one-year implicit rates of
interest that could be calculated from the yield curve
data that provide the current rates on bonds with one,
two and three years to maturity.

ANSWER

Implicit interest rates that could be calculated on the

basis of the above yield curve are 1i1 , 1i2 and 2i1.

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(iv) Given the following yield curve data, calculate the
2i2, 1i2 and 3i1 implicit rates:

𝑖1 = 4.30% p.a.
𝑖2 = 5.15% p.a.
𝑖3 = 5.80% p.a.
𝑖4 = 6.25% p.a.

ANSWER

formula:
(1+0 𝑖𝑛+𝑘 )𝑛+𝑘 1
𝐸𝑛 𝑖𝑘 = [ ]𝑘 − 1
(1+0 𝑖𝑛 )𝑛
where:
n = the number of periods until the future rate starts
k = the number of periods over which the future rate
applies

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(i) Calculate 2i2 where: n=2; k=2
(1 + 0.0625) 4 0.5
2 i2 = [ ] −1
(1 + 0.0515) 2

= 7.361507%

(ii) Calculate 1i2 where: n=1; k=2

(1 + 0.0580)3 0.5
1 i2 = [ ] −1
(1 + 0.0430)1
= 6.558070%

(iii) Calculate 3i1 where: n=3; k=1

(1 + 0.0625) 4 1
3 i1 = [ ] −1
(1 + 0.0580) 3

= 5.135093%

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HO1-1 If a pure discount three-year bond sells for $782 and a pure
discount four-year bond sells for $733, what is the expected
12-month interest rate in three years’ time? Both have a face
value of $1000.

ANSWER

FV
MV =
(1+ 0 i 3 ) 3
1,000
782 =
(1+ 0 i 3 ) 3
i = 8.54198% p.a.
0 3

FV
MV =
(1+ 0 i 4 ) 4
1,000
(1+ 0 i 4 ) 4 =
733
0 i 4 = 8.07469% p.a.

(1+ 0 i 4 ) 4
(1+ 3 i 4 ) =
(1+ 0 i 3 ) 3
1.3642565
=
1.278723
= 1.0668486
i = 6.68% p.a.
3 4

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HO1-2 If 12-month interest rates are expected to be 6% in three
years time, describe how investors could take advantage of the
pricing in question 1. What impact would this have on interest
rates?

ANSWER

Based on Q1 above, investors would wish to manufacture an

“investment” to earn the higher interest rate of 6.68% p.a.
rather than the expected 6% p.a.

That is, they wish to BUY an instrument to cover the fourth

period.

Buy

Sell

Therefore will buy 4yr bond and sell 3yr bond.

yield on 4yr bond will fall

yield on 3yr bond will rise

3i4
will fall until an equilibrium in line with
expectations is established

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HO1-3 Twelve-month interest rates for the next four years are
expected to be 5%, 6%, 6.8% and 7.4% respectively. Calculate
the yield to maturity on:
i) a pure discount four-year bond, and
ii) a four-year 8% annual coupon bond.
Explain why there is a difference.
ANSWER

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HO1-4 An investor purchases the following debt instruments with a
$1,000 face value, for $826.44 and $1,000 respectively.
i) a pure discount two-year bond, and
ii) a two-year 10% annual coupon bond
Calculate the return after two years if immediately after
purchase interest rates
a) fall by 1% p.a.
b) remain constant, and
c) increase by 1`% p.a. on all maturities.
(Assume that the yield curve is flat).

ANSWER

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As a point of interest, question 4 could be repeated to
demonstrate that the return is more stable for the coupon
paying bond over the period 697 days. This is the “duration”
of the coupon bond.

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Preliminary calculations – the value of the bonds after 697
days:

Calculating Returns:

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13
Questions

13-6 Interest rates play an important role in monetary policy determinations,

economic performance and the business cycle, and the cost of funds. Financial
market participants must therefore understand the term structure of interest
rates.

a. Define in detail the term yield and explain how a yield curve is constructed.
ANSWER

• Yield—the total return on an investment; comprising interest receipts

and any capital gain or loss.
• Yield curve—a graph, at a single point in time, of yields on a specific type
of security with different terms to maturity.
• For example, it is possible to plot the yield, as at today, for bank bills that
have 30 days, 60 days, 90 days and 180 days to maturity.

b. Identify three different types of yield curves. Describe each of these yield
curves and draw a fully labelled diagram of each curve.
ANSWER

(1) Normal/positive/upward sloping yield curve—reflects the preference

for higher interest rates if funds are invested longer-term. Short-term rates
are lower than long-term rates.

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(2) Inverse/negative/downward sloping yield curve—illustrates that yield
declines as maturity lengthens. Short-term rates are higher than long-term
rates.

Humped yield curve—combines the normal yield curve and the inverse
yield curve and joined by a period of a flat or horizontal yield curve.

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13-7 Market participants observe that the yield curve is normal (upward
sloping). Use expectations theory to explain this observation.
ANSWER

• Expectations theory—the shape of a yield curve is a function of the

current and future short-term interest rates.
• That is, the return received on a continuous series of short-term
investments should be the same as that received for a longer-term
investment.
• An investor will therefore be indifferent as to whether they invest for a
short period or a longer period.
• For example, an investor has two options:
(1) invest today for a one-year period at 4 per cent per annum and
reinvest the funds in 12 months time; or
(2) invest the funds today for a two-year period at 4.5 per cent per
annum. The expectation theory will contend that the one-year investment
rate in 12 months time should be 5 per cent per annum (that is, 4.5% x 2
= 9% - 4% = 5%)
• The expectations theory implies that the yield curve is upward sloping
because market participants expect interest rates to increase. To be
precise, future short-term interest rates are expected to be higher than
current short-term interest rates.

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13-8 Over time, market participants observe that the yield curve has changed
from being upward sloping to being downward sloping. Use expectations
theory to explain why the yield curve has changed shape.
ANSWER

• A normal yield curve will result from expectations that future short-term
rates will be higher than current short-term rates.
• An inverse yield curve will result if the market expects future short-term
rates to be lower than current short-term rates.
• An inverse yield curve may emerge even though the central bank may
increase rates at the short end of the yield curve to achieve its monetary
policy objectives.
• Market participants expect that once those objectives have been
achieved, short-term rates will be lowered again.
• In this circumstance, long-term rates will not rise to the same extent as
the policy-induced change in short-term rates, and therefore the yield
curve will slope downwards.

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13-9 The segmented markets theory extends our understanding of factors
that influence the determination of interest rates.

a. Identify and explain two assumptions of the expectations approach that are
challenged by the segmented markets approach to interest rate
determination.
ANSWER

The segmented markets theory rejects two expectation theory

assumptions:
(1) All bonds are perfect substitutes for one another.
(2) Investors are indifferent between holding instruments with a short
term to maturity and holding instruments with a long term to maturity.

• Securities in different maturity ranges—for example, a 1 to 3 year range

versus a 9 to 10 year range—are not viewed by various market
participants as being perfect substitutes for one another.
• Whereas bonds with a very short term to maturity may well be close
substitutes for each other, and likewise for bonds with long terms to
maturity, a one-month-to-maturity bond is unlikely to be seen as a close
substitute for a 10-year bond.
• Some market participants have a preference for short-dated securities,
and others have a preference for longer-term maturities.
• That is, different investors have preferences for different segments of the
market.
• The particular preferences are motivated out of a desire by the various
participants to reduce the riskiness of their portfolios.
• Investors will seek to minimise their exposure to fluctuations in the prices
and yields associated with their assets and liabilities by matching the cash
flows and maturities of their assets and liabilities.
• For example, life offices have mainly long-term liabilities and therefore
tend to hold more longer-term assets.
• The implication of the segmented markets approach is that it is the
relative demands for and supplies of securities in the various maturity
ranges that determine yields.

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 • The shape and slope of the yield curve are determined by the relative
demand and supply conditions that exist along the maturity spectrum.

b. It may be argued that the segmented markets approach is negated by modern

risk management practices, arbitrage and speculation. Explain what is meant
by this assertion.
ANSWER

1. The segmented markets approach emphasises the risk management

motivation of market participants.
2. That is, the matching of cash flows and maturities of assets and liabilities
in order to minimise associated risk exposures.
3. By implication, this approach would cause discontinuities in a yield
curve, thus exposing significant speculation and arbitrage opportunities.
4. Arbitrageurs, who are indifferent about the maturity of the bonds they
hold, will sell and buy to take advantage of the discontinuities along the
yield curve.
5. Their actions will smooth out the yield curve; that is, remove the
segmentation distortions.
6. Therefore, it may be reasonable to argue that certain investors do have
segment preferences along a yield curve, but those preferences are
balanced by investors with different preferences: arbitrageurs and
speculators.

_____________________________

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