Summary of chapter 20 : The term structure of interest rates

The most prevalent risks associated with an investment in a debt security include the risk of default, the coupon reinvestment risk, and the risk of inflation. Relying on financial analysis, the risk of default can be isolated and analysed separately. However, the other two risks lie at opposite ends of the risk scale. Investors factor them into the risk equation through a liquidity premium, which depends on the maturity of the debt security.

Rates of return on bonds with different maturity dates can be plotted on a graph known as the yield curve. In order to avoid distortions linked to coupon rates of bonds, it is better to analyse zero coupon curves that can be reconstituted on the basis of the yield curve.

The shape of the yield curve depends on changes in expectations about short-term rates and the liquidity premium that investors will require for making a long-term investment. In a risk-free environment, the long-term rate at n years is a geometrical average of short-term rates anticipated for future periods. Generally, there is a positive link between the interest rate of a financial asset and its duration, which is where the rising yield curves come from. However, the yield curve can also slope the other way, especially during a recession.

Different mathematical models are now seeking to model and anticipate the shape of yield curves and how they will change on the basis of simple parameters.

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