book 07 - Spot and Foward Yields [2004-11-24] - Page 1 of 19

Chapter 7
Spot and forward yields
Executive Summary

Many students and practitioners are somewhat perplexed when they first begin to deal
with fixed income securities and derivatives. On the one hand, for ease of quotation, bond
yields are expressed either as yields to maturity (YTM) or as par yields (par yield is the
yield to maturity of a fixed-rate bond priced at par). Yield to maturity, also known as
redemption yield, is used not only for bonds but also for bond futures’ conversion factors
(see chapter 12.2). Par yields are routinely used for interest rate swap quotations.
On the other hand, almost all analytical work on fixed income securities and
derivatives rests firmly on the concepts of spot and forward yields. Therefore, we shall try
to reconcile the YTM and the spot yield approaches in an easy and intuitive way, and then
introduce forward yields that are the cornerstone of interest rate derivatives and hedging.

Contents
7.1 - Spot yield curves and discount factors
7.2 - Pricing coupon and amortizing bonds
7.3 - Yield to maturity: the modern interpretation
7.4 - Par yield
7.5 - Forward yields: bootstrapping and interpolation
7.6 - Instantaneous forward yields *
7.7 - Limits of arbitrage-free forward pricing
7.8 - Appendix: zero coupon bonds and treasury strips

7.1 Spot yield curves and discount factors

7.1.1 Spot yields

A spot yield (often referred to as zero-coupon yield) is defined with reference to fixed-
income financial instruments reimbursed at maturity, without any intermediate payment of
coupons and/or principal. For example:

ƒ Discount securities (treasury bills, commercial paper, zero coupon bonds, etc.)

ƒ Other short-term fixed-income instruments, such as bank deposits, coupon bonds

with only the last coupon left, etc.
 book 07 - Spot and Foward Yields [2004-11-24] - Page 2 of 19

Most long-term fixed income securities and loans typically pay coupons before maturity.
Coupon payments (and sometimes amortizing principal) also apply to interest-rate and
currency swaps. Therefore, one could think that spot yields are relevant only for short-
term instruments, and for investment strategies based on zero-coupon bonds.
In reality, the spot yield approach is a lot more powerful than traditional yield-to-
maturity analysis, and is now widely used to price and structure all fixed income securities
and interest-rate derivatives. The spot yield approach also helps in gaining a deeper
understanding of risk measures, such as duration and convexity.

7.1.2 The basic equations

When dealing with spot and forward yields we often use a complex-looking but accurate
notation. For example, Y(T) indicates the spot yield over the time-horizon (T), and Y(0,t,T)
indicates the forward yield for the time horizon of length (T–t), as of time-zero. As usual,
time is expressed in years.
Take a security that promises to pay unconditionally V(T) at some future time, and is
priced at P(0) today. Using the symbols introduced in Chapter 3, we can define both a
value relative v(T) and a discount factor d(T).

V (T )
v(T ) =
P (0)
P (0)
d (T ) = = 1/ v (T )
V (T )

Discount factors and value relatives can be easily transformed into an annualized
compounded yield (Y).

Computing compounded yield

1
d (T ) =
⎡1 + Y (T )⎤ T
⎣ ⎦
1
⎛ 1 ⎞⎟ T
Y (T ) = ⎜⎜ ⎟ −1
⎜⎝ d (T ) ⎠⎟⎟

Example 7.1 - Compute the discount factor and the spot yield for a 4-year zero coupon
bond, face value of $1,000, priced at $800.
 book 07 - Spot and Foward Yields [2004-11-24] - Page 3 of 19

800
d (4) = = 0.80
1, 000

⎛ 1 ⎟⎞1/4
Y (4) = ⎜⎜ ⎟⎟ − 1 = 5.7371%
⎜⎝ 0.8 ⎠

7.1.3 U.S. bond yield quotation *

In the U.S. bond market, yields are quoted as if they were capitalized twice a year. The
historical origin of this peculiar (and somewhat impractical) convention reflects the fact
that in the U.S. (like in the UK) bonds traditionally pay interest twice a year. Therefore,
when the bond trades at par, its yield to maturity equals the coupon rate. In other words,
the U.S. bond yield convention means that the quoted yield is the semiannual yield
multiplied by two. Indicating with the subscript (us) this metric, we have:

U.S. bond yield quotation

2T
v(T ) = [1 + Yus (T ) / 2]

Yus (T ) = 2 ⎡⎢v (T ) − 1⎤⎥

1/ 2T
⎣ ⎦
=2 ( 1 + Y −1 )
Example 7.2 - Compute the spot yield, with the U.S. convention, for a 4-year zero coupon
bond, face value = $1,000, priced at $800.

1, 000
v(4) = = 1.25
800
Yus (4) = 2 ⎡⎢(1.25) − 1⎤⎥ = 5.6571%
1/8
⎣ ⎦

If we first make the necessity numerical conversion, this result is identical to that of
example 7.1:

2
⎛ 0.056571 ⎞
⎜1 + ⎟ = 5.7371%
⎝ 2 ⎠

We must also remember that in the United States bond prices and futures quotations are
not decimalized but are quoted in points and 32nds of a point. In some cases the
quotation may include half of a 32nd. For example:
 book 07 - Spot and Foward Yields [2004-11-24] - Page 4 of 19

U.S. bond quotation

103 : 8 = 105.25
16.5
98 :165 = 98 + = 98.515625
32

7.1.4 Spot yield curves (SYC) and discount factors

A spot yield curve is simply a curve that shows spot yield values as a function of time-to-
maturity. There are a few things to keep in mind:

ƒ Spot yield curves are usually constructed based on actively traded securities (with
reliable market prices) that are relatively homogeneous in terms of currency of
denomination, credit risk and liquidity. Therefore, we have many possible spot yield
curves. For example: treasuries, interest rate swaps, triple-A corporate bonds, etc.

ƒ Also in large and liquid markets (such as that for U.S. Treasury bonds and notes)
there is only a limited number of securities. It follows that to obtain a SYC curve we
must use some reliable interpolation method (see section 7.5).

ƒ We often want to compute the SYC implied in the prices of coupon-bearing securities.
For an outline of some techniques used to achieve this result, see chapter 8.

Spot yield curves are often non-monotonic; they can rise with time-to-maturity (tenor) as
well al fall. The pattern shown in exhibit 7.1 is relatively common for long-dated bonds.
This non-monotonic feature accounts for the relative complexity of the
interpolating/smoothing techniques that are adopted in fixed income analysis. Note that in
the following exhibit we have not applied any smoothing interpolation; the curve is simply
obtained by joining successive data points with non-smoothed straight lines. Therefore,
the slope of the curve changes suddenly in correspondence to each data point. (From a
calculus point of view, this entails that there is no first derivative.)
 book 07 - Spot and Foward Yields [2004-11-24] - Page 5 of 19

7.0%

6.5%

6.0% U.S. Treasury zeros

5.5%

5.0%
0 5 10 15 20 25 30
Tenor

Exhibit 7.1 – This US$ spot yield curve is computed using U.S. Treasury zeros as at
November 15, 1996. The curve is upwards sloping for maturities of up to 20/25 years, and
then it slopes downwards. This pattern is a rather typical shape for long-maturity zero
coupon yield curves. The treasury strip yield curve has now a shorter time-horizon
because, in 2001, the United States Department of the Treasury discontinued the
issuance of 30-year bonds. The longest-dated fixed rate bond now trading is the 5 3/8 of
February 2031.

7.1.5 Term Structure of Discount Factors

While the spot yield curve is often non-monotonic, the term structure of discount factors is
always decreasing because we rule out negative forward rates (see section 7.5). This is
shown in exhibit 7.2.

1.0

0.8 U.S. Treasury zeros discount factors

0.6

0.4

0.2

0.0
0 5 10 15 20 25 30
Tenor

Exhibit 7.2 – This discount factors curve is based on the U.S. treasury strips yield curve
used in exhibit 7.1.
 book 07 - Spot and Foward Yields [2004-11-24] - Page 6 of 19

7.2 Pricing coupon and amortizing bonds

Any regular coupon security (with or without amortization schedule) can be ideally
decomposed into a basket of zeros. In well functioning capital markets, we have prices
that are close to their arbitrage-free values; this implies the principle of value additivity
(see chapter 6). As a consequence, a regular fixed income security will have a price that
is transaction-costs-close to that of the basket of zeros in which we can decompose it. For
sinking fund securities, the basket of zeros will, of course, include the principal
repayments.
In exhibit 7.3 we use a spot yield curve to price a 6.00% straight coupon bond. The
pricing is done at the beginning of the coupon-accrual period, so that the invoice price
equals the clean price. To keep the exhibit short, we consider an annual coupon bond
and annual yields.

T d(T) Y(T) Cash flow Price

1 0.9845 1.57% 6 5.9073
2 0.9597 2.08% 6 5.7580
3 0.9278 2.53% 6 5.5667
4 0.8913 2.92% 6 5.3475
5 0.8522 3.25% 6 5.1133
6 0.8126 3.52% 6 4.8753
7 0.7739 3.73% 106 82.0305
142.0000 114.5986

Exhibit 7.3 – SYC pricing of a 6.00% coupon bond. The price column is obtained
multiplying each element of the cash flow by the relevant discount factor.

Exhibit 7.4 shows an example of SYC pricing of a 7-year bond amortized with five equal
principal payments, starting at year three. We can see that the total cash flow is lower that
in the straight coupon bond case, because interest is paid only on outstanding principal.
(In chapter 8, we shall consider the case of bonds amortized with level payments – this
means that the sum of interest and principal payments is constant.)
 book 07 - Spot and Foward Yields [2004-11-24] - Page 7 of 19

Outstanding ________Cash Flow________

T d(T) Principal Coupon Principal Total Price
0 1 100.00 0 0 0 0
1 0.9845 100.00 6.00 0.00 6.00 5.9073
2 0.9597 100.00 6.00 0.00 6.00 5.7580
3 0.9278 80.00 6.00 20.00 26.00 24.1224
4 0.8913 60.00 4.80 20.00 24.80 22.1031
5 0.8522 40.00 3.60 20.00 23.60 20.1123
6 0.8126 20.00 2.40 20.00 22.40 18.2013
7 0.7739 0.00 1.20 20.00 21.20 16.4061
30.00 100.00 130.00 112.61

Exhibit 7.4 – SYC pricing of a 6.00% amortizing coupon bond. Coupon payments are
computed on the outstanding principals. The price column is obtained multiplying each
element of the cash flow by the relevant discount factor.

7.3 Yield to maturity: the modern interpretation

7.3.1 Yield to maturity (YTM)

Yield to maturity, also known as redemption yield, is often explained in terms of the yield
we would obtain on a coupon security if we could reinvest all the intermediate payments at
the YTM rate, until the final. Economists are used to heroic assumptions, but this is a bit
too heroic:

ƒ Market rates change throughout time

ƒ The yield curve in never really flat

This entails that coupon and principal reinvestments will happen at different rates. In fact,
zero coupon bonds were designed to fit the needs of investors such as life insurance
companies and defined-benefit pension plans that needed to overcome this reinvestment
rate uncertainty (see section 7.8).
We now interpret YTM as a complex weighted average of the spot rates (where the
weights are the cash flows) of the basket of zeros that compose our coupon bond. There
is no need for reinvestment assumptions. The computation requires the use of numerical
methods. Using a single number to indicate the rate on a fixed income instrument is
clearly very practical, and YTM is widely used as a quotation mechanism, not only for
bonds but also for swaps. Yield to maturity is also used to determine the conversion
factors for bond futures (see chapter 12.2). However, we should be fully aware of the fact
 book 07 - Spot and Foward Yields [2004-11-24] - Page 8 of 19

that averaging implies a loss of information, and therefore all fixed-income analysis is
done with reference to the full spot yield curve
When we deal with a bullet bond (or loan) that pays a fixed and constant coupon, we
can determine its price with a well known equation that we are likely to find in many
operational documents, including those of futures and options exchanges. The following
equation is for pricing an annual coupon bond, on the first day of an interest accrual
period, so that invoice price and the clean price are equal. The symbols are: P = price, c =
coupon rate, F = face value, T = tenor in years.

Pricing a straight bond with YTM

1 − (1 + YTM )−T
P = c× F + F (1 + YTM )−T
YTM

The above equation must be adapted to take into account pricing within an interest-
accrual period and for U.S. yield quotation.
Using cash flow discounting, we can compute YTM with numerical methods identical to
those used to find the internal rate of return (IRR) of an investment. In essence, we must
find the value of YTM for which the PV equals the market price. This can be done with a
number of Excel functions (IRR, Solver, etc).

7.3.2 Yield to maturity: the coupon effect

We shall now explore how the coupon rate influences YTM for two different 7-year bullet
bonds, both priced off the same spot yield curve, shown in exhibits 7.5 and 7.6. The bond
with the lower coupon (3%) will clearly have a lower fair-value price than the 6% bond.
What is less self-evident is that the YTM of the 3% bond is slightly higher that the YTM
of the 6% bond. This is due to the fact that, as we have seen, the yield to maturity is a
complex weighted average of the spot yields. With an upwards-sloping yield curve
{1.57%, …, 3.73%} a lower coupon means that the principal payment will carry a higher
weight, thus increasing the YTM.
 book 07 - Spot and Foward Yields [2004-11-24] - Page 9 of 19

T Y(T) d(T) Cash flow Price

1 1.5700% 0.9845 6.00 5.9073
2 2.0800% 0.9597 6.00 5.7580
3 2.5300% 0.9278 6.00 5.5667
4 2.9200% 0.8913 6.00 5.3475
5 3.2500% 0.8522 6.00 5.1133
6 3.5200% 0.8126 6.00 4.8753
7 3.7300% 0.7739 106.00 82.0305
142.00 114.5986

Exhibit 7.5 – Coupon = 6.00%, YTM = 3.6033%

T Y(T) d(T) Cash flow Price

1 1.5700% 0.9845 3.00 2.9536
2 2.0800% 0.9597 3.00 2.8790
3 2.5300% 0.9278 3.00 2.7834
4 2.9200% 0.8913 3.00 2.6738
5 3.2500% 0.8522 3.00 2.5566
6 3.5200% 0.8126 3.00 2.4377
7 3.7300% 0.7739 103.00 79.7089
121.00 95.9929

Exhibit 7.6 -- Coupon = 3.00%, YTM = 3.6592%

7.4 Par yield

We have seen that, given the spot yield curve, the YTM of a security is influenced by the
coupon rate. Therefore, we cannot use the YTM to quote a yield term structure without
introducing some element of ambiguity. To overcome this problem we quote a spot yield
curve that assumes that the coupon rate (c) equals the YTM.

c = YTM

For example, if the par-Y for a 6-year coupon bond is 3.60%, this entails a 3.60% coupon.
If the coupon rate = YTM, it is easy to prove that (for an integer number of coupon accrual
periods) the bond must be priced at par, hence the name par yield. One of the main
applications of the par yield curve is the quotation of interest rate swaps (IRS), where bid
and ask are fixed rates, against a floating rate, usually against LIBOR flat. Therefore, the
much used swap yield curve is a par yield curve (see chapter 13).
 book 07 - Spot and Foward Yields [2004-11-24] - Page 10 of 19

7.5 Forward yields: bootstrapping and interpolation

7.5.1 Forward yields

A clear understanding of forward yields is extremely relevant because a number of

interest-rate derivatives are based on forward yields. For example: forward rate
agreements (FRAs), and interest rate futures. Forward rates are fully implied in the spot
yield curve. Let us consider the following example to gain the relevant intuition.

Example 7.3 – Megabank’s London branch has excess funds for €10 million that it needs
to invest in the global interbank market. The bid rates for Euro-denominated money
market deposits, denoted with (r), are 3.00% for three months, and 3.60% for six months
(for simplicity we assume that a quarter equals 90 days). Therefore, we can easily
compute the value relatives for 3m and 6m deposits. If Megabank decides to choose the
six-month deposit, it is implicitly depositing €10,075,000 for three months, three months
forward, at a rate of 4.1687%.

Forward money market yield (simple rate)

v (0, 14 ) = 1 + 0.03 14 = 1.0075

v (0, 12 ) = 1 + 0.036 12 = 1.018

1.018
v (0, 14 , 12 ) =
1.0075
⎛ 1.018 ⎞
r (0 , 14 , 12 ) = ⎜⎜ − 1⎟⎟⎟× 4 = 4.1687%
⎜⎝1.0075 ⎠

Given a series of spot yields (or an interpolated yield curve) we can define a series of
value relatives for different maturities. Using compounded yield we have:

v(0, t ) = [1 + Y (0, t )] t

If we consider a pair of such value relatives, we can compute a forward value relative and
a forward yield implied in the spot yield curve.

[1 + Y (0, t + ∆ t )] t +∆t
v(0, t , t + ∆ t ) =
[1 + Y (0, t )] t
Y (0, t , t + ∆t ) = [v(t , t + ∆ t )] 1/ ∆t − 1
 book 07 - Spot and Foward Yields [2004-11-24] - Page 11 of 19

Therefore, we can compute implied discrete forward yields for consecutive time horizons
(one year, six months, one quarter). This is shown, for yearly intervals, in exhibit 7.8,
based on the SYC used in exhibits 7.3 to 7.6. For example, the one-year forward yield for
year 7 is:

[1 + Y (0, 7)]7
Y (0, 6, 7) = −1
[1 + Y (0, 6)] 6
1.03737
= − 1 = 4.9990%
1.0352 6

7.7 – Spot and forward yields

T Y(0, t) v(t) Y(t-1, t)
0 –- 1 –-
1 1.5700% 1.0157 1.5700%
2 2.0800% 1.0420 2.5926%
3 2.5300% 1.0778 3.4360%
4 2.9200% 1.1220 4.0989%
5 3.2500% 1.1734 4.5806%
6 3.5200% 1.2307 4.8806%
7 3.7300% 1.2922 4.9990%

7.5.2 From forward to spot yields

Forward yields can be computed using only spot yields. (This procedure is known as
bootstrapping.) Conversely, spot yields can be computed from a series of forward yields
for consecutive time intervals. For example, if we consider a back-to-back series of one-
year yields, we can write:

v (n) = [1 + Y (0,1)]× ...×[1 + Y (n − 1, n) ]

1/ n
Y (0, n) = [v (n)]
If we use the log yield notation, it turns out that the spot yield equals the arithmetic
average of forward yields, as shown in the following equation:

v(n) = exp [ R (0,1) + ... + R (n − 1, n) ]

R (0, n) = log [ v(n) ] / n
= [ R (0,1) + ... + R (n − 1, n) ] / n
 book 07 - Spot and Foward Yields [2004-11-24] - Page 12 of 19

A numerical example is provided by exhibit 7.8, where forward yields are derived from the
90-day Eurodollar futures (ticker ED) traded on the Chicago Mercantile exchange (see
chapter 12). The data cover the time-horizon from mid-June 2004 to mid-September 2006.
The ED quotations are adjusted to take into account dollar LIBOR daycount (see the
additional note PDF file for chapter 1).

7.8 From forward to spot yields

Eurodollar Adjusted
Month Futures rate v(t) Y(t)
Jun '04 1.340% 1.359% 1
Sep '04 1.745% 1.769% 1.0034 1.366%
Dec '04 2.200% 2.231% 1.0078 1.573%
Mar '05 2.675% 2.712% 1.0135 1.798%
Jun '05 3.135% 3.179% 1.0203 2.033%
Sep '05 3.530% 3.579% 1.0284 2.268%
Dec '05 3.875% 3.929% 1.0376 2.494%
Mar '06 4.165% 4.223% 1.0478 2.706%
Jun '06 1.0589 2.902%

7.5.3 Spot and forward yield curves *

Consider Exhibit 7.9, which shows both a smooth spot yield curve and its forward yield
curve for 3-month intervals. We see that the forward yield curve:

ƒ Lies above the spot yield curve when the SYC is upwards sloping,
ƒ Crosses the spot yield curve when it stops increasing and flattens out

ƒ Lies below the spot yield curve when the SYC is downwards sloping

This characteristic of the forward yield curve is easily explained in terms of a property of
arithmetic averages. If we add one term to a sequence of (n) numbers, the arithmetic
mean of the sequence ( µ ) will change by a relatively small amount equal to:

a 1+...+ a n
µ ( n) =
n
a − µ( n)
∆µ = µ(n + 1) − µ( n) = n+1
n +1
 book 07 - Spot and Foward Yields [2004-11-24] - Page 13 of 19

Spot and forw ard yield curves

8%

6%

4%
SYC FY C

2%

0%
0 5 10 15 20
Years

Exhibit 7.9 – Spot and forward yield curves, smoothed data.

7.5.4 Interpolating the spot yield curve *

In order to obtain a smooth forward yield curve (FYC) we need to use a smooth spot yield
curve. This is achieved by interpolating the market values (see also chapter 8). The
interpolation is usually done using cubic polynomials. The problem that we face when we
want to interpolate a SYC covering a long horizon is that a single cubic polynomial will
provide a less than satisfactory fit. The technique that we use to overcome this problem is
known as cubic splines. This consists of using more than one cubic polynomial (over more
than one time-interval). These polynomials must be joined in such a way that:

ƒ The resulting SYC is continuous (there must not be jumps at the joining points of the
polynomial curves).

ƒ The resulting forward yield curve must also be smooth (there must not be jumps in the
first derivative at the joining points of the polynomial curves).
ƒ Getting into the detail of the cubic splines technique is clearly beyond the scope of
this book. A more detailed description can be found in Tuckman (2002). For a fully
operational approach see: Press, Teulosky, Vetterling, and Flannery (1992).

7.6 Instantaneous forward yield *

Instantaneous forward yield is defined as the forward yield for a time interval (h) that tends
to zero. Given this definition, it is clear that there is no financial instrument based on
instantaneous forward yield. However, instantaneous forward yield allows us to use
calculus, and has been the theoretical foundation for a number of continuous-time,
 book 07 - Spot and Foward Yields [2004-11-24] - Page 14 of 19

continuous-state interest rate models (see part IV). The instantaneous forward yield,
always computed using log yield (R), is equal to the log-derivative of v(t) with respect to
(t), as shown in the following equation:

v(0, t + h) − v(0, t ) 1
lim R(t , t + h) = lim
h→0 h→0 v(0, t ) h
d 1 d
= v(0, t ) = log [v(t )]
dt v(0, t ) dt

Example 7.4 – Assume for simplicity that the spot yield curve can be described
adequately with a simple quadratic polynomial. The instantaneous forward yield will be:

R (0, t ) = a + bt + ct 2

( )
v(t ) = exp ⎡⎢ a + bt + ct 2 t ⎤⎥
⎣ ⎦
d
R (t ) = log [v(t ) ] = a + 2bt + 3ct 2
dt

7.7 Limits of arbitrage-free forward pricing

In liquid markets, such as treasuries, FX, etc. the arbitrage-free price-band will be very
narrow. Therefore, we can think of it as a pinpoint value. In most cases, however the
range is wide, and tends to become wider when there is a temporary decrease in market
liquidity (Asian crisis, Russian crisis, etc.). In other cases, arbitrage cannot be
implemented. We should then speak of fair market prices, and not of arbitrage-free
prices.
Liquidity and market microstructure factors often result in price discrepancies that are
too costly to arbitrage away. Consider the following prices for US Treasury strips. In a
perfectly frictionless market, the price differences would be arbitraged away. In real life,
transaction costs and liquidity constraints result in pricing discrepancies, as shown in
exhibit 7.9. (For a more detailed discussion of this topic with reference to the U.S.
treasuries market, see Tuckman, 2002.)
 book 07 - Spot and Foward Yields [2004-11-24] - Page 15 of 19

Mty t Ask Price Ask Yield

Feb-03 np 1 97.78125 2.2691%
Feb-03 ci 1 97.84375 2.2038%
Feb-04 np 2 94.06250 3.1079%
Feb-04 ci 2 94.15625 3.0565%
Feb-06 bp 4 84.50000 4.3004%
Feb-06 ci 4 84.96875 4.1562%
Feb-10 np 8 66.96875 5.1395%
Feb-10 ci 8 66.40625 5.2504%
np = note principal, ci = coupon, bp = bond principal

Exhibit 7.9 – US Treasury zeros: spot and forward yields

7.7 Historical Note on Zero Coupon Bonds

Zero-coupon bonds have gained a prominent position, especially in the more innovative
U.S. market. They are widely used, not only as investment vehicles but also as the
instrument of choice for long-horizon hedging.
Short-term zero-coupon securities have been around for many years, in the form of
bills, commercial paper, etc. The long-term zero-coupon bond is, however, a product of
the volatile yield rates environment prevailing in the late 1970s and early 1980s. We shall
now give a brief account of how the zero-coupon market developed in the U.S. in the early
1980s. This is an interesting case study in the emergence and progressive refinement of
an important financial innovation.
The first issues of zeros, in the form of private placements, took place in 1980. The
following year, private placements were followed by public issues (the first, for J.C.
Penney, a U.S. corporation, took place in April 1981). In 1982, the U.S. municipal bonds
market followed with an issue of tax-exempt zeros by the Massachusetts Bay
Transportation Authority.

7.7.1 Synthetic zero-coupon bonds

In 1982, a number of investment banks, notably Salomon Brothers (once a famous

investment bank) and Merrill Lynch, pioneered the concept of creating zeros based on
U.S. treasury bonds and notes. These investment banks made substantial profits by
supplying the market with a much-in-demand product that also benefited from the zero
credit risk usually associated with U.S. Treasury securities.
 book 07 - Spot and Foward Yields [2004-11-24] - Page 16 of 19

The mechanics worked as follows: a certain quantity of T-bonds or of T-notes was

bought by the investment bank and deposited in a fiduciary trust account with a bank. The
investment bank would then issue a set of zeros (with maturities corresponding to the
maturity of all the coupons and principal of the T-bond or T-note).
Payments to the holders of the zeros were fully collateralized by the payments that the
depository bank would receive on the treasury securities; these payments would flow-
through to the holders of the zeros. These receipts were not directly guaranteed by the full
faith and credit of the U.S. government. There was always the possibility, albeit minimal,
that the custodian bank would go bankrupt after having improperly utilized the treasuries
held in custody (securities held in custody should be segregates from the depository
bank’s proprietary assets). Synthetic zeros had names designed to catch the attention of
the prospective clients. The best known of such names are:

ƒ TIGRs (Treasury Investment Growth Receipts - Merrill Lynch)

ƒ CATS (Certificates of Accrual on Treasury Securities - Salomon Brothers)

ƒ LIONS (Lehman Investment Opportunity Notes − Lehman Brothers)

The product was an instant hit. By the end of 1982, $14 billion of treasury securities had
been utilized to issue zero-coupon bonds. On the other hand, such instruments were
proprietary to the issuing firms, who branded them. Therefore, other bond dealers were,
understandably, somehow unwilling to make markets in them. This did limit liquidity and
only CATS – given their large trading volumes and the paramount position then held by
Salomon Brothers in fixed income trading – really became available in the general market.
To overcome this liquidity problem, in 1984 a group of primary dealers began issuing a
“generic” product known as Treasury receipts (TR).

7.7.2 The Callable Tail Problem

Distilling synthetic zeros out of 30yr T-bonds created a problem because such bonds were
callable at par on any coupon date in the last 5 years to maturity. This problem, known as
the callable tail, was solved in an ingenious way by issuing:

ƒ A series of zeros corresponding to the coupons payable before the possible call (for a
maximum of 50 zeros corresponding to the 50 semiannual coupons in the first 25
years of non-callable life of the bond.

ƒ A certificate representing both the corpus and the coupons that would be paid after
the possible call date. This certificate could turn out to be either a zero-coupon bond
(payable on the first possible call date), or a coupon bond paying interest up to the
repayment date (either call or final maturity).

It is intuitively evident that, after 25 year, the value of the callable tail could be:
 book 07 - Spot and Foward Yields [2004-11-24] - Page 17 of 19

ƒ $100 if the call is exercised at par, at the first call date, 5 years prior to maturity.

ƒ Less than $100 if the call is not exercised at the first call date: the Treasury will not
exercise the call if the bonds trade below par.

For example, in 1984, Salomon Brothers placed a CATS issue based on $ 1,700 million
par value of 30 year, 12.50% treasury bonds, due August 15, 2014. The bonds were
callable at par on any coupon date in the last five years of life. Therefore the issue
consisted of:

ƒ 50 coupon CATS with maturities {0.5, 1, …, 25} corresponding to the coupons in the
first call-protected 25 years, for a par value of U.S.$ 5.312.5 million

5,312.5 = 50×1, 700× 0.125 12

ƒ One callable CAT, for a par value of $ 1,700, corresponding to the callable tail.

7.7.3 Treasury Strips

In February 1985, the zero-coupon market received an important boost by the U.S.
Treasury, with the introduction of STRIPS (Separate Trading of Registered Interest and
Principal of Securities). This system, based on the fact that U.S. treasury securities are
held in book-entry form accessible through Fed Wire, allows a holder of treasury bonds
and notes to convert them into a series of zeros. Strips based on coupons are identified
with the code (ci), while zeros based on principal are identified as (bp) = bond principal or
(np) = note principal.
When the introduction of STRIPS, the treasury began issuing non-callable 30yr.
bonds. The absence of a call option allowed the origination of 30yr STRIPS and avoided
the complication of dealing with the callable tail. STRIPS were also made easier to trade
in August 1985, when the Treasury decided to assign a CUSIP (Committee on Uniform
Securities Identifying Procedures) code to all interest-based STRIPS with the same
maturity.
A step that further enhanced the STRIP market liquidity was taken by the U.S.
Treasury in May 1987 when it decided to allow coupon and principal STRIPS to be pooled
and recombined into the original T-note or T-bond, in a process known as reconstitution.
When reassembling a bond or note, only (ci’s) can be used for coupons and only (bp’s ) or
(np’s) for principal. This constraint avoids recompositions that could create synthetic
coupon bonds that were never issued by the U.S. Treasury.
 book 07 - Spot and Foward Yields [2004-11-24] - Page 18 of 19

Summary and conclusions

In this chapter we have covered a number of relevant topics:

ƒ How to compute spot yields and discount factors for discount securities.

ƒ How to use spot yields to price coupon-paying and amortizing debt instruments, such
as bonds, loans, and swaps.

ƒ The interpretation of YTM as a weighted average of spot yields. This entails that two
bonds of equal maturity, priced on the same SYC, will have different yield to maturity
if their coupon rates are different.

ƒ How to construct a par yield curve.

ƒ The concept of arbitrage-free forward yields, and their derivation from the spot yield
curve (bootstrapping).

ƒ How to compute instantaneous forward yields, which have been widely used in
interest rate models.

ƒ The development of zero coupon bonds in the U.S. market – an interesting case of
innovative financial engineering.

Key Terms
Bootstrapping
Callable tail
Clean price
Corpus
CUSIP (Committee on Uniform Securities Identifying Procedures)
Discount factors
Discount securities
Fair market value
Forward yields
Instantaneous forward yields
Invoice price
Local expectations hypothesis
Non-monotonic
Par yield
Projected yield curve
Reconstitution
Redemption yield
Spot yield curve
Spot yields
Strip
Synthetic zero-coupon bonds
Tenor
Treasury strips
U.S. bond basis
Zero coupon bonds
 book 07 - Spot and Foward Yields [2004-11-24] - Page 19 of 19

References and Suggested Readings

Benninga, Simon Z., and Benjamin Czaczkes. (2000), Financial Modeling, 2nd Edition.
MIT Press
Bodie Zvi, Alex Kane, and Alan J. Marcus (2002). Investments, 5th Edition. New York:
McGraw-Hill/Irwin
Campbell, John Y. (1986), “A Defense of Traditional Hypotheses about the Term Structure
of Interest Rates”, The Journal of Finance, Vol. 41, No. 1. (Mar., 1986), pp. 183-193

Cox, John C.; Jonathan E. Ingersoll, Jr.; Stephen A. Ross (1981), “A Re-Examination of
Traditional Hypotheses about the Term Structure of Interest Rates”, The Journal of
Finance, Vol. 36, No. 4. (Sep., 1981), pp. 769-799.

Fabozzi, Frank J. (2000). The Handbook of Fixed Income Securities, 6th Edition, McGraw-
Hill Professional

Grinblatt, Mark, and Sheridan Titman (2002): Financial Markets and Corporate Strategy,
2nd Edition, New York: McGraw-Hill/Irwin.

Press, W. H., S. A. Teulosky, W. T. Vetterling, and B. P. Flannery (1992): Numerical

Recipes: The Art of Scientific Computing, Cambridge University Press, Cambridge,
England.

Sharpe, William F., Gordon J. Alexander, and Jeffery V. Bailey (1999): Investments, 6th
Edition. Upper Saddle River, New Jersey, Prentice Hall
Sundaresan, Suresh M. (2001). Fixed Income Markets and Their Derivatives, 2nd Edition,
Dryden Press
Tuckman, Bruce (2002). Fixed Income Securities, 2nd Edition, John Wiley & Sons