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1. Introduction

A yield curve is a graphical representation of where interest rates are today. There is not one single interest rate; there is an interest rate for those who want to invest now for the next three months, there is another interest rate for those who want to invest now for the next six months, and so on out to thirty years and longer. The yield curve shows the rate of return that can be locked in now for various terms into the future. The left, vertical axis of the graph shows the annual percent yield that is currently available in the marketplace. The bottom, horizontal axis shows the investment holding period. The yield curve is a line connecting the rates of return that can be earned to the time periods that can be committed to.

Suppose an investor could choose from the following returns for their respective investment holding periods:

Yield (%) 3.0 4.0 5.5 6.0

Holding Period (years) 1 5 10 20

At this point in time, an investor could lock in a one-year return of 3%. By locking in right now for the next five years, he could lock in an annual return of 4%. Further, an investment in a 10- year bond offers a 5.5% return per year right now, and 20-year bonds are currently returning 6% per annum. The current yield curve is found by simply graphing these data points.

It is impossible to estimate the zero coupon curve from the existing par bond yield curve. and 3. there exists a zero coupon rate that discounts the payment to its present value. 2. points along which represent the yield to maturity of a zero coupon bond for the appropriate maturity rate. As a result. because: 1. the only difference in the returns that can be earned should be attributable to the holding period. The zero coupon rates are calculated using an interactive methodology whereby the zero coupon rate is determined from a known yield curve for the successive points in time (often referred to as “bootstrapping”). In theory. Page 2 . the same features and the same coupon rate. for each future payment of a coupon security. They have a broad range of maturities available. Differences in coupon rates are nullified by using stripped (no coupon) versions of the various bonds. All maturities have the same credit risk as each other. These rates constitute the zero coupon yield curve.The investment instruments used to construct the yield curve should all have the same risk. Government bonds are often used to construct yield curves.

Cash flows that occur at time 1 should be discounted at 5%. we can compute zero-coupon rates.2. From this. At what rate should the cash flows at time 2 be discounted so that rY2 = 0.05 rY2 = 0.0511 where rYi is the yield on a par bond that matures at time i. Bootstrapping the Zero Curve Consider a 4-year security with annual payments where the curve is as follows: The rates above give us a par bond yield curve: rY1 = 0.0511? Page 3 .

11 + 1. This implies: 100 = 5.30 5.226%.2) for the second year. In the case above: (1.rZC2 is the zero coupon rate for the two year maturity.2 = 5. 2 ) meaning that r1.113%.312%. Arbitrage should make both returns identical: (1 + rZC 2 ) 2 = (1 + rZC 1 ) ⋅ (1 + r1. These rates can be used as discount rates for cash flows occurring at the corresponding times. Repeating for the third zero coupon yield: 100 = 5.05113) (1 + rZC 3 ) 3 so rZC3 = 5. Page 4 .11 105. This can easily be repeated for the forward rates r2. 3.4.3 and r3.30 + + 2 1. You can either lock in the 2-year rate (5.05113) 2 = (1.05 (1 + rZC 2 ) 2 so rZC2 = 5.05 (1. Consider investing your money for 2 years.30 105.2 is the forward rate for an investment beginning at time 1 and ending at time 2.05) ⋅ (1 + r1. Forward Rates We can also imply forward rates from these zero-coupon rates. 2 ) where r1.113%) or invest for one year (5%) and lock in the forward rate (r1.

1128% 5.0414% Because the cash flow dates of the instruments to be valued rarely exactly match the dates for which zero curve points have been developed.0000% 5. interpolation between data points is needed to solve the problem. including linear interpolation.8667 95. Page 5 .2095 4.0000 4.1564 Par ZC Rates Forwards 100 100 100 100 5.7969 90.3122% 5.1554 4.47% Year 1 Year 2 Year 3 5.11% 5.0476 Year 4 5.30% 5.0000% 5.9508 100.6833 85. Various methods are used.1333 4.4940% 5.00% 5.7122% 6. exponential interpolation and cubic splining.Maturity 1 2 3 4 Curve 5.2257% 5.

BEASSA Zero Coupon Curves Zero Coupon Curves .00 8.00 12.00 SwapsBD BondsBD Rate (%) 11.22 Nov 2002 14. The Swap curve is consistently above the Bond curve.4.00 7. This indicates the credit spread inherent in the Swap curve and the fact that the likelihood of default is lower with government bonds. Swap & Bond Curve Spread 90 80 70 60 50 40 30 20 10 0 3 Da ys 94 36 7 10 96 18 26 25 58 32 87 40 18 47 49 54 79 62 09 69 40 76 70 84 03 Points Page 6 .00 10.00 3 94 367 1096 1826 2558 3287 4018 4749 5479 6209 6940 7670 8403 9131 9862 10594 Days The chart above represents the BEASSA Zero Coupon curves for 22 November 2002.00 13.00 9.

Page 7 .The above chart is a representation of the points spread between the Swap and Bond Zero Curves for 22 November 2002.

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