Yield Curve

Group 4: Qianyi Luo, Xuan Wu, Chen Wang, Zhi Qiao, Zhirong Xie

ISE 563 Fall 2012

............... 6 Effect on bond prices ............ 3 c.................... 3 Different types of yield curves . Flat or humped yield curve ...................................................CONTENT Yield Curve ............ 2......... 8 Ⅳ.......... Concepts of yield curve ................................................................................................. Inverted yield curve................................ 2........................................................................................................ 4 Liquidity Preference Hypothesis ....................................................................................... 5 Ⅲ......... Market expectations hypothesis ... 4 1... 3.................................... 3 b..... 1 Ⅰ........................ 5 Market Segmentation Hypothesis ... Method for constructing a yield curve .. 7 Source of Interest Rate ................................................................................. 3 a....................................................... Normal yield curve ....................................................................................................................... Definition of yield curve .......... 3.................................................................................................................... Yield curve as a powerful indicator for real economic activity ............................................................. 4 Theories Explaining Yield Curves .. 2................. Ⅱ................................ 9 References ............. 6 1........ 10 ........................................................................... Usage of the Yield Curve ................................ 3 1.........................................................................................................................

The greater the slope.Ⅰ. the larger gap there is between the yields of short term and long term debts. It still . Concepts of yield curve 1. Definition of yield curve The yield curve is a plot or a relation that shows the relative yields according to different times to maturity of the contracts of debt. They are normal yield. 2. such as mortgage rates or bank lending rates. market participants will ask for higher rates of return on financial instruments with longer contract length in anticipation of higher future interest rates in general. A flat or humped yield curve usually indicates the uncertainty in market and future economic condition. Generally speaking. A fast growing economy and rising inflation rate usually result in tightening the monetary policy and increasing in short-term interest rates by the central bank in order to prevent the overheated economy and mitigate the pressure from inflation. this kind of yield curve reflects market participants expect a growing economy and inflation in the future since they are willing to lend loans and borrow debts in a higher interest rate for the longer contract length. The curve is also used to predict changes in economic output and growth. the normal yield curve (Figure 1) describes an up sloping yield curve showing that the debt with longer contract length has a higher interest rate than those similar debts with shorter contract lengths. Sometimes also it can be shown a humped yield curve means medium-term yields are higher than those of the short-term and long-term which are equal or close. the yields do not change with different times to maturity. b. which is also a signal of uncertainty in the economy. Generally. This yield curve can be used as a benchmark for other borrowing and lending activities in the market. which shows that. A flat (or humped) yield curve is one in which there is no difference among the yields of different contract lengths of debts. flat or humped yield curve and inverted yield curve. which means lender will receive the same interest rates for lending money in different time terms. An inverted yield curve is one in which the yield decreases with time to maturity of the debt. the common used instruments for obtaining the yields are similar treasury debts. Flat or humped yield curve In a flat yield curve (Figure 2). Thus. A normal yield curve is one in which the yield increases with time to maturity of the debt due to the risks associated with the different time structures. Normal yield curve As stated above. There is also a kind of humped yield curve. which can be a sign of potential recession. short term and long term debts still offer the same yield while medium term maturities offer varying rates of return. The slope of the yield curve is another important indicator for its properties. Different types of yield curves There are three main different types of yield curves which respectively deliver different information about the market. Time to maturity Figure 1 Normal Yield Curve a.

That is. or a belief that inflation will drop even deflation will occur. Overall. pessimistic expectations about future economy conditions might cause this kind of yield curve. As the name implies. the greater should be the slope of the current yield curve. Market expectations hypothesis The market expectation theory says that.remains to be investigated after more information about the economy comes out whether a transition to normal or inverted yield curve would happen or not. indicating a down sloping curve. driving up the interest rates on financial instruments with a shorter times to maturity. Theories Explaining Yield Curves 1. Time to maturity Figure 2 Flat or Humped Yield Curve c. the more market participants expect the interest rate to rise. Market’s expectation that central bank will lower short term interest rates to stimulate economy also pushes down the long term yield. as demand for short-term investments exceed long-term. What the expectation theory implies is . This structure indicates an expectation of economy recession in the future. Inverted yield curve An inverted yield curve occurs when yields decrease with the times to maturity. the shape of the yield curve should be determined by the interest rate expectation. it shows an inverted relationship to the normal yield curve. Time to maturity Figure 3 Inverted Yield Curve Ⅱ.

Bonds of different maturities are based on different function of supply and demand and different utility function of investors. Matthew Richardson Ex Ante Bond Returns and the Liquidity Preference Hypothesis. What if different investors do not equally value each segment of the maturity structure at the same degree? Is it possible that there are inherent differences between maturities perceived by individuals? These two doubts lead to the third hypothesis: Market Segmentation Theory. Liquidity Preference Hypothesis The liquidity preference hypothesis (LPH) was proposed first by John Hicks in 1946. As longer term bonds are riskier. Just like speculators prefer buying short term bonds in order to profit from interest rate changes. 10. However. so they need additional compensation for longer term bonds. Secondly. As a result. there are two major limitations of the market expectation theory. The first is that expectations of future rates coincide exactly with future rates realized in time. the projection of future interest rate rarely matches the realized future spot interest rate. while real estate company would like to borrow long term bonds to meet their liquidity needs. far from being substitutable or partly substitutable which is assumed by market expectation hypothesis and liquidity preference hypothesis. are compounded from the yields on shorter maturities. where the longer term bond could be simply replicated by compounding short term bond. or 30 year bond). Individual investors require a risk premium to compensate the risk of holding these bonds. First of all. Bond prices for a particular maturity are determined in isolation from other maturity bonds. there probably does not exist a unified bond market. five-year. they are more sensitive to interest rate changes than shorter term bonds 2. The market expectation hypothesis is based on two assumptions. LPH successfully solved the problem of explaining the shape of the yield curve. ten-year bond markets. which fails to explain why the shape of the yield curve is upwards. due to larger price uncertainty over intermediate holding period1. MSH states that each lender and borrower has a specific timeframe in mind when entering into the bond market. it is not like that. Journal of Banking and Finance 5 (1981) 539-546. It assumes that all investors have similar preference. The market expectation hypothesis assumes that bonds with different maturities are substitutable. Thus. lenders generally cluster around the short –side of the yield 1 Robert A. In other words. which results into the relatively higher interest rate. 3. but rather two-year. NO.that the slope of the yield curve should change accordingly to the subsequent movement of the interest rate. Market Segmentation Hypothesis The market segmentation hypothesis (MSH) argues that due to institutional factors. Thus. bonds with different maturities are imperfect substitutes. This phenomenon is quite common in practice. THE JOURNAL OF FINANCE * VOL. The hypothesis also supposes that yields at higher maturities (such as that of 5. 2. Jarrow Liquidity Premiums and the Expectations Hypothesis. resulting into the higher expected return. 3 * JUNE 1999 . North-Holland Publishing Company 2 Jacob Boudoukh. these bonds are all unique products and traded in separate markets. investors perceive long maturity bonds as riskier than short maturity bonds. According to Hicks. which indicates the market precisely predicts the demand and supply of the currency in the future. as the roles played by these instruments are not equivalent in any way. different maturity bonds are not substitutes. However. It said nothing about the kind of risk undertaken by investors who hold longer term bonds. LI. LPH states that no. The hypothesis essentially is an improved version of the market expectation hypothesis. But LPH has its own shortage. the hypothesis does not explain why longer term maturity requires a higher rate of return.

Yield curve as a powerful indicator for real economic activity Common consensus Scholars. Changes in investor expectations can also affect the slope of the yield curve. When intend to reduce the inflation pressure. which would lead to a slow down for economy growth. whereas long-term rates are relatively low. thus stimulate the economy or increase inflation. in the future. A steep positive curve usually indicates a high economy growth or inflation expectation. one could reasonably expect the interest rate in different market would move independently up and down separately driven by the law of demand and supply. Number 5 July/August 2006 . if it is an inverted curve. Usage of the Yield Curve 1. The tightening policy slows down the economy and flattens or inverts the yield curve3. short-term rates are relatively high. banks make profits and would be more likely to increase its loans. But this often contradicts what has been observed in market. Since bonds of different maturities constitute different market. a) positive or ―normal‖(short -term yields are lower than long-term yields. slowing activity may result in lower expected inflation. and investors have always craved to find reliable business cycle indicators. A rise in short-term interest rates induced by monetary policy could be expected to lead to a future slowdown in real economic activity and demand for credit.) Conceptual Considerations The logic for yield curve theory is fairly simple: In modern economic system. as a result of tightening. borrowers want long-term loans more because of the flexibility of managing the funds. Generally. the slope of the yield curve. MSH has the advantage over the previous two hypothesis for its success in explaining the upwards trend of the yield curve. Unfortunately. banks would realize the interest they received is less than the interest they paid. Banks are the engine for monetary circulation and economic development. Subsequently. The expected declines in short-term rates would tend to reduce current long-term rates and 3.curve due to lower risk and higher liquidity. it has its own Achilles’ heel. Trubin FEDERAL RESERVE BANK OF NEW YORK Volume 12. are believed to be a powerful indicator for future real economic activity. Future short-term interest rates are related to future demand for credit and to future inflation. which leads into a higher yield to maturity. ) b) inverted or ―negative‖ (short -term yields are higher than long-term yields. Banks would become reluctant to extend new loans to public borrowers.) c) flat yield curve (the difference between short-term and long-term yields is little. In contrast.4 Arturo Estrella and Mary R. on the other hand. Otherwise. If it is a positive curve. increasing the possibility of a future easing in monetary policy. there are three primary shapes. in order to make better moves at advance. such as monetary policy and investors’ expectation. Empirically. monetary officials. At the same time. often a signal for recession. which means that people require a higher rate of return for lending money for a longer period of time. usually indicate a rise in short-term interest rate. it is expected to have an easing policy--lower rates. It is widely accepted that short-term interest rate is one of most important operating instruments which a central bank used to conduct monetary policy. leading into a lower interest rate. The yield curve can be explained in various aspects. Therefore. to lend money by long-term mortgages or loans and receive interest. Ⅲ. The typical mode for banking industry is to borrow money from public’s short-term saving and offer interest. a tightening policy would be implemented.

every occurrence of an inverted yield curve has been followed by recession as declared by the NBER business cycle dating committee. Related studies Since 1980s. an initially trading-at-par bond will always be traded at the par through the end of maturity. and it performed well with strong results for predicting GNP. the probability rises more rapidly. As the spread approaches zero. investment. and Harvey (1988) claimed a strong correlation between the slope of the yield curve and consumption applying capital asset pricing model (CCAPM). Also.flatten the yield curve. Estrella and Hardouvelis (1991) presented tests of the predictive power of the yield curve. Arturo The International Economy.5 All of the recessions in the US since 1970 (up through 2011) have been examined to have an inverted yield curve. 5 6 Estrella. Effect on bond prices A. come out to be statistically coordinated with the later pace of output growth. particularly in Europe. Over the same time frame. Empirical evidence Yield curve slope related to economic performance. as shown in the chart. Clearly. an initially trading-at-premium or discount bond will be traded more and more close to its face value as the time approaches the maturity. furthermore.org/wiki/Yield_curve#Steep_yield_curve . which has been the case prior to every recession since 1960. Estrella and Mishkin(1997) found the same significant results for many other countries. Estrella (2005) claimed that the probability of recession is strongly correlated with the spread between the 10-year interest rate and 3-month interest rate (converted by 10-year Treasury bonds and 3-month T-bills). 6 2. Summer 2005 http://en. When the yield curve is flat. For instance.wikipedia. many economists have argued about the close relationship between the yield curve and subsequent shifts in certain significant economy variables. Laurent (1988) examined the yield curve as an predictive indicator of monetary policy. it is one of the simplest ways of forecasting a recession. consumption and recessions. this scenario is consistent with the observed correlation between the yield curve and recessions 4. The shaded region represents the range of spread for which the probability of recession exceeds 30 percent.

at some point.B. C. Source of Interest Rate . When the yield curve is inverted. When the yield curve is steep. bond price will decrease as the higher interest rate becomes the new market rate. the bond price will change the direction and be traded more and more close to its face value as the maturity is approaching. however. bond price will increase as the lower interest rate becomes the new market rate. at some point. the bond price will change the direction and be traded more and more close to its face value as the maturity is approaching. 3. however.

Finally. define set of yielding products. borrowers. some inter-bank money market rates will be used.7 Using these zero-coupon products it becomes possible to derive zero rates (forward and spot) for all maturities by making a few assumptions (including linear interpolation). 7 Patrick S. Method for constructing a yield curve Here we primarily talk about the Bootstrap Method to build yield curve.Lenders. like e**rt in the bond price calculation. The term structure of spot returns is recovered from the bond yields by solving for them recursively. buyers and sellers of derivatives use the yield curve as the source of the interest rates. a bank making a 10-year loan will pick off the corresponding 10-year interest rate in that curve. For example. by forward substitution. Typically some rates at the short end of the curve will be known. where there is insufficient liquidity at the short end. For instance.Hagan. some zero-coupon bonds might trade which give us exact rates. these are the internal rates of return of the bonds. This iterative process is called the Bootstrap Method. There are three major procedures of this method. Ⅳ. First of all. these will generally be coupon-bearing bonds. 'Bootstrap' the zero-coupon curve step-by-step. In some markets. Analysts and traders will also use it as an input in their derivative price calculations. Then derive discount factors for all terms. Graeme West Methods for Constructing a Yield Curve . add a bit and make the loan at that rate.

Matthew Richardson Ex Ante Bond Returns and the Liquidity Preference Hypothesis.References Robert A. Number 5 July/August 2006 Estrella. Journal of Banking and Finance 5 (1981) 539-546. Arturo The International Economy. Graeme West Methods for Constructing a Yield Curve Patrick S. Jarrow Liquidity Premiums and the Expectations Hypothesis. Summer 2005 Patrick S.Hagan. North-Holland Publishing Company Jacob Boudoukh. NO. THE JOURNAL OF FINANCE * VOL. URL: http://en. 2006. LI.wikipedia. Graeme West.org/wiki/Yield_curve#Steep_yield_curve . 3 * JUNE 1999 Arturo Estrella and Mary R. 13 (2):89—129. Applied Mathematical Finance. Trubin FEDERAL RESERVE BANK OF NEW YORK Volume 12. Interpolation methods for curve construction. Hagan.

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