November 12th 2019 TUTORIAL

YIELD CURVE
Discuss and evaluate the major theories evaluating the shape of the yield
curve. In your answer also discuss the uses of the yield curve in financial
markets, why strips are used in the construction of yield curves, and why
investors would want to invest in zero coupon bonds.

What is a yield curve?

- Shows the relationship between the yield on a particular security vs. the
maturity of that security. What do we mean by particular security? – Here,
we are talking about a bond which is issued by a particular issuer.
- Bonds have liquidity risk, default risk and tax issues.
- These risks will be the same once it’s the same issuer.
- The issuer is government bonds.

What are the shapes of the yield curve?

- Normal positively sloping – Majority of the time, the yield curve is normal or
positively sloping.
- Inverted yield curve – Or downward sloping yield curve – Longer term
securities have lower rates than short term securities.
- Flat yield curve – Long term rates are not different than short term rates?
o.O
- Humped curve – Rates in the middle are higher than the rates at the two
ends. There are 2 versions of the hump curve, the second is where medium
term rates are lower than long and short term rates.

What are the Major Theories that describe the shape of the yield curve?
1. Liquidity Theory
2. Expectation Theory
3. Preferred habitat theory
4. Market Segmentation theory
- Liquidity theory – An investor, regardless of what they are being provided,
prefer liquid securities ( short term securities ). Because, they get back their
investment faster.
So liquidity theory states that investors would prefer liquid securities and
hence to entice an investor to invest longer, then the increase rate must be
sufficient to cover the liquidity risk.
Remember bonds have a fixed coupon rate, maturity value and term. So the
only thing that you can change is discount rate.

- Expectation theory – Yield curve is made up of a series of implied forward

rates. E.g. can invest 6% in one year and 8% in one year, which is equivalent
to 7% for two years. So implied forward rate (8%) is higher than 1 year rate
(8% more than 6%).
So theory says that interest rates are essentially a series of implied forward
rates and therefore if the implied forward rate are higher than current for the
same term, then the yield curve is positively sloping.
- Preferred habitat and market segmentation theory are very similar.
Preferred habitat/market theory states that in order to entice an investor
away from one segment, the security needs to be made attractive enough
e.g. to move from a short term security to a long term security. Investors do
not want to move from one segment to another, unless the offer is made
attractive.

So in this theory investor preference to a particular maturity segment and is

difficult or impossible to move from a particular maturity segment.

So e.g. if an investor is insurance company and invests in long term securities,

it is difficult to move from long term to short term despite the rate because
there is a mismatch between assets and liabilities, which is more important to
the investor than rates. Insurance companies have long term liabilities and
assets. Don’t want the mismatch.
Commercial banks like short term securities, so do not want to switch to long
term which are less liquid, would not be able to meet liquidity requirements.

Now,

Uses of yield curve in financial markets:

Yield curve are used to price other types of financial instruments.

Why are strips used in yield curve?: Strips are synthetic products that are
developed from bonds. So a 5 year bond has five components : 1 year strip 2
year strip etc.
Strips have no reinvestment risk. No need to be worry about investing in the
coupon. There is nothing to reinvest.

Why investors want to invest in zero coupon

Because with zero coupon you buy a bond at current price, there are no
coupons to reinvest.

SIR
- Focuses on maturity.
- How do interest rates vary with the maturity of the loan? – This is what the yield
curve/term structure of interest rates deals with. CHAPTER 19 POWERPOINT.
How do interest rates vary with the maturity of the loan? – As time increases, interest rates
go up.
Yield curve is a plot of yield and maturity to show relationship. Can take on three shapes.
Explaining different shapes to yield curve?: POWERPOINT. Three different shapes:
1. Flat – (C) Maturity has no impact on interest rates.
2. Inverted – Downward sloping yield curve. This implies that the longer the time, the
lower the interest rate.
3. Positively slop – Longer time to maturity, higher interest rate.
- Yield curve only use government bonds. Because only government has different levels of
maturity – T bills, 10 year bonds etc.

- Typically yield curves are upwardly sloping. It is a “normal yield curve”. Longer loan,
higher interest rate. But, it is not always so.

What determines shape of yield curve? There are 3 theories:

1. Liquidity Preference Theory – Oldest theory. Investors prefer to hold liquid assets
e.g. in bank account. Investors prefer liquidity, they don’t like uncertainty. To get an
investor to put it in something less liquid is to offer them a higher interest rate (must
be coaxed out).
So what does this theory imply?: Yield curve can only take on one shape: Upward sloping.
Because to get people to hold longer assets, must offer them higher interest rate. Thus
prefer liquidity.
But this theory cannot explain the other yield curve shapes: Flat and downward. It is not
always upward.

2. Preferred habitat or market segmentation – Investors have a preference for

investments of different maturity. E.g. commercial bank have short term liabilities
and prefer liquid assets. But, life insurance have longer term liabilities so prefer
longer term investments.
Can explain any shape of the yield curve. Because any shape can come out from demand
and supply in that segment.
Economists don’t like this theory because it implies that investors are not willing to go in
different maturity segments and different yields.

3. Pure Expectations Theory – Most popular theory among economists. Yield curve
represents what investors expect interest rates to be in the future. So e.g. the rate
on a 30 year bond is what people expect the rate to be on a one year bond thirty
years from now.
Idea is that upward they expect interest rates to rise, inverse expect it to fall.

** project, yield curve downward sloping in recent times.

 Zero coupon bond – There is no coupon payment. What is the appeal of this bond?-
An investor only earns the YTM on a coupon bond if 2 things offer:
1. Bond is held to maturity
2. Coupons can be reinvested at YTM.

Also, next lecture,

Theories:
1. Liquidity preference
2. Preferred habitat
3. Expectations
Yield curve looks at relationship between time to maturity on a loan and its
rate of interest.
It summarizes the relationship between the term (time to maturity) of the
debt and the interest rate (yield) associated with that term.
X axis: Time to maturity, Y: Yield.
How does time to maturity affect yield:
3 shapes: Flat (suggests that length of the loan has no impact on its interest
rates). 1 year loan has same interest rate as a 30 year loan.
Positive sloped curve: Suggests that longer you want to borrow money for, the
higher the interest rate you have to pay. As time to maturity increases, interest
rate is higher.
Inverted yield curve: Or downward sloping curve – longer term of the loan,
lower the interest rate.

Liquidity preference – Investors have a preference for liquidity so prefer

shorter term investments. If you want them to take a longer term loan, you
have to offer them a higher interest rate. So it implies that the curve is upward
sloping. Now yes, it is most of the time, but it does not explain the inverted or
flat shapre.

Preferred habitat – Different maturities represent separate preferred markets.

Shape of yield curve is the outcome of demand and supply conditions. Appeal
of theory it explains all shapes of the yield curve. But challenge, degree of
irrationality among investors. Because all segments are totally independent is
irrational.

Expectations – Interest rates reflect future expectations. Logic of this model is

that the rate of interest rate of 30 year loan is what people expect a 1 year rate
to be on a loan 30 years from now. So an upward curve says they expect
interst rates to be higher in the future, inverted expect interest rates to fall in
the future, flat expect for interest rates to remain the same.

Use of a yield curve: Most useful function is that it helps people set interest
rates. Provides a useful benchmark that other players in financial markets can
use to set interest rates. So you see the benchmark then add a default risk
premium for the lender.

Strip and zero coupon bond:

Lets say Face Value – 10 million, Coupon rate 8%, YTM 9%

To actually earn 9% a year, two things have to hold:

1. Hold the bond to maturity – cannot sell before maturity because there is
an element of uncertainty/risk, cause you don’t know what bond price
will be to sell it for.

2. Coupons received must be reinvested at 9%. Must reinvest the coupons

and reinvest them at 9%. Reinvestmnet risk: risk that when you get the
coupon at the end, you may not be able to find an investment to give
you 9%, it may be lower or higher. This is issue with a coupon bond.

!!!!!!!!!! Zero coupon Bond:

Pay $12,000,000 and in the end get $14,000,000. There are no payments in
between. Yield 9%.
Why would investors want to invest in zero coupon bond rather than normal
coupon bond?
What’s the problem with the coupon bond? You have to reinvest the coupon.
So zero coupon bond advantage is you can earn the 9% and all you have to do
is hold bond to maturity. There are no coupons to reinvest so there is no
reinvestment risk. Allows investors to lock in a rate of return.

Coupon bond, 2 things have to hold: must hold bond to maturity and must
reinvest the coupon. But with zero coupon bond, only one thing holds: you
have to hold it to maturity and that’s it. No reinvestment.

Strips:
Are synthetic zero coupon bonds, that are created from original coupon bonds.
So the investor that bought these bonds can strip out the components and sell
them separately.
2020
2021
2022

So can take the 2021 and sell it separately cause he owns it.

Ideally, when a yield curve is being constructed, zero coupon bonds should be
used. If you cant find any 0 coupon bond, can use strip, since they behave like
0 coupon bond.