# Theories of the Yield Curve

Copyright © 1996-2006 Investment Analytics

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The Yield Curve
What is the yield curve? How is the curve constructed? Why is the yield curve shaped the way it is? Why does its shape change? How can a trader profit from this?

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Yield Curve Theories

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The Yield Curve
Zero-Coupon Bonds, Face Value \$1,000: Term Price Discount YTM 1 925.93 1/(1+y1) 8.000% 2 841.75 1/(1+y2)2 8.995% 9.660% 3 758.33 1/(1+y3)3 4 683.18 1/(1+y4)4 9.993% Spot Yield (Zero Coupon Yield)
y1 is called the one year spot rate y2 is called the two year spot rate
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Yield Curve Example
Spot Rate

8%

1 Years to Maturity
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Yield Curve Theories Slide: 4

Building a Yield Curve
In practice we have coupon bonds, not just zeros Term Price Discount YTM 8.000% 1 925.93 Z 1/(1+y1) 2 841.75 Z 1/(1+y2)2 8.995% 3 952.40 C Bond in year 3 is a coupon bond
Pays 8% coupon (\$80 per year) How do we proceed?

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Yield Curve Theories

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Bootstrapping
Method: split into coupon and principal payments and treat each as a zero
\$80 \$80 \$1,080

Then solve equation:

1

2

3

952.40 = \$80/(1+y1) + \$80/(1+y2)2 + \$1080/(1+y3)3 y1 & y2 are known y3 = 10.020%
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Example: US Treasury Yield Curve
YIELD vs. MATURITY 7.48% 7.47% 7.46% 7.45% 7.44% 7.43% 7.42% 7.41% 7.40% Dec-14 Jul-15 Jan-16 Aug-16 Mar-17 Sep-17
15-Feb-15 15-Feb-16 15-May-16 15-Nov-15 15-Aug-15 15-Nov-16 15-May-17

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Yield Curve Theories

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Yield Curve Analysis
Fairly normal yield curve
Yield on the 9 1/4 of Feb ‘16 looks to be a basis point too high 2.4bp pickup on the 8 /4% of May ‘17 indicates value in this sector

Clear relationship between yield and tenor What about relationship between yield and risk?
Use duration as a proxy for risk Plot yield vs. duration Makes relative values more distinct
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Yield vs. Duration
YIELD vs. DURATION 7.48% 7.47% 7.47% 7.46% 7.46% 7.45% 7.45% 7.44% 7.44% 7.43% 7.43% 7.42% 9.20
May 17

Feb 16 Nov 15 Aug 15 Feb 15

May 16 Nov 16

9.40

9.60

9.80

10.00

10.20

10.40

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Yield Curve Theories

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Yield Enhancement Swap
Because it has higher coupon, the 8 3/4 of May ’17 has lower duration than the 7 1/4 of May ’16 or the 7 1/2 or Nov ’16. By trading at slightly higher yield, the market would appear to be underpricing it slightly Bond Swap:
Action Maturity Coupon Price YTM Duration Sell 15-Nov-16 7 1/2% 100 18/32 7.4467% 10.278 Buy 15-May-17 8 3/4% 11323/32 7.4706% 10.054

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Yield Curve Theories

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Limitations to Traditional Yield Curve Analysis
Yield curve:
A primitive expression of risk/return tradeoff

Drawbacks
Maturity is poor indicator of bond price volatility YTM is not a measure of potential return
For Buy and Hold investor, assumes coupons are reinvested at YTM For Active investor, assumes that if bond is sold prior to maturity, it is sold at same yield as on purchase date

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Yield Curve Theories

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Example: Euro Yield Curves
Euro Yield Curves
5

4.5 France Germany 4

3.5

3 Source: Bloom berg 9/Apr/99 2.5 1 Years 2 Years 3 Years 4 Years 5 Years 6 Years 7 Years 8 Years 9 Years 10 Years 15 Years 20 Years 30 Years 3 Months 6 Months

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Yield Curve Theories

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Other Yield Curves
Swaps curve
Swap rate (coupon) by tenor Swap curve lies above treasury curve
Due to default risk Swap rates quoted as spread over same maturity treasury yield

Corporate bond yield curve
Trades at spread over treasury curve
Default risk

Many corporate bonds include option features
Callable, putable, convertible Calculate option-adjusted spread

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Yield Curve Theories

Slide: 13

LIBOR Spot Rates
Spots quoted as add-on interest Actual/360 daycount Example: 3 month deposit
Today is Jan 12 2001 Deposit matures April 12, 2001 Number of days: 91 Rate is r, P is principal

Value at maturity: P x (1 + r x 91 / 360)
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Daycounts
How many days in a month and year
30/360 (Money Market)
in one month, get 1+(30/360)r

Actual/360 (LIBOR)
in one month get 1 + (31/360)r if 31 days

Actual/365 (Treasury)
(or actual/actual: adjust for leap year)

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Yield Curve Theories

Slide: 15

Discount Factors and Compounding
Notation:
R = % Interest rate, T = Time (days), D = Discount Factor

R is simple:
D = 1 / (1 + R x T / 360) R = (-1 + 1/D) * 360 / T

R is annually compounded (LIBOR):
D = 1 / (1 + R) T/360 R = -1 + (1 / D)360/T

R is Semi-annually compounded (Treasury)
D = 1 / (1 + R / 2) T/182.5 R = 2 * (-1 + 1 / D)182.5/T

R is continuously compounded:
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D = e-RT/360 R = -Ln(D) x 360 / T

Yield Curve Theories

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Yield Curve Theories
Expectations Theory Liquidity Preference Theory Risk Theory

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Yield Curve Theories

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Expectations Theory
Forward rate = Expected future spot rate FT = E(ST) Implications:
Bond yields relate to expected future spot rates
(1 + y2)2 = (1 + S1) (1 + f2) = (1 + S1) (1 + E[S2])

Upward sloping yield curve means investors anticipate higher interest rates

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Yield Curve Theories

Slide: 18

Liquidity Preference Theory
Investors require a liquidity premium to hold long term securities FT > E[ST] Liquidity Premium: LT = FT - E[ST] Example: S1 = E[S2] = 10%
Expectations Hypothesis Liquidity Preference
(1 + y2)2 = (1 + S1) (1 + E[S2]) => y2 = 10%

F2 = 11% > E[S2] = 10% (L2 = 1%)
(1 + y2)2 = (1 + S1) (1 + f2) => y2 = 10.5%

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Yield Curve Theories

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Constant Liquidity Premium
Forward Rate 11% Yield Curve 10% Expected Spot Rate Constant Liquidity Premium

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Yield Curve Theories

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Rising Liquidity Premium

Forward Rate 11% Yield Curve 10% Expected Spot Rate
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Rising Liquidity Premium

Risk Measures
Price Risk:
Change in price for 1% change in yield (dollar duration or “PV of an 01”)

Probability of Zero Loss (over 1 month):
Likelihood that price of an issues falls by no more than interest earned (over 1 month)

Required Holding Period:
Period require to hold a security so that the probability of zero loss exceeds a specified level

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Yield Curve Theories

Slide: 22

Risk and Yield
Price risk is proportional to duration
30 year bond has greater price risk than 2 year note

Higher yield means lower price risk
A par bond at 15% yield has a price risk just over half that of a par bond at 7% yield

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Yield Curve Theories

Slide: 23

Holding Period for 30Y Bond x Yield
4
Volatility = 11%

Years

7%

e Yi

ld
Yie ld

11%

15

ie %Y

ld

0 50%

Probability of Zero Loss
Yield Curve Theories

90%
Slide: 24

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Holding Period for 30Y Bond x Vol
3
Yield= 11%

Years

15

%

ol V
11% l Vo

ol %V 7

0 50%

Probability of Zero Loss
Yield Curve Theories

90%
Slide: 25

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Holding Period for 2Y Note x Yield
60
Volatility = 2.2%

Days

7%

e Yi

ld

11

ie %Y

ld

0 50%

eld % Yi 15

Probability of Zero Loss
Yield Curve Theories

90%
Slide: 26

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Implications for Yield Curve Shape
2y Note much safer than 30y Bond
(holding period days rather than years)

As investor extends along yield curve, probability of losing money rises Hence must receive risk premium in higher yields CONCLUSION: Yield curve +ve slope
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Yield Curve Shape & Yield Level
Curve has +ve slope at low yields Curve has -ve slope at high yields Why? As yields increase:
Probability of Zero Loss rises Risk of long-maturity issue relative to shortmaturity issue falls Investors buy the long end, yield curve flattens, then inverts
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Shape of Yield Curve Changes with Yield Level
Averages 6/1/79 - 3/9/99

16.00% 14.00% 12.00% 10.00% Yield 8.00% 6.00% 4.00% 2.00% 0.00% 2 3 5 7 10 30 8-9% 7-8% > 14% 13-14% 12-13%

10-11% 9-10%

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Yield Curve Theories

Lo ng Bo nd Yi eld

11-12%

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Empirical Tests
Forward rates: biased or unbiased forecast of future spot rates?
Spot vs Forward Rates 1971 - 1995
20% 18% Spot 3M 16% 14% 12% 10% 8% 6% 4% 2% 0% 3/12/71 3/12/72 3/12/73 3/12/74 3/12/75 3/12/76 3/12/77 3/12/78 3/12/79 3/12/80 3/12/81 3/12/82 3/12/83 3/12/84 3/12/85 3/12/86 3/12/87 3/12/88 3/12/89 3/12/90 3/12/91 3/12/92 3/12/93 3/12/94 3/12/95 Forw ard 3M

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Yield Curve Theories

Slide: 30

Yield Curve Regression Model
Regression Model
St = a0 + bFt-3 + εt
St is spot rate at time t Ft is 3m forward rate εt is a white noise process: IID ~ No(0, σ2)

Expectations theory: b = 1 Liquidity/risk theory: b < 1
Forward typically exceeds future spots rates By an amount, which is the liquidity/risk premium

See lab exercise
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Regression Analysis
Regression Statistics Multiple R 89% R Square 79% Adjusted R Square 79% Standard Error 1.56% Observations 1294
Coefficients Std. Error 0.0046 0.0012 0.9476 0.0138 t Stat 3.6847 68.7944 P-value Lower 95% Upper 95% 0.0002 0.0021 0.0070 0.0000 0.9206 0.9746

Intercept Forward 3M

b < 1: indicates expectations theory does not hold (reject at the 5% confidence level)
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Residual Plot
Evidence of violation of model assumptions
Residual variance is not constant
Need more sophisticated model, testing procedures Residual Plot
8% 6% 4% 2%

Residuals

0% 0% -2% -4% -6% -8% -10% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

Forward 3M

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Yield Curve Theories

Slide: 33

Other Empirical Evidence
Fama (1976, 1984), Shiller (1979), Mankiw & Miron (1986)
Predictive power of forward rate is weak Varies dramatically over sub-periods Due to term premium (he conjectured)

Buser, Kayroli, Sanders (1996)
Variation is due to the term premium Model term premium using GARCH model Adjusted forward rate is good predictor of spot

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Yield Curve Theories

Slide: 34

Summary: Yield Curve Theories
Expectations Hypothesis FT = E(ST) Liquidity Preference
Investors require a liquidity premium to hold long term securities Liquidity Premium: LT = FT - E[ST] Idea: why not try to capture LT ? Probability of zero loss

Empirical evidence suggests otherwise

Risk Theory

Empirical evidence: favors liquidity/risk model
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