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Copyright © 1996-2006 Investment Analytics

1

**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?

Copyright © 1996-2006 Investment Analytics

Yield Curve Theories

Slide: 2

**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

Copyright © 1996-2006 Investment Analytics Yield Curve Theories Slide: 3

**Yield Curve Example
**

Spot Rate

8%

1 Years to Maturity

Copyright © 1996-2006 Investment Analytics

4

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?

Copyright © 1996-2006 Investment Analytics

Yield Curve Theories

Slide: 5

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%
**

Copyright © 1996-2006 Investment Analytics Yield Curve Theories Slide: 6

**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

Copyright © 1996-2006 Investment Analytics

Yield Curve Theories

Slide: 7

**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

Copyright © 1996-2006 Investment Analytics Yield Curve Theories Slide: 8

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

Copyright © 1996-2006 Investment Analytics

Yield Curve Theories

Slide: 9

**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

Copyright © 1996-2006 Investment Analytics

Yield Curve Theories

Slide: 10

**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

Copyright © 1996-2006 Investment Analytics

Yield Curve Theories

Slide: 11

**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

Copyright © 1996-2006 Investment Analytics

Yield Curve Theories

Slide: 12

**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

Copyright © 1996-2006 Investment Analytics

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)
**

Copyright © 1996-2006 Investment Analytics Yield Curve Theories Slide: 14

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)

Copyright © 1996-2006 Investment Analytics

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:

Copyright © 1996-2006 Investment Analytics

D = e-RT/360 R = -Ln(D) x 360 / T

Yield Curve Theories

Slide: 16

**Yield Curve Theories
**

Expectations Theory Liquidity Preference Theory Risk Theory

Copyright © 1996-2006 Investment Analytics

Yield Curve Theories

Slide: 17

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

Copyright © 1996-2006 Investment Analytics

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%

Copyright © 1996-2006 Investment Analytics

Yield Curve Theories

Slide: 19

**Constant Liquidity Premium
**

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

Copyright © 1996-2006 Investment Analytics

Yield Curve Theories

Slide: 20

Rising Liquidity Premium

**Forward Rate 11% Yield Curve 10% Expected Spot Rate
**

Copyright © 1996-2006 Investment Analytics Yield Curve Theories Slide: 21

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

Copyright © 1996-2006 Investment Analytics

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

Copyright © 1996-2006 Investment Analytics

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

Copyright © 1996-2006 Investment Analytics

**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

Copyright © 1996-2006 Investment Analytics

**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

Copyright © 1996-2006 Investment Analytics

**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

Copyright © 1996-2006 Investment Analytics Yield Curve Theories Slide: 27

**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

Copyright © 1996-2006 Investment Analytics Yield Curve Theories Slide: 28

**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%

Copyright © 1996-2006 Investment Analytics

Yield Curve Theories

Lo ng Bo nd Yi eld

11-12%

Slide: 29

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

Copyright © 1996-2006 Investment Analytics

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
**

Copyright © 1996-2006 Investment Analytics Yield Curve Theories Slide: 31

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)
**

Copyright © 1996-2006 Investment Analytics Yield Curve Theories Slide: 32

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

Copyright © 1996-2006 Investment Analytics

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

Copyright © 1996-2006 Investment Analytics

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
**

Copyright © 1996-2006 Investment Analytics Yield Curve Theories Slide: 35

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