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WHAT IS YIELD ?

y Yield refers to the annual return on an investment. The yield

on a bond is based on both the purchase price of the bond and the interest, or coupon, payments received. y Although a bond's coupon interest rate is usually fixed, the price of the bond fluctuates continuously in response to changes in interest rates, as well as the supply and demand, time to maturity, and credit quality of that particular bond. y After bonds are issued, they generally trade at premiums or discounts to their face values until they mature and return to full face value. Because yield is a function of price, changes in price cause bond yields to move in the opposite direction.

CURRENT YIELD y Current yield is the annual return earned on the price paid for a bond.When a bond is purchased at full face value. y However.6 per cent ($60/ $900). if an investor bought a bond with a coupon rate of 6 per cent at par. of $900. if the same bond were purchased at less than face value. or at a discount price. That would produce a current yield of 6 per cent ($60/$1. and full face value of $1. the interest payment over a year would be $60. the current yield is the same as the coupon rate.000. y For example. the current yield would be higher at 6.000). . It is calculated by dividing the bond's annual coupon interest payments by its purchase price.

investors can compare bonds with varying characteristics. Equally important. including interest on interest. and that the investor will be paid face value on the call date. such as different maturities. By examining yields to maturity. it is generally more meaningful for investors than current yield. y Because yield to maturity (or yield to call) reflects the total return on a bond from purchase to maturity (or the call date). or repurchased by the issuer before its maturity date.YIELD TO MATURITY y Yield to maturity reflects the total return an investor receives by holding the bond until it matures. y Yield to call is calculated the same way as yield to maturity. coupon rates or credit quality. . A bond's yield to maturity reflects all of the interest payments from the time of purchase until maturity. but assumes that a bond will be called. it also includes any appreciation or depreciation in the price of the bond.

y By anticipating movements in the yield curve. y The yield curve can be used as a benchmark for pricing many other fixed interest securities. fixed-interest managers can attempt to earn above-average returns on their bond portfolios . alerting investors to an imminent recession or signaling an economic upturn.What are the Different Uses of the Yield Curve? y The yield curve has an impressive record as a leading indicator of economic conditions.

. y The yield of a debt instrument is the overall rate of return available on the investment. In general the percentage per year that can be earned is dependent on the length of time that the money is invested. a bank account that pays an interest rate of 4% per year has a 4% yield.MEANING OF YIELD CURVE y The yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. For instance.

the curve flattens out).NATURE OF YIELD CURVE y Yield curves are usually upward sloping asymptotically: the longer the maturity. it may be that the market is anticipating a rise in the risk-free rate. under the arbitrage pricing theory. they may receive a better rate in the future. y There are two common explanations for upward sloping yield curves. the higher the yield. If investors hold off investing now. Therefore. investors who are willing to lock their money in now need to be compensated for the anticipated rise in rates³thus the higher interest rate on long-term investments. First. as one moves to the right. with diminishing marginal increases (that is. .

the lender). since at longer durations there is more uncertainty and a greater chance of catastrophic events that impact the investment. This effect is referred to as the liquidity spread . A risk premium is needed by the market.NATURE OF YIELD CURVE y However. y This explanation depends on the notion that the economy faces more uncertainties in the distant future than in the near term. interest rates can fall just as they can rise. Another explanation is that longer maturities entail greater risks for the investor (i.e.

or short-term volatility outweighing long-term volatility. y The shape of the yield curve is influenced by supply and demand. reflecting the market's reaction to news .NATURE OF YIELD CURVE y The yield curve may also be flat or hump-shaped. y Yield curves continually move all the time that the markets are open. due to anticipated interest rates being steady.

TYPES OF YIELD CURVE y Normal yield curve: means that yields rise as maturity lengthens (i. the slope of the yield curve is positive). for this growth to be associated with a greater expectation that inflation will rise in the future rather than fall.e. y It also creates a need for a risk premium associated with the uncertainty about the future rate of inflation and the risk this poses to the future value of cash flows. y This expectation of higher inflation leads to expectations that the central bank will tighten monetary policy by raising short term interest rates in the future to slow economic growth and dampen inflationary pressure. . Investors price these risks into the yield curve by demanding higher yields for maturities further into the future.. importantly. y This positive slope reflects investor expectations for the economy to grow in the future and.

NORMAL YIELD CURVE .

y The assumption behind a steep yield curve is interest rates will begin to rise significantly in the future. has often preceded an economic upturn.STEEP YIELD CURVE y A sharply upward sloping. y . which can both hurt bond returns. Investors demand more yield as maturity extends if they expect rapid economic growth because of the associated risks of higher inflation and higher interest rates. or steep yield curve. When inflation is rising. the Federal Reserve will often raise interest rates to fight inflation.

STEEP YIELD CURVE .

whereas a humped curve results when short-term and long-term yields are equal and medium-term yields are higher than those of the short-term and long-term. This mixed signal can revert to a normal curve or could later result into an inverted curve .FLAT OR HUMPED YIELD CURVE y A flat yield curve is observed when all maturities have similar yields. y A flat curve sends signals of uncertainty in the economy.

FLAT YIELD CURVE .

usually in conjunction with a slowing economy and lower inflation.INVERTED YIELD CURVE y When yields on short term bonds are higher than those on long-term bonds. it implies that investors expect interest rates to decline in the future. The yield curve tends to become inverted 12 to 16 months prior to a recession. .

INVERTED YIELD CURVE .

YIELD CURVE THEORIES MARKET EXPECTATION THEORY LIQUIDITY PREFERENCE THEORY MARKET SEGMENTATION THEORY PREFERRED HABITAT THEORY .

if investors have an expectation of what 1-year interest rates will be next year. the 2-year interest rate can be calculated as the compounding of this year's interest rate by next year's interest rate. is enough information to construct a complete yield curve. y These expected rates. This theory perfectly explains the observation that yields usually move together. y Rates on a long-term instrument are equal to the geometric mean of the yield on a series of short-term instruments. . y For example.MARKET EXPECTATION THEORY y This hypothesis assumes that the various maturities are perfect substitutes and suggests that the shape of the yield curve depends on market participants' expectations of future interest rates. along with an assumption that arbitrage opportunities will be minimal.

1) Interest rate risk 2) Reinvestment rate risk .MARKET EXPECTATION THEORY y Shortcomings of expectations theory: Neglects the risks inherent in investing in bonds (because forward rates are not perfect predictors of future rates).

y This premium compensates investors for the added risk of having their money tied up for a longer period. y Long term yields are also higher not just because of the liquidity premium.LIQUIDITY PREFERENCE THEORY y The Liquidity Preference Theory asserts that long-term interest rates not only reflect investors· assumptions about future interest rates but also include a premium for holding long-term bonds (investors prefer short term bonds to long term bonds). and the yield curve slopes upward. including the greater price uncertainty. y Because of the term premium. called the term premium or the liquidity premium. but also because of the risk premium added by the risk of default from holding a security over the long term. long-term bond yields tend to be higher than short-term yields. .

LIQUIDITY PREFERENCE THEORY y The market expectations hypothesis is combined with the liquidity preference theory: y Where rpn is the risk premium associated with an n year bond. .

the supply and demand in the markets for short-term and long-term instruments is determined largely independently.MARKET SEGMENTATION THEORY y In this theory. As a result. . Higher demand for the instrument implies higher prices and lower yield. financial instruments of different terms are not substitutable. If investors prefer their portfolio to be liquid. the market for short-term instruments will receive a higher demand. This explains the stylized fact that shortterm yields are usually lower than long-term yields. y Therefore. they will prefer short-term instruments to long-term instruments. y Prospective investors decide in advance whether they need shortterm or long-term instruments.

an insurance company may want to lock in a higher yield for 30 years to match the longer term liability of the life insurance contracts they provide. y For example. a company may want to earn interest for 6 months until they must invest in a new factory.PREFERRED HABITAT THEORY y The Preferred Habitat Theory is another guise of the Market Segmentation theory. and states that in addition to interest rate expectations. or habitat. . investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their "preferred" maturity. Alternatively.

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