FI: Understanding Yield Spreads Flashcards
CB Interest Rate Policy Tools =
x4
Discount rate - rate banks can borrow from the Fed
OMO - buying/selling treasury securities in the open market to effect changes in cash balances and interest rates
**Reserve requirements - **
Persuading banks to tighten/loosen credit policies
OMO is the most commonly used tool.
4x shapes of the yield curve =
normal/upward sloping
inverted/downward sloping
Flat
Humped
Yield curve theories: pure expectations =
yield for a maturity is an average (not arithmetic) of the short term rates expected in the future
ie if short term rates are expected to rise in the future, so will long term rates
PURE EXPECTATIONS THEORY DOES NOT IMPLY A SHAPE ON ITS OWN
rather, expectations of short term rates rising = upward sloping yield curve
falling = inverted
constant = flat
rise and then fall = humped
Liquidity preference theory =
in addition to expectations about future rates, bondholders demand compensation for the risk of holding longer maturity bonds
this is consistent with the fact that longer maturity bonds generally have greater interest rate risk.
is based on HOW GREAT THE PREFERENCE FOR THE GREATER LIQUIDITY OF SHORT TERM DEBT IS.
a curve can be ANY SHAPE, as even the addition of a liquidity premium may still result in a downward sloping curve if expectations are for rates to fall (which means the pure expectations curve is downward sloping already)
Market segmentation theory =
investors and borrowers have different MATURITY PREFERENCES
yields are determined by SUPPLY AND DEMAND - how much people want to borrow/lend at each maturity
ie inst investors may want debt to match liabilities, banks may want shorter term debt, some investors are restricted to certain maturities.
CAN BE ANY SHAPE - no specific linkage among yields for that maturity range
Spot rate/theoretical treasury spot rate curve =
the appropriate discount rate for each node on the curve - ie if the spot rates are 4%, 5%, 6% at the 1yr, 2yr and 3yr nodes, we’ll discount the individual cash flows of a 3yr bond at the respective spot rate.
these spot rates make up the theoretical treasury spot rate curve which is ARBITRAGE FREE
(YTM is the discount rate that equates the present value of the bond’s cash flow with the current market price - different from a spot rate)
Absolute yield spread =
difference between yields on two bonds.
sometimes called nominal spread.
expressed in basis points.
= yield on higher yield bond - yield on lower yield bond
Relative Yield Spread =
absolute yield spread expressed as a percentage of the yield on the benchmark bond.
= subject bond spread/benchmark bond yield
Yield ratio =
= subject bond yield/benchmark bond yield
same as 1 plus relative yield spread
note that the absolute spread will not show changes in rates if spreads stay constant - but relative yield spread and yield ratio would decrease if both yields rose by the same amount.
Effect on spreads:
embedded options
liquidity
both affect spreads
a call option will increase yield vs an identical non-callable (increasing spread)
put option is the opposite
investors prefer greater liquidity so yield will be greater on a less liquid bond (increasing spread)
liquidity will be greater for a larger issue size.
After tax yield =
= taxable yield x (1-marginal tax rate)
Taxable equivalent yield =
= tax free yield/(1-marginal tax rate)
rearrange the after tax yield formula
if i have a tax free yield of X and a tax rate of Y, what taxable yield would i need to get for an equivalent yield?
LIBOR and funded investors =
LIBOR is the most important benchmark rate for floating rate securities and short term lending.
Published by the british bankers association.
LIBOR is most imporant for short term rates of a year or less.
a FUNDED INVESTOR borrows to finance an investment position - for such investors, the reference rate is very important as it determines cost of funding and their required rate of return.
