Lecture 2 The Yield Curve Flashcards
1
Q
The Nominal Yield Curve
A
- The nominal yield curve is defined by treasury bills or bonds issued by the Federal government
- each yield is associated with a specific term to maturity –> risk free rate
2
Q
Short-end of the yield curve
A
Up to 2 years - monetary policy
3
Q
Mid-area of the yield cruve
A
3-10 years
4
Q
Long end of the yield curve
A
over 10 years
5
Q
On-the-run Government of Canada Bonds
A
The most recently auctioned government bonds and are used as a pricing benchmark by the financial markets
6
Q
Off-the-Run Government of Canada Bonds
A
Once the bonds are no longer used as a pricing benchmark by the market, they are considered ‘off-the-run’
7
Q
Importance of the Yield Curve #1
A
- Relative pricing for all other bonds
- A key function of the yield curve is to serve as a benchmark for pricing all other bonds
- The YTM on any other bonds will be composed of: benchmark government bond yield +credit spread
- Credit spread is equal to the premium necessary to compensate the investor for the risks associated with investing in the bond
8
Q
Steps of Linear Interpolation
A
- Find two close ‘on-the-run’/liquid government bonds
- Calculate the number of days between the two bonds
- Yield difference between the two bonds
- Divide the yield difference by the number of days
- Find the number of days between the on-the-run and issuance you are looking at
- Calculate the bps to be added to the lower yielding bond`
9
Q
Importance of the Yield Curve #2
A
- reflects market sentiment on the economy
- the shape and steepness of the yield curve has implications for investors
- a normal/upward sloping yield indicates that the longer the term to maturity the higher the yield
- an inverted yield curve indicates that the longer the maturity the lower the yield
- A flat curve is approximately the same yield across the maturity spectrum
10
Q
Central Banks and Monetary Policy
A
- monetary policy is focused on the front end of the yield curve
11
Q
Federal funds rate target
A
- the rate at which banks lend to each other overnight is the actual Fed Funds rate
- the federal funds rate encourages banks to keep the interest rate charged on interbank overnight loans within a certain range
- to stay within the target, the FED conducts open market operations, buying or selling government securities in the open market
- buying securities increases banks’ reserve funds available to lend (increasing money supply), putting downward pressure on the Federal Funds Rate
12
Q
Term Structure of Interest Rates
A
- the term structure of interest rates is the relationship between interest rates or bond yields and different terms or maturities. The term structure of interest rates is the yield curve
13
Q
The term structure of interest rate changes in response to:
A
- wide economic shocks
- central bank monetary policy decisions
- market specific events
14
Q
Pure Expectations Theory
A
- this theory makes the simplest and most direct link between the yield curve and investors’ expectations about future interest rates
- the markets sets yields based solely on expectations for future interest rates
- future short term rates are equal to forward rates
- if forward rates were perfect predictors of future interest rates, then future bond prices would be known with certainty
- Not the case…future interest rates are not known; future bond prices are not known
15
Q
Risk Premium or Liquidity Theory
A
- this theory asserts that investors want tot be compensated for the interest rate risk associated with holding longer-term bonds
- the longer the maturity, the greater the price volatility when interest rates change and investors want to be compensated for risk
- Therefore, the term structure of interest rates is determined by:
- -> expectations about future interest rates and
- -> a yield premium for interest rate risk AND because interest rate risk increases with maturity the theory assets that the yield premium increases with maturity as well
