Yield Curve, Spot Rates, Duration & Convexity Flashcards
What is the yield curve / term structure of interest rates?
The relationship between interest rate and time to maturity
1) Normally upward sloping
2) Longer dated securities have a higher risk (risk term premium)
What does the shape of the yield curve indicate?
Market expectations of interest rates
What are the three theories that explain yield curve shape?
1) Liquidity Preference Theory
2) Market Expectations Theory
3) Preferred Habitat Theory
What is liquidity preference theory?
Investors have a preference for liqudiity. Interest can therefore be considered an incentive to part with it.
The longer you are parted with it the more you must be compensated.
This is reflected in a normal upward sloping yield curve (term premium increases as maturity does)
What is Market expectations theory?
The shape of the yield curve is a representation of future expectations of interest rates.
The only point on the yield curve which can be fixed is immediate short-term rates, set by intervention
of the central bank through its operations in the money markets.
According to expectations theory, where will demand be when:
1) Curve is upward sloping
2) Curve is inverted
1) Demand at the short end, defer purchases of long dated bonds as expectations are that rates will rise
2) Demand at long end, expectations for yield to fall - buy long to lock in duration
A flat yield curve suggests rates will not materially change in the future
How does expectation theory link with spot / future rates
It argues the yield curve is a reflection of spot rates, and in turn spot rates are expectations of forward rates.
What is preferred habitat theory?
Different investors have different preferred segments on the yield curve.
1) Long end is pension funds / life insurance
2) Short-end is FIGs and Corps
Explains the hump at the 5yr mark as demand is concentrated at either end.
What is a spot rate?
Interest agreed today for borrowing for a fixed term.
e.g. 2 year spot rate is the rate for a cash flow occuring in two years
How can spot rates more accurately discount cash flows?
GRY / IRR assumes reinvestment at an identical rate which is unrealistic
Spot rates can discount each cash flow with a different rate which is more realistic.
e.g. discount any cashflow in 1 year’s time with the 1 year rate and in two years’ time use 2yr rate.
Where can spot rates be obtained from?
Money Market & STRIP rates
Spot rates can also be derived from normal bond prices if you have: GRY, Coupon and current price
