Yield Curves
1) What is a Yield Curve ?
This is the line graph that you get when you plot the Yield (or Interest Rate) on the y-axis against the time to maturity on the x-axis using similar instruments that have the same credit quality or risk profile.
Its the graphical representation of the relationship between the interest rate on a particular class of security against time to maturity.
The vertical axis shows the annual interest rate available in the market.
The horizontal axis shows the time of the investment.
2) How many different types of Yield Curve are there ?
There are lots and they can be classified in many different ways.
You can create yield curves using government bonds (lower risk, so lower yield curve).
You can create yield curves using corporate bonds (higher risk, so higher yield curve).
Only bonds from the same class of issuer and with the same degree of risk should be used.
3) Can any other instruments can be used to create yield curves, or is it just bonds ?
You can create yield curves from other instruments as well.
Overnight Indexed Swap (OIS) rates can be used to indicate short-term rates.
Swap rates can be used to indicate long-term rates.
4) When people say Yield Curve which yield curve are they referring to ?
They are most likely talking about the Spot Yield Curve.
5) When people say Spot Curve which spot curve are they referring to ?
They are most likely taking about the Treasury Spot Yield Curve.
6) What is the Treasury Spot Curve ?
This is a Spot Curve that has been constructed using Treasury Securities.
7) Why are yield curves useful ?
This is the relationship between the cost of borrowing and time.
(1) They can provide us with projected discount rates so we can discount future cash flows (discounting curve)
(2) They can provide us with projected forward rates for cash flows in the future (forwarding curve)
Interest Rate Curves
Interest rate curves (or projected interest rates) are not published by market participants.
However you can use the prices of market instruments to build interest rate curves.
Importance of Yield Curves
Swap valuations uses the zero coupon yield curve and forward rates.
Forward rates are used to forecast floating payments of the swap.
Relative Value Analysis
This is the process when investors compare a corporate bond yield curve to the US Treasury yield curve to determine if a bond is worth buying
All investors have a specific risk/reward profile that they are comfortable with and a bonds yield relative to its perceived risk will influence whether they buy or sell
Parallel Shift
Steepness
Curvature
Spread
Par swaps are used to construct yield curves
Factors Affecting Yield Curves
Inflation
Supply / Demand
Liquidity Desires
The most important factor affecting a yield curve is the currency in which is denominated.
The ecomonic situation in that country is also very important.
Discount Curves - extract discount rates to "value" cashflows
Old Curve - uses specific instruments and bootstrapping
New Curve - uses market observables. Define the curve using discount factors at certain dates. Fits the curve to the market
The yield to maturity of a bond is the most frequently used measure for indicating the interest rate when you hold a bond to maturity.
Important
Yields are normally measured with continuous compounding interest.
When you compare two yield curves you get a yield spread.
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