Yield Curve

abhishreshthaa

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WHAT IS YIELD CURVE:


  • It is Used to observe interest rates in the market

  • Drawn from YTM of the traded bonds

  • Gives a functional relationship between time to maturity and YTM

  • Relationship modeled as a function used to value bonds where the

    independent variable is tenor (x) & the dependent variable the yield (y)

  • This can be done by plotting x & y and fitting a 3rd degree polynomial to describe the functional relationship.

Type of Yield Curve

  • Flat –constant Interest Rates.

  • Upward Sloping- as term to maturity increases yield increases.

  • Downward Sloping-as term to maturity increases yield decreases.

  • Humped- Fluctuating Interest Rates.


Restrictions of Yield Curve:

  • May not represent the yields and interest rates for various tenures

  • It discounts all the future cash flows at a uniform discount rate i.e. the YTM resulting in a flat yield curve

  • True interest rates cannot be observed from the Yield Curve

  • It is a simplified and erroneous assumption on reinvestment of intermittent coupons.


Drawbacks in Yield Curve:

  • It describes the single rate that present values the sum of all future cash flows to it’s current price.

  • Each cash flow is present valued at same rate ,an unrealistic assumption in anything then a flat yield curve environment.

  • It will be achieved only if

  • A bond is purchased on issue & held till maturity.

  • All coupons paid throughout the bond’s life are reinvested at the same YTM at which the bond was purchased.


Application of Yield Curve:

  • Setting of Yield for all debt market instruments

  • Acting as an indicator of future Yield levels(Corporate financers ,central banks ,government treasury dpt)

  • Measuring & comparing returns across the maturity spectrum(Portfolio mgr’s )

  • Indicating relative value between different bonds of similar maturity(Cheap or Dear bonds)

  • Pricing Interest rate derivative securities.

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