abhishreshthaa
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WHAT IS YIELD CURVE:
Type of Yield Curve
Restrictions of Yield Curve:
Drawbacks in Yield Curve:
Application of Yield Curve:
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- 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
- 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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