Yield Curve

Group 4: Qianyi Luo, Xuan Wu, Chen Wang, Zhi Qiao, Zhirong Xie

ISE 563 Fall 2012

CONTENT
Yield Curve ................................................................. 1 . Concepts of yield curve ..................................................... 3 1. 2. Definition of yield curve ............................................................................................... 3 Different types of yield curves ...................................................................................... 3 a. Normal yield curve ................................................................................................ 3

b. Flat or humped yield curve .................................................................................... 3 c. . Inverted yield curve............................................................................................... 4

Theories Explaining Yield Curves ........................................... 4 1. 2. 3. Market expectations hypothesis ..................................................................................... 4 Liquidity Preference Hypothesis ................................................................................... 5 Market Segmentation Hypothesis .................................................................................. 5

Usage of the Yield Curve .................................................. 6 1. 2. 3. Yield curve as a powerful indicator for real economic activity ....................................... 6 Effect on bond prices .................................................................................................... 7 Source of Interest Rate .................................................................................................. 8

. Method for constructing a yield curve ......................................... 9 References .................................................................. 10

. Concepts of yield curve 1. Definition of yield curve The yield curve is a plot or a relation that shows the relative yields according to different times to maturity of the contracts of debt. Generally speaking, the common used instruments for obtaining the yields are similar treasury debts. This yield curve can be used as a benchmark for other borrowing and lending activities in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth. 2. Different types of yield curves There are three main different types of yield curves which respectively deliver different information about the market. They are normal yield, flat or humped yield curve and inverted yield curve. A normal yield curve is one in which the yield increases with time to maturity of the debt due to the risks associated with the different time structures. An inverted yield curve is one in which the yield decreases with time to maturity of the debt, which can be a sign of potential recession. A flat (or humped) yield curve is one in which there is no difference among the yields of different contract lengths of debts, which is also a signal of uncertainty in the economy. Sometimes also it can be shown a humped yield curve means medium-term yields are higher than those of the short-term and long-term which are equal or close. The slope of the yield curve is another important indicator for its properties. The greater the slope, the larger gap there is between the yields of short term and long term debts.

Time to maturity Figure 1 Normal Yield Curve a. Normal yield curve As stated above, the normal yield curve (Figure 1) describes an up sloping yield curve showing that the debt with longer contract length has a higher interest rate than those similar debts with shorter contract lengths. Generally, this kind of yield curve reflects market participants expect a growing economy and inflation in the future since they are willing to lend loans and borrow debts in a higher interest rate for the longer contract length. A fast growing economy and rising inflation rate usually result in tightening the monetary policy and increasing in short-term interest rates by the central bank in order to prevent the overheated economy and mitigate the pressure from inflation. Thus, market participants will ask for higher rates of return on financial instruments with longer contract length in anticipation of higher future interest rates in general. b. Flat or humped yield curve In a flat yield curve (Figure 2), the yields do not change with different times to maturity, which means lender will receive the same interest rates for lending money in different time terms. There is also a kind of humped yield curve, which shows that, short term and long term debts still offer the same yield while medium term maturities offer varying rates of return. A flat or humped yield curve usually indicates the uncertainty in market and future economic condition. It still

remains to be investigated after more information about the economy comes out whether a transition to normal or inverted yield curve would happen or not.

Time to maturity

Figure 2 Flat or Humped Yield Curve c. Inverted yield curve An inverted yield curve occurs when yields decrease with the times to maturity. As the name implies, it shows an inverted relationship to the normal yield curve, indicating a down sloping curve. This structure indicates an expectation of economy recession in the future, or a belief that inflation will drop even deflation will occur. Overall, pessimistic expectations about future economy conditions might cause this kind of yield curve, as demand for short-term investments exceed long-term, driving up the interest rates on financial instruments with a shorter times to maturity. Markets expectation that central bank will lower short term interest rates to stimulate economy also pushes down the long term yield.

Time to maturity Figure 3 Inverted Yield Curve . Theories Explaining Yield Curves 1. Market expectations hypothesis The market expectation theory says that, the shape of the yield curve should be determined by the interest rate expectation. That is, the more market participants expect the interest rate to rise, the greater should be the slope of the current yield curve. What the expectation theory implies is

that the slope of the yield curve should change accordingly to the subsequent movement of the interest rate. The market expectation hypothesis is based on two assumptions. The first is that expectations of future rates coincide exactly with future rates realized in time, which indicates the market precisely predicts the demand and supply of the currency in the future. The hypothesis also supposes that yields at higher maturities (such as that of 5, 10, or 30 year bond), are compounded from the yields on shorter maturities. However, there are two major limitations of the market expectation theory. First of all, the projection of future interest rate rarely matches the realized future spot interest rate. This phenomenon is quite common in practice. Secondly, the hypothesis does not explain why longer term maturity requires a higher rate of return. It said nothing about the kind of risk undertaken by investors who hold longer term bonds, which results into the relatively higher interest rate. 2. Liquidity Preference Hypothesis The liquidity preference hypothesis (LPH) was proposed first by John Hicks in 1946. The hypothesis essentially is an improved version of the market expectation hypothesis, which fails to explain why the shape of the yield curve is upwards. The market expectation hypothesis assumes that bonds with different maturities are substitutable, where the longer term bond could be simply replicated by compounding short term bond. However, LPH states that no, it is not like that. According to Hicks, investors perceive long maturity bonds as riskier than short maturity bonds, due to larger price uncertainty over intermediate holding period1. Thus, bonds with different maturities are imperfect substitutes. LPH successfully solved the problem of explaining the shape of the yield curve. As longer term bonds are riskier, they are more sensitive to interest rate changes than shorter term bonds 2. Individual investors require a risk premium to compensate the risk of holding these bonds, resulting into the higher expected return. But LPH has its own shortage. It assumes that all investors have similar preference, so they need additional compensation for longer term bonds. What if different investors do not equally value each segment of the maturity structure at the same degree? Is it possible that there are inherent differences between maturities perceived by individuals? These two doubts lead to the third hypothesis: Market Segmentation Theory. 3. Market Segmentation Hypothesis The market segmentation hypothesis (MSH) argues that due to institutional factors, different maturity bonds are not substitutes. Bond prices for a particular maturity are determined in isolation from other maturity bonds. In other words, there probably does not exist a unified bond market, but rather two-year, five-year, ten-year bond markets, as the roles played by these instruments are not equivalent in any way. Bonds of different maturities are based on different function of supply and demand and different utility function of investors. Thus, these bonds are all unique products and traded in separate markets, far from being substitutable or partly substitutable which is assumed by market expectation hypothesis and liquidity preference hypothesis. MSH states that each lender and borrower has a specific timeframe in mind when entering into the bond market. Just like speculators prefer buying short term bonds in order to profit from interest rate changes, while real estate company would like to borrow long term bonds to meet their liquidity needs. As a result, lenders generally cluster around the short side of the yield
1

Robert A. Jarrow Liquidity Premiums and the Expectations Hypothesis; Journal of Banking and Finance 5 (1981) 539-546. North-Holland Publishing Company 2 Jacob Boudoukh, Matthew Richardson Ex Ante Bond Returns and the Liquidity Preference Hypothesis; THE JOURNAL OF FINANCE * VOL. LI, NO. 3 * JUNE 1999

curve due to lower risk and higher liquidity, leading into a lower interest rate. In contrast, borrowers want long-term loans more because of the flexibility of managing the funds, which leads into a higher yield to maturity. MSH has the advantage over the previous two hypothesis for its success in explaining the upwards trend of the yield curve. Unfortunately, it has its own Achilles heel. Since bonds of different maturities constitute different market, one could reasonably expect the interest rate in different market would move independently up and down separately driven by the law of demand and supply. But this often contradicts what has been observed in market. . Usage of the Yield Curve 1. Yield curve as a powerful indicator for real economic activity Common consensus Scholars, monetary officials, and investors have always craved to find reliable business cycle indicators, in order to make better moves at advance. Empirically, the slope of the yield curve, are believed to be a powerful indicator for future real economic activity. Generally, there are three primary shapes, a) positive or normal(short -term yields are lower than long-term yields, which means that people require a higher rate of return for lending money for a longer period of time. A steep positive curve usually indicates a high economy growth or inflation expectation. ) b) inverted or negative (short -term yields are higher than long-term yields, often a signal for recession.) c) flat yield curve (the difference between short-term and long-term yields is little.) Conceptual Considerations The logic for yield curve theory is fairly simple: In modern economic system, Banks are the engine for monetary circulation and economic development. The typical mode for banking industry is to borrow money from publics short-term saving and offer interest, on the other hand, to lend money by long-term mortgages or loans and receive interest. If it is a positive curve, banks make profits and would be more likely to increase its loans, thus stimulate the economy or increase inflation. Otherwise, if it is an inverted curve, banks would realize the interest they received is less than the interest they paid. Banks would become reluctant to extend new loans to public borrowers, which would lead to a slow down for economy growth. The yield curve can be explained in various aspects, such as monetary policy and investors expectation. It is widely accepted that short-term interest rate is one of most important operating instruments which a central bank used to conduct monetary policy. When intend to reduce the inflation pressure, a tightening policy would be implemented, usually indicate a rise in short-term interest rate. Subsequently, it is expected to have an easing policy--lower rates, in the future. Therefore, as a result of tightening, short-term rates are relatively high, whereas long-term rates are relatively low. The tightening policy slows down the economy and flattens or inverts the yield curve3. Changes in investor expectations can also affect the slope of the yield curve. Future short-term interest rates are related to future demand for credit and to future inflation. A rise in short-term interest rates induced by monetary policy could be expected to lead to a future slowdown in real economic activity and demand for credit. At the same time, slowing activity may result in lower expected inflation, increasing the possibility of a future easing in monetary policy. The expected declines in short-term rates would tend to reduce current long-term rates and

3,4

Arturo Estrella and Mary R. Trubin FEDERAL RESERVE BANK OF NEW YORK Volume 12; Number 5 July/August 2006

flatten the yield curve. Clearly, this scenario is consistent with the observed correlation between the yield curve and recessions 4. Related studies Since 1980s, many economists have argued about the close relationship between the yield curve and subsequent shifts in certain significant economy variables. For instance, Laurent (1988) examined the yield curve as an predictive indicator of monetary policy, come out to be statistically coordinated with the later pace of output growth, and Harvey (1988) claimed a strong correlation between the slope of the yield curve and consumption applying capital asset pricing model (CCAPM). Estrella and Hardouvelis (1991) presented tests of the predictive power of the yield curve, and it performed well with strong results for predicting GNP, investment, consumption and recessions. Also, Estrella and Mishkin(1997) found the same significant results for many other countries, particularly in Europe. Empirical evidence Yield curve slope related to economic performance, furthermore, it is one of the simplest ways of forecasting a recession. Estrella (2005) claimed that the probability of recession is strongly correlated with the spread between the 10-year interest rate and 3-month interest rate (converted by 10-year Treasury bonds and 3-month T-bills), as shown in the chart.

As the spread approaches zero, the probability rises more rapidly. The shaded region represents the range of spread for which the probability of recession exceeds 30 percent, which has been the case prior to every recession since 1960.5 All of the recessions in the US since 1970 (up through 2011) have been examined to have an inverted yield curve. Over the same time frame, every occurrence of an inverted yield curve has been followed by recession as declared by the NBER business cycle dating committee. 6 2. Effect on bond prices A. When the yield curve is flat, an initially trading-at-par bond will always be traded at the par through the end of maturity, an initially trading-at-premium or discount bond will be traded more and more close to its face value as the time approaches the maturity.

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Estrella, Arturo The International Economy; Summer 2005 http://en.wikipedia.org/wiki/Yield_curve#Steep_yield_curve

B. When the yield curve is steep, bond price will increase as the lower interest rate becomes the new market rate, however, at some point, the bond price will change the direction and be traded more and more close to its face value as the maturity is approaching.

C. When the yield curve is inverted, bond price will decrease as the higher interest rate becomes the new market rate, however, at some point, the bond price will change the direction and be traded more and more close to its face value as the maturity is approaching.

3.

Source of Interest Rate

Lenders, borrowers, buyers and sellers of derivatives use the yield curve as the source of the interest rates. For instance, a bank making a 10-year loan will pick off the corresponding 10-year interest rate in that curve, add a bit and make the loan at that rate. Analysts and traders will also use it as an input in their derivative price calculations, like e**rt in the bond price calculation. . Method for constructing a yield curve Here we primarily talk about the Bootstrap Method to build yield curve. Typically some rates at the short end of the curve will be known. For example, some zero-coupon bonds might trade which give us exact rates. In some markets, where there is insufficient liquidity at the short end, some inter-bank money market rates will be used.7 Using these zero-coupon products it becomes possible to derive zero rates (forward and spot) for all maturities by making a few assumptions (including linear interpolation). The term structure of spot returns is recovered from the bond yields by solving for them recursively, by forward substitution. This iterative process is called the Bootstrap Method. There are three major procedures of this method. First of all, define set of yielding products, these will generally be coupon-bearing bonds. Then derive discount factors for all terms, these are the internal rates of return of the bonds. Finally, 'Bootstrap' the zero-coupon curve step-by-step.

Patrick S.Hagan, Graeme West Methods for Constructing a Yield Curve

References
Robert A. Jarrow Liquidity Premiums and the Expectations Hypothesis; Journal of Banking and Finance 5 (1981) 539-546. North-Holland Publishing Company Jacob Boudoukh, Matthew Richardson Ex Ante Bond Returns and the Liquidity Preference Hypothesis; THE JOURNAL OF FINANCE * VOL. LI, NO. 3 * JUNE 1999 Arturo Estrella and Mary R. Trubin FEDERAL RESERVE BANK OF NEW YORK Volume 12; Number 5 July/August 2006 Estrella, Arturo The International Economy; Summer 2005 Patrick S.Hagan, Graeme West Methods for Constructing a Yield Curve Patrick S. Hagan, Graeme West. Interpolation methods for curve construction. Applied Mathematical Finance, 13 (2):89129, 2006. URL: http://en.wikipedia.org/wiki/Yield_curve#Steep_yield_curve