Yield curve

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The US dollar yield curve as of 9 February 200 ! The curve has a typical up"ard sloping shape! This article is about yield curves as used in finance! For the term#s use in physics, see $ield curve %physics&! 'n finance, the yield curve is the relation bet"een the interest rate %or cost of borro"ing& and the time to maturity of the debt for a given borro"er in a given currency! For e(ample, the current U!S! dollar interest rates paid on U!S! Treasury securities for various maturities are closely "atched by many traders, and are commonly plotted on a graph such as the one on the right "hich is informally called )the yield curve!) *ore formal mathematical descriptions of this relation are often called the term structure of interest rates! The yield of a debt instrument is the annuali+ed percentage increase in the value of the investment! For instance, a ban, account that pays an interest rate of -. per year has a -. yield! 'n general the percentage per year that can be earned is dependent on the length of time that the money is invested! For e(ample, a ban, may offer a )savings rate) higher than the normal chec,ing account rate if the customer is prepared to leave money untouched for five years! 'nvesting for a period of time t gives a yield Y(t)! This function Y is called the yield curve, and it is often, but not al"ays, an increasing function of t! $ield curves are used by fi(ed income analysts, "ho analy+e bonds and related securities, to understand conditions in financial mar,ets and to see, trading opportunities! /conomists use the curves to understand economic conditions!

The yield curve function $ is actually only ,no"n "ith certainty for a fe" specific maturity dates, "hile the other maturities are calculated by interpolation %see Construction of the full yield curve from market data below&!

Contents
0hide1

2 The typical shape of the yield curve o 2!2 Types of yield curve

2!2!2 3ormal yield curve 2!2!2 Steep yield curve 2!2!4 Flat or humped yield curve 2!2!- 'nverted yield curve

2 Theory
o o o o o

2!2 *ar,et e(pectations %pure e(pectations& hypothesis 2!2 5i6uidity preference theory 2!4 *ar,et segmentation theory 2!- 7referred habitat theory 2! 8istorical development of yield curve theory

4 9onstruction of the full yield curve from mar,et data - See also 3otes : ;eferences < /(ternal lin,s

[edit] The typical shape of the yield curve

The =ritish pound yield curve as of 9 February 200 ! This curve is unusual in that long>term rates are lo"er than short>term ones! $ield curves are usually up"ard sloping asymptotically? the longer the maturity, the higher the yield, "ith diminishing marginal gro"th! There are t"o common e(planations for this phenomenon! First, it may be that the mar,et is anticipating a rise in the ris,>free rate! 'f investors hold off investing no", they may receive a better rate in the future! Therefore, under the arbitrage pricing theory, investors "ho are "illing to loc, their money in no" need to be compensated for the anticipated rise in rates @ thus the higher interest rate on long>term investments! 8o"ever, interest rates can fall Aust as they can rise! Bnother e(planation is that longer maturities entail greater ris,s for the investor %i!e! the lender&! ;is, premium should be paid, since "ith longer maturities, more catastrophic events might occur that impact the investment! This e(planation depends on the notion that the economy faces more uncertainties in the distant future than in the near term, and the ris, of future adverse events %such as default and higher short>term interest rates& is higher than the chance of future positive events %such as lo"er short>term interest rates&! This effect is referred to as the liquidity spread! 'f the mar,et e(pects more volatility in the future, even if interest rates are anticipated to decline, the increase in the ris, premium can influence the spread and cause an increasing yield! The opposite situation @ short>term interest rates higher than long>term @ also can occur! For instance, in 3ovember 200-, the yield curve for UC Dovernment bonds "as partially inverted! The yield for the 20 year bond stood at -!:E., but only -!- . on the 40 year bond! The mar,et#s anticipation of falling interest rates causes such incidents! 3egative li6uidity premiums can e(ist if long>term investors dominate the mar,et, but the prevailing vie" is that a positive li6uidity premium dominates, so only the anticipation of falling interest rates "ill cause an inverted yield curve! Strongly inverted yield curves have historically preceded economic depressions!

The yield curve may also be flat or hump>shaped, due to anticipated interest rates being steady, or short>term volatility out"eighing long>term volatility! $ield curves move on a daily basis, reflecting the mar,et#s reaction to ne"s! B further )styli+ed fact) is that yield curves tend to move in parallel %i!e!, the yield curve shifts up and do"n as interest rate levels rise and fall&!

[edit] Types of yield curve

There is no single yield curve describing the cost of money for everybody! The most important factor in determining a yield curve is the currency in "hich it is denominated! The economic situation of the countries and companies using each currency is a primary factor in determining the yield curve! For e(ample the sluggish economic gro"th of Japan throughout the late 2990s and early 2000s has meant the yen yield curve is very lo" %rising from virtually +ero at the three month point to only 2. at the 40 year point&! =y contrast, during that time the =ritish pound curve ranged from -> . along its curve! Fifferent institutions borro" money at different rates, depending on their credit"orthiness! The yield curves corresponding to the bonds issued by governments in their o"n currency are called the government bond yield curve %government curve&! =an,s "ith high credit ratings %BaGBB or above& borro" money from each other at the 5'=H; rates! These yield curves are typically a little higher than government curves! They are the most important and "idely used in the financial mar,ets, and are ,no"n variously as the 5'=H; curve or the s"ap curve! The construction of the s"ap curve is described belo"! =esides the government curve and the 5'=H; curve, there are corporate %company& curves! These are constructed from the yields of bonds issued by corporations! Since corporations have less credit"orthiness than governments and most large ban,s, these yields are typically higher! 9orporate yield curves are often 6uoted in terms of a )credit spread) over the relevant s"ap curve! For instance the five>year yield curve point for Iodafone might be 6uoted as 5'=H; J0!2 ., "here 0!2 . %often "ritten as 2 basis points or 2 bps& is the credit spread! [edit] Normal yield curve From the post>Dreat Fepression era to the present, the yield curve has usually been )normal) meaning that yields rise as maturity lengthens %i!e!, the slope of the yield curve is positive&! This positive slope reflects investor e(pectations for the economy to gro" in the future and, importantly, for this gro"th to be associated "ith a greater e(pectation that inflation "ill rise in the future rather than fall! This e(pectation of higher inflation leads to e(pectations that the central ban, "ill tighten monetary policy by raising short term interest rates in the future to slo" economic gro"th and dampen inflationary pressure! 't also creates a need for a ris, premium associated "ith the uncertainty about the future rate of inflation and the ris, this poses to the future value of cash flo"s! 'nvestors price these ris,s into the yield curve by demanding higher yields for maturities further into the future! 8o"ever, a positively sloped yield curve has not al"ays been the norm! Through much of the 29th century and early 20th century the US economy e(perienced trend gro"th "ith persistent deflation, not inflation! Furing this period the yield curve "as typically inverted, reflecting the fact that deflation made current cash flo"s less valuable than future cash flo"s! Furing this period of persistent deflation, a #normal# yield curve "as negatively sloped!

[edit] Steep yield curve 8istorically, the 20>year Treasury bond yield has averaged appro(imately t"o percentage points above that of three>month Treasury bills! 'n situations "hen this gap increases %e!g! 20> year Treasury yield rises relatively higher than the three>month Treasury yield&, the economy is e(pected to improve 6uic,ly in the future! This type of curve can be seen at the beginning of an economic e(pansion %or after the end of a recession&! 8ere, economic stagnation "ill have depressed short>term interest rates? ho"ever, rates begin to rise once the demand for capital is re>established by gro"ing economic activity! [edit] Flat or humped yield curve B flat yield curve is observed "hen all maturities have similar yields, "hereas a humped curve results "hen short>term and long>term yields are e6ual and medium>term yields are higher than those of the short>term and long>term! B flat curve sends signals of uncertainty in the economy! This mi(ed signal can revert bac, to a normal curve or could later result into an inverted curve! 't cannot be e(plained by the Segmented *ar,et theory discussed belo"! [edit] nverted yield curve Bn inverted yield curve occurs "hen long>term yields fall belo" short>term yields! Under unusual circumstances, long>term investors "ill settle for lo"er yields no" if they thin, the economy "ill slo" or even decline in the future! Bn inverted curve has indicated a "orsening economic situation in the future out of : times since 29<0! The 3e" $or, Federal ;eserve regards it as a valuable forecasting tool in predicting recessions t"o to si( 6uarters ahead! 'n addition to potentially signaling an economic decline, inverted yield curves also imply that the mar,et believes inflation "ill remain lo"! This is because, even if there is a recession, a lo" bond yield "ill still be offset by lo" inflation! 8o"ever, technical factors, such as a flight to 6uality or global economic or currency situations, may cause an increase in demand for bonds on the long end of the yield curve, causing long>term rates to fall! This "as seen in 299E during the 5ong Term 9apital *anagement failure "hen there "as a slight inversion on part of the curve!

[edit] Theory
There are four main economic theories attempting to e(plain ho" yields vary "ith maturity! T"o of the theories are e(treme positions, "hile the third attempts to find a middle ground bet"een the former t"o!

[edit] !arket e"pectations #pure e"pectations$ hypothesis

This hypothesis assumes that the various maturities are perfect substitutes and suggests that the shape of the yield curve depends on mar,et participants# e(pectations of future interest rates! These e(pected rates, along "ith an assumption that arbitrage opportunities "ill be minimal, is enough information to construct a complete yield curve! For e(ample, if investors have an e(pectation of "hat 2>year interest rates "ill be ne(t year, the 2>year interest rate can be calculated as the compounding of this year#s interest rate by ne(t year#s interest rate! *ore

generally, rates on a long>term instrument are e6ual to the geometric mean of the yield on a series of short>term instruments! This theory perfectly e(plains the observation that yields usually move together! 8o"ever, it fails to e(plain the persistence in the shape of the yield curve! Shortcomings of e(pectations theory: 3eglects the ris,s inherent in investing in bonds %because for"ard rates are not perfect predictors of future rates&! 2& 'nterest rate ris, 2& ;einvestment rate ris,

[edit] %iquidity preference theory

The 5i6uidity 7reference Theory, an offshoot of the 7ure /(pectations Theory, asserts that long>term interest rates not only reflect investorsK assumptions about future interest rates but also include a premium for holding long>term bonds, called the term premium or the li6uidity premium! This premium compensates investors for the added ris, of having their money tied up for a longer period, including the greater price uncertainty! =ecause of the term premium, long>term bond yields tend to be higher than short>term yields, and the yield curve slopes up"ard! 5ong term yields are also higher not Aust because of the li6uidity premium, but also because of the ris, premium added by the ris, of default from holding a security over the long term!

[edit] !arket se&mentation theory

This theory is also called the se&mented market hypothesis! 'n this theory, financial instruments of different terms are not substitutable! Bs a result, the supply and demand in the mar,ets for short>term and long>term instruments is determined independently! 7rospective investors "ould have to decide in advance "hether they need short>term or long>term instruments! Fue to the fact that investors prefer their portfolio to be li6uid, they "ill prefer short>term instruments to long>term instruments! Therefore, the mar,et for short>term instruments "ill receive a higher demand! 8igher demand for the instrument implies higher prices and lo"er yield! This e(plains the styli+ed fact that short>term yields are usually lo"er than long>term yields! This theory e(plains the predominance of the normal yield curve shape! 8o"ever, because the supply and demand of the t"o mar,ets are independent, this theory fails to e(plain the observed fact that yields tend to move together %i!e!, up"ard and do"n"ard shifts in the curve&! 'n an empirical study, 2000 Ble(andra /! *acCay, /lie+er L! 7risman, and $isong S! Tian found segmentation in the mar,et for 9anadian government bonds, and attributed it to differential ta(ation! For a brief period in the last "ee, of 200 , and again in early 200:, the US Follar yield curve inverted, "ith short>term yields actually e(ceeding long>term yields! *ar,et segmentation theory "ould attribute this to an investor preference for longer term securities, particularly from pension funds and foreign investors "ho prefer guaranteed longer term yields!

[edit] 'referred ha(itat theory

The 7referred 8abitat Theory states that in addition to interest rate e(pectations, investors have distinct investment hori+ons and re6uire a meaningful premium to buy bonds "ith maturities outside their )preferred) maturity, or habitat! 7roponents of this theory believe that

short>term investors are more prevalent in the fi(ed>income mar,et and therefore, longer>term rates tend to be higher than short>term rates, for the most part, but short>term rates can be higher than long>term rates occasionally! This theory represents a middle ground bet"een the *ar,et Segmentation Theory and the *ar,et /(pectations Theory! *oreover, it seems to e(plain both the persistence of the normal yield curve shape and the tendency of the yield curve to shift up and do"n "hile retaining its shape!

[edit] )istorical development of yield curve theory

Hn 2 Bugust 29<2, U!S! 7resident ;ichard 3i(on announced that the U!S! dollar "ould no longer be based on the gold standard, thereby ending the =retton Moods system and initiating the era of floating e(change rates! Floating e(change rates made life more complicated for bond traders, including importantly those at Salomon =rothers in 3e" $or,! =y the middle of the 29<0s, due to the prodding of the head of bond research at Salomon, *arty 5iebo"it+, traders began thin,ing about bond yields in ne" "ays! ;ather than thin, of each maturity %a ten year bond, a five year, etc!& as a separate mar,etplace, they began dra"ing a curve through all their yields! The bit nearest the present time became ,no"n as the short end@yields of bonds further out became, naturally, the long end! Bcademics had to play catch up "ith practitioners in this matter! Hne important theoretic development came from a 9+ech mathematician, Hldrich Iasice,, "ho argued in a 29<< paper that bond prices all along the curve are driven by the short end %under ris, neutral e6uivalent martingale measure&, and accordingly by short>term interest rates! The mathematical model for Iasice,#s "or, "as given by an Hrnstein>Uhlenbec, process, and has since been discredited because the model predicts a positive probability that the short rate becomes negative and is infle(ibile in creating yield curves of different shapes! Iasice,#s model has been superseded by many different models including the 8ull>Mhite model %"hich allo"s for time varying parameters in the Hrnstein>Uhlenbec, process&, the 9o(>'ngersoll> ;oss model, "hich is a modified =essel process, and the 8eath>Jarro">*orton frame"or,! There are also many improvements on each of these models, but see the article on short rate model! Bnother modern approach is the 5'=H; *ar,et *odel, introduced by =race, Datare, and *usiela in 299< and advanced by others later! 'n 299: a group of derivatives traders led by Hlivier Foria %then head of s"aps at Feutsche =an,& and *ichele Faissola, contributed to the e(tension of the s"ap yield curves in all the maAor european currencies! Until then the mar,et "ould give prices until 2 years maturities! The team e(tended the maturity of european yield curves up to 0 years %lira french franc, deutsche mar,, danish ,rona and many other currencies including ecu&! This innovation "as a maAor contribution for the issuance of long dated +ero coupon bonds and for the creation of long dated mortgages

[edit] Construction of the full yield curve from market data

Typical inputs to the money market curve Type 9ash The usual representation of the yield curve is a function 7, defined on all future times t, such that 7%t& represents the value today of receiving one unit of currency t years in the future! 'f 7 is defined for all future t then "e can easily recover the yield %i!e! the annuali+ed interest rate& for borro"ing money for that period of time via the formula 9ash 9ash 9ash Future Future Future Future Future S"ap S"ap S"ap S"ap S"ap S"ap S"ap S"ap S"ap Settlement date Hvernight rate Tomorro" ne(t rate 2m 4m Fec>9< *ar>9E Jun>9E Sep>9E Fec>9E 2y 4y -y y <y 20y 2 y 20y 40y *ate #+$ ! E:< ! 94< !:2 !<2E< !<: !<< !E2 !EE :!00 :!022 4 :!20E24 :!2: :!22 :!42 :!-2 :! : :! : :! :

B list of standard instruments used to build a money mar,et yield curve! The data is for lending in US dollar, ta,en from : Hctober 299<

The significant difficulty in defining a yield curve therefore is to determine the function 7%t&! 7 is called the discount factor function! $ield curves are built from either prices available in the bond market or the money market! Mhilst the yield curves built from the bond mar,et use prices only from a specific class of bonds %for instance bonds issued by the UC government& yield curves built from the money mar,et uses prices of )cash) from today#s 5'=H; rates, "hich determine the )short end) of the curve i!e! for t N 4m, futures "hich determine the mid>section of the curve %4m N t N 2 m& and interest rate s"aps "hich determine the )long end) %2y N t N :0y&! 'n either case the available mar,et data provides a matri( A of cash flo"s, each ro" representing a particular financial instrument and each column representing a point in time! The %i,j&>th element of the matri( represents the amount that instrument i "ill pay out on day

j! 5et the vector F represent today#s prices of the instrument %so that the i>th instrument has value F%i&&, then by definition of our discount factor function P "e should have that F O APP %this is a matri( multiplication&! Bctually noise in the financial mar,ets means it is not possible to find a P that solves this e6uation e(actly, and our goal becomes to find a vector P such that APPOFJQ "here Q is as small a vector as possible %"here the si+e of a vector might be measured by ta,ing its norm, for e(ample&! 3ote that even if "e can solve this e6uation, "e "ill only have determined P%t& for those t "hich have a cash flo" from one or more of the original instruments "e are creating the curve from! Ialues for other t are typically determined using some sort of interpolation scheme! 7ractitioners and researchers have suggested many "ays of solving the BP7 O F e6uation! 't transpires that the most natural method > that of minimi+ing Q by least s6uares regression > leads to unsatisfactory results! The large number of +eroes in the matri( A mean that function P turns out to be )bumpy)! 'n their comprehensive boo, on interest rate modelling James and Mebber note that the follo"ing techni6ues have been suggested to solve the problem of finding 7: 2! Bppro(imation using 5agrange polynomials 2! Fitting using parameterised curves %such as splines, the 3elson>Siegel family, the Svensson family or the 9airns restricted>e(ponential family of curves&! Ian Feventer, 'mai and *esler summari+e three different techni6ues for curve fitting that satisfy the ma(imum smoothness of either for"ard interest rates, +ero coupon bond prices, or +ero coupon bond yields 4! 5ocal regression using ,ernels -! 5inear programming 'n the money mar,et practitioners might use different techni6ues to solve for different areas of the curve! For e(ample at the short end of the curve, "here there are fe" cashflo"s, the first fe" elements of 7 may be found by bootstrapping from one to the ne(t! Bt the long end, a regression techni6ue "ith a cost function that values smoothness might be used!

[edit] See also

+ero>coupon bond short rate model

[edit] Notes [edit] *eferences

Jessica James R 3ic, Mebber %2002&! Interest ate !odelling! John Miley R Sons! 'S=3 0>-<2>9< 24>0! ;iccardo ;ebonato %299E&! Interest" ate #$tion !odels! John Miley R Sons! 'S=3 0> -<2>9<9 E>9! 3icholas Funbar %2000&! Inventing !oney! John Miley R Sons! 'S=3 0>-<2>E9999>2! 3! Bnderson, F! =reedon, *! Feacon, B! Ferry and *! *urphy %299:&! %stimating and inter$reting the yield curve! John Miley R Sons! 'S=3 0>-<2>9:20<>-! Bndre" J!D! 9airns %200-&! Interest ate !odels " An Introduction! 7rinceton University 7ress! 'S=3 0>:92>22E9->9! John 9! 8ull %29E9&! #$tions& futures and other derivatives! 7rentice 8all! 'S=3 0>24> 02 E22>-! See in particular the section 'heories of the term structure %section -!< in the fourth edition&! Famiano =rigo, Fabio *ercurio %2002&! Interest ate !odels " 'heory and Practice! Springer! 'S=3 4> -0>-2<<2>9! Fonald ;! van Feventer, CenAi 'mai, *ar, *esler %200-&! Advanced Financial isk !anagement& An Integrated A$$roach to Credit isk and Interest ate isk !anagement! John Miley R Sons! 'S=3>24: 9<E>0-<0E222:E! ;uben F 9ohen %200:& )B Ia;>=ased *odel for the $ield 9urve 0do"nload1) (ilmott !aga)ine, *ay 'ssue! 7aul F! 9"i, %200 & )The 'nverted $ield 9urve and the /conomic Fo"nturn 0do"nload1) *ew Pers$ectives on Political %conomy, Iolume 2, 3umber 2, 200 , pp! 2>4<! ;oger Mets, Stephen =ianchi R 5iming $ang %2002&, )Serious Lero>9urves) 0do"nload1)

[edit] ,"ternal links

/uro area yield curves > /uropean 9entral =an, "ebsite Fynamic $ield 9urve > This chart sho"s the relationship bet"een interest rates and stoc,s over time! =ramaan!com > B free online utility to bootstrap 5'=H; yield curves! =ritish =an,er#s Bssociation page "ith historic yield curve data in various currencies 3$Fed 9urrent 'ssue > 9urrent 'ssue of 3e" $or, Federal ;eserve outlining their vie" of inverted yield curve