Yield Curve and Bond Basics

Yield Curve also called Term Structure of Interest Rates for a bond issuer, the structure of yields for bonds with Woman Doing Calculationsdifferent terms to maturity (but no other differences) is called Term Structure of Interest Rates.

The relationship between and yield on a similar risk class of securities is called the Yield Curve. The relationship represents the time value of money  showing that people would demand a positive rate of return on the money they are willing to part today for a payback into the future. It also shows that a Rupee payable in the future is worth less today because of the relationship between time and money. A yield curve can be positive, neutral or flat.A positive yield curve, which is most natural, is when the slope of the curve is positive, i.e. the yield at the longer end is higher than at the shorter end of the time axis. This result as people demand higher compensation for parting their money for a longer time into the future. A neutral yield curve is that which has a zero slope, i.e. is flat across time. This occurs when people are willing to accept more or less the same returns across maturities. The negative yield curve (also called an inverted yield curve) is one of which the slope is negative, i.e. the long term yield is lower than the short term yield. It is not often that this happens and has important economic ramifications when it does. It generally represents an impending downturn in the economy, where people are anticipating lower interest rates in the future.

Yield Pick-up

Yield Pick-up or Yield give-up refers to the yield gained or lost at the time of initiation of a trade primarily in bonds and debentures. Suppose one sold 12.50% GOI 2004 at a yield of 10.00% and moved into 11.83% GOI 2014 at a yield of 11.25% the yield pick-up is to the tune of 125 basis points. If one did exactly the reverse of this yield give-up is to the extent of 125 basis points. These concepts are ordinarily used in bond swap evaluation.

Yield to Maturity

Yield to Maturity (YTM) is that rate of discount that equates that discounted value of all future cash flows of a security with its current price. In a way, it is another way of stating the price of a security as other things remaining constant the price is a direct function of the YTM. The deficiency of YTM is that it assumes that all intermediate and final cash flow of the security is re-invested at the YTM, which ignores the shape of the yield curve. This makes YTM applicable as a measure for an individual security and to different bonds in the same risk class. The YTM, given its instrument-specific nature does not provide unique mapping from maturity to interest rate space. It is used primarily for its simplicity of nature and ease of calculation. More sophisticated traders would use the Zero Coupon Yield Curve (ZCYC) for valuation.

Bonds and YTM

  •  Yields will decline with rise in price and vice versa.
  •  If required rate of return is same as the coupon rate, bond price is the par value.
  • If required rate of return:
  • Is higher than coupon rate bond price is lower than face value
  • Is lower than coupon rate bond price is higher than face value
  • Discount or Premium on face value will fall as the bond approaches maturity.
  •  As  the  YTM  increases,  the  percentage  change  in  price  increases  at  a diminishing rate. The capital gain/loss on bonds will emerge on account of changes in price due to interest rate changes.

Zero Coupon Yield Curve :

The Zero Coupon Yield Curve (also called Spot Curve) is a relationship between maturity and interest rates. It differs from a normal yield curve by the fact that it is not the YTM of coupon bearing securities, which gets plotted. Represents against time are the yields on zero coupon instruments across maturities. The benefit of having zero coupon yields (or spot yields) is that the deficiencies of the YTM approach are removed.

However, zero coupon bonds are generally not available across the entire spectrum of time and hence statistical estimation processes are used. The ZCYC is useful in valuation of even coupon bearing securities and can be extended to other risk classes as well as after adjusting for the spreads. It is also an important input for robust measures of Value at Risk (VaR).

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