The Yield Curve
6.1 CHAPTER OVERVIEW
Chapter 4 explored the bond markets and the traditional measure of return on bonds: yield-to-maturity, or internal rate of return. This chapter extends the discussion and considers the relationship between bond yield and time to maturity. It reviews the components of a quoted or nominal interest rate, and the concept of annual equivalent rate. It then moves on to the yield curve itself and prevalent theories about the shape of the curve. Most investors and traders agree that the curve builds in expectations of future interest rates, although others believe that there may be other factors at work, such as the preference investors have to ‘keep their options open’ by favouring short-dated securities. The chapter looks at how to extract forward interest rates from the yield curve. To do this it uses a methodology called ‘bootstrapping’ to derive zero coupon or spot rates from the yields on coupon bonds trading at par. Forward interest rates are derived from the spot rate curve and the results are related back to the expectations theory of yield curves. Finally, the chapter shows how to derive discount factors which can be applied directly to future cash flows to calculate present values, without making reinvestment assumptions, and how discount factors and forward interest rates are related.
6.2 REAL AND NOMINAL INTEREST RATES
The cost of borrowing money for a period of time (its time value) is measured by the interest rate for the period. ...