Yield Curve or Term Structure of Interest Rates

Yield curve, also known as, term structure of interest rates is a graph that shows relationship between yield or interest rates and maturity. Yield curve is plotted for bonds with similar credit rating but with different maturity dates. Yield of a bond inversely varies to time to maturity (tenor). Long-term bonds carry more risk of default and liquidity risk compared to short-term bonds. Liquidity in short-term bonds is more because of less volatility in interest rates. Long-term bonds should offer short term interest rates plus risk and liquidity premiums. So usually yield of a 10 year treasury bond is more than that of a 1 year treasury bill. Read more

May 31, 2008 | Filed Under Bonds | Leave a Comment 

Different types of Yield Curves

The following graphs show three different types of yield curves

.normal-yield-curve.jpg flat-yield-curve.jpgInverted yield curve

Explanation of Yield Curves by Market Expectation Theory (Hypothesis) :

Normal Yield Curve:
When long term interest rates are more compared to short term interest rates, the shape of the yield curve is upward sloping.

Flat Yield Curve:
When there is no change in market outlook on interest rates then we get flat yield curve. This is because yields are almost same across tenors. Read more

May 31, 2008 | Filed Under Bonds | Leave a Comment 

Constructing Yield Curve

In general we don’t have all the data points that needed to construct a yield curve because there is only fixed number of products in the market with varying coupon frequencies. So a yield curve is constructed by plotting yield to maturities of zero coupon bonds for short term and zero coupon rates derived from long term fixed coupon bonds. Deriving zero coupon rates from a long-term bond is called bootstrapping. To put it in clear terms, the first few values of yield curve are directly available as 1 year, 2 year zero coupon bonds are available in the market. Read more

May 31, 2008 | Filed Under Bonds | Leave a Comment 

Pricing a Bond

bond-pricing.jpg

The fundamental principle of pricing a bond is that the price of a bond is the present value of all future cash flows that arise from the bond. As you know the money received today is more valuable than the same amount of money that will be received in the future at some point of time. So to know the current value of a bond we should discount the future cash flows from the bond with a proper discounting rate (also known as opportunity cost). This opportunity cost is usually the interest rate that is offered in the market on similar kind of bonds i.e. same tenor and same quality.

The general formula for calculating the present value of future cash flows is

PV = CF1/(1+r)t1 + CF2/(1+r)t2 + …….+ CFn/(1+r)tn

In the above formula Read more

May 29, 2008 | Filed Under Bonds | Leave a Comment 

Factors influencing Price of a Bond

Effect of Discount Rate on Price of a Bond:

It is obvious from the above formula that the discounting rate or market interest rate plays main role in pricing a bond. Higher the discounting rate or the expected rate of return, lower will be the price of a bond. In other words, if we purchase a bond at lower levels compared to other bonds with the similar profile in the market, you will get more rate of return on your investment. The conclusion is ‘interest rates and bond prices move in opposite directions’. The following statements hold good at the beginning of the bond period.

Interest gets accumulated as the time passes by till the time of coupon payment. Read more

May 29, 2008 | Filed Under Bonds | Leave a Comment 

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