The Yield Curve

For bankers understanding the behavior and properties of the yield curve is an essential part of
the risk management process. The reasons are,

Interest rates have a direct impact on bank revenue and yield curve is an important tool
for estimating expected revenue since it captures the current state of term interest rates
and market expectations of the future state as well.
The interest rate gap which reflects the state of bank borrowing and lending, is sensitive
to the change in the shape and slope of yield curves.
Current and future trading strategy including asset allocation and credit policy decisions
also need to consider the shape and behavior of yield curve.
The balance sheet management and valuation requires an accurate yield curve reflecting
liquidity in the market.

Types of yield curve

Yield-to-Maturity (YTM) Yield Curve
The most commonly occurring yield curve is the YTM yield curve. The curve is constructed by
plotting the YTM against the term to maturity for a group of bonds of the same class. Bonds used
in constructing the curve will only rarely have an exact number of whole years to redemption.
However, it is common to see yields plotted against whole years on the x-axis. This is because
once a bond is designated as benchmark for that term, its yield is taken to be the representative
yield. The main weakness of the YTM measure is the assumption of a constant rate of coupon
reinvestment during the bonds life at the redemption yield level. However, market rates
fluctuate overtime and there is always reinvestment risk.
Further, the YTM curve does not distinguish between different payment patters that result from
bonds with different coupons. For instance, a low-coupon bond pays a higher portion of its cash
flows at a later date than high coupon bonds of the same maturity. It assumes an even cash flow
pattern for all bonds. Therefore, the cash flows are not discounted at the appropriate rates.
The Coupon Yield Curve
The coupon yield curve is a plot of the YTM against term to maturity for a group of bonds with
the same coupon. In general high coupon bonds trade at a discount or cheap to the curve or
have higher yields, relative to low coupon bonds, because of reinvestment risk and tax reasons. It
is frequently the case that yields vary considerably with coupons for the same term to maturity
and with term to maturity for different coupons. Distortions arise in the YTM curve if no
allowance is made for coupon differences.
The Par Yield Curve
The par yield curve is not usually encountered in secondary market trading. It is often
constructed for use corporate financiers and participants in the primary market. The par yield

curve plots YTM against term to maturity for current bonds trading at par. The par yield is
therefore, equal to the coupon rate for bonds priced at par or near par. Those involved in the
primary market will use a par yield curve to determine the required coupon for a new bond that is
to be issued at par. Because investors prefer not to pay over par for a new bond, the bond
requires a coupon that will result in a price at or slightly below par. However, it is rare to
encounter secondary market bonds trading at par. Therefore, first zero-coupon yield curves are
derived and then hypothetical par yields are constructed which would be observed were there any
par bonds being traded.
The Zero-Coupon Yield Curve
The zero-coupon (or spot) yield curve plots zero-coupon yields against term to maturity. If there
is a market for zero-coupon bonds, then the curve can be plotted easily by considering their
YTM and term to maturity. However, in many markets where no zero-coupon bonds are traded, a
spot yield curve can be derived from a conventional YTM yield curve. This, of course is a
theoretical spot yield curve as opposed to a market or observed yield curve.
Theoretically, the spot yield for a particular term to maturity is the same as the yield on a zero
coupon bond of the same maturity. That is why spot yields are also known as zero-coupon yields.
However, the spot rate is a theoretical construct and zero coupon rates are spot rates in practice.
The different between YTM and the spot rate is the fact that while the former uses an average
rate throughout, the latter varies from period to period. Hence, it gives a more accurate discount
factor for present value calculation. Spot yield curve is viewed as the true terms structure of
interest rate because there is no reinvestment risk involved. The stated yield is equal to the actual
annual return. Because of this, analysts often construct a theoretical spot yield curve. This is
done by breaking down each observed coupon bond into its constituent cash flows and each is
treated as individual zero coupon bond. For example, a 100 nominal of a 5% 2-yar bond with
annual payment is considered equivalent to 5 nominal of a 1-year zero coupon bond and 105
nominal of a 2-year zero coupon bond. Therefore, the spot yield must comply with the following
equation

=
=1 (1+

+ (1+

=
=1 +

(1)

where rsn is the spot yield on a bond of dirty price Pd with n years to maturity; C is the coupon
payment; M the final payment including coupon and the face value; and df is the corresponding
discount factor.
If there are 30 bonds paying annual coupons with maturity spanning from 1 to 30 years, and we
know the price of each of these bonds, then we can find out what the prices imply about the
markets estimates about the future interest rates. Assume that all payment being made on the
same date is valued using the same rate. If the one year bond has a coupon of 5% and the bond is
priced at par at 100, then the rate of interest is also 5%. Assume that the 2-year bond pays a
coupon of 6% and is priced at 99 with nominal at 100. If 99 were invested at the same rate as

the 1-year bond, it would accumulate to 103.95 in one year (99+5% of 99). On the payment
date, the one-year bond matures and the 2-year bond makes a coupon payment of 6. If everyone
could expect that at this time the price of the 2-year bond would be more than 97.95 (103.95-6),
then no one would buy the one year bond, since it would be more profitable to buy the 2-year
bond and sell it after 1 year for greater return. Alternatively, it the price is less than 97.95, then
no one would buy the 2-year bond, as it would be cheaper to buy the shorter bond and then buy
the longer dated bond with the proceeds from the 1-year bond. Therefore, the 2-year bond must
be priced exactly at 97.95 in 12 months time. Thus, for 97.95 to grow to 106 in 1 year, the
interest rate in year 2 must be 8.22%. This result shows that there can be no arbitrage opportunity
along the yield curve. This is known as the break-even principle, the law of no arbitrage.
Using the price and coupon of the 3-year bond we can calculate the price of the 3-year bond
exactly the same way. Thus, we can link together the implied 1-year rates for each year up to the
maturity of the longest dated bond. This process is known as bootstrapping. In real world, things
are not that straightforward as several bonds with different coupons may on some dates and on
some dates there may be no bond maturing. Further, it is most unlikely that there will be regular
spacing on bond redemptions exactly one year apart. Therefore, often analysts use software
models to calculate the set of implied spot rates. For instance, if there are several 1-year bonds,
each of their prices would imply slightly different interest rate. The rate that gives the smallest
average price error is generally chosen. In practice, all bonds are used to find the rate in year 1;
all bonds with a term longer than one year are used to calculate the rate in year 2 and so on.
Zero coupon yield curve is ideal to use when deriving implied forward rates and defining the
term structure of interest rates. The zero-coupon curve can also be calculated from the coupon
yield curve with the bonds assumed to be priced at par and their coupons set to the par yield
values. As mentioned earlier that when deriving spot yields from redemption yields, we view
conventional bonds as being made up of an annuity, the stream of fixed coupon payments, and a
zero coupon bond which is the redemption payment on maturity. Consider equation (1) for YTM
and set Pd = M = 100.
100 =
=1 + 100 = + 100

(2)

where dfn = (1+) is the discount factor or the fair price of a zero coupon bond with a par value
of 1 with N years to mature and r is the YTM, and
=
=1 = 1 +

(3)

is the fair price of an annuity of 1 per year for N years. Substituting equation (3) into equation (2) and
rearranging terms gives the following expression for the N year discount factor:
=

1( 1 )
1+

(4)

Where rmN = C/100 is the par yield (since the bond is trading at par, so the coupon is equal to the
yield) for a term to maturity of N years; Suppose, 1-year, 2-year and 3-year redemption yield for
bonds priced at par are 5%, 5.25% and 5.75%, respectively. Then, from equation (4), the following
discount factors can be obtained:
1 =

1
= 0.952
1 + 0.05

2 =

1 (0.0525 0.952)
= 0.903
1 + 0.0525

3 =

1 0.0575 (0.952 + 0.903)

= 0.845
1 + 0.0575
1

And the spot yields can be further calculated as = (1+

. Thus, rs1 = 5%, rs2 = 5.256% and

rs3 = 5.784%. Alternatively, if zero coupon rates are given for different years then YTM can be
1

calculated by first computing the discount factors using the formula = (1+

. Then, from

equation (2) the bond prices can be obtained and thereafter YTM can be calculated for bonds
having different maturities using the usual procedure. Thus, as claimed earlier the spot yield
curve is the correct method for pricing any cash flow since it matches any cash flow to the
discount rate that applied to the time period in which the cash flow is paid.
The Forward Yield Curve
For financial transactions with a forward settlement date the parties agree upon a price today to
be used for settlement on the transaction date. So, the forward rate applicable to a bond is the
spot bond yield as at the forward date. That is it is the yield of a zero coupon bond that is
purchased for settlement at the forward date. Forward rates can be derived from spot interest
rates, since they are implied by the current range of spot interest rates. Forward rates satisfy
equation (5):
C
C
C
M
Pd

...

(5)
(1 0 rf1 ) (1 0 rf1 )(11 rf 2 )
(1 0 rf1 )...(1 N 1 rf N ) (1 0 rf1 )...(1 N 1 rf N )
N

Pd
n 1

(1
i 1

i 1

rf i )

(6)

(1

i 1

rf i )

i 1

where i 1rfi is the implicit forward rate on a 1-year bond maturing in year N, with coupon C and
redemption payment M. Comparing equation (1) and (6) we can see that the spot yield is the
geometric mean of the forward rates. This implies the following relationship between the spot
and the forward rates.
(1+ rsn)n = (1+0rf1) (1+1rf2) ... (1+ n 1rfn)
(7)

(1 n1 rf n )

(1 rs n ) n
df
n
n 1
df n1
(1 rs n1 )

Using the spot yield from the previous example rs1 = 5%, rs2 = 5.256% and rs3 = 5.784% the 2year and 3-year forward rates can be derived as, (1+1rf2) = 5.5138 and (1+2rf3) = 6.8479%. This
implies that given the current spot yield the market would set the yield on a bond with one year
to mature in three years time at 6.848%. The relation between par, spot and forward yields can
be shown as
Year
Coupon yield (%)
Zero-coupon yield (%)
Forward rate (%)
1
5.000
5.000
5.000
2
5.250
5.2566
5.5138
3
5.750
5.7844
6.8479
Now, continuing with the same example, note that the spot yield of 5.257% requires the same
investment of 100 to have a maturity value of 110.79. This illustrates why the zero-coupon
curve is important for new bond issues. If we know the spot yields, we can calculate the coupon
required on a new 3-year bond that is going to be issued at par in this interest rate environment

+100

by making the following calculation 100 = 1.05 + (1.05257)2 + (1.05784)3 where C turns out to be
5.75%.
Considering the relationship between spot and forward rates, it appears that if spot is the average
return, forward is the marginal return. The forward zero coupon rate from interest period a to
period b is given by
1/()

(1 + )
= [
]
1
(1 + )
Similarly, spot rates could be calculated from forward rates as,

rsn 1 0 rf1 11 rf 2 1 2 rf 3 ... 1 n1 rf n

1/ n

This directly follows from equation (7).