THE YIELD CURVE, SPOT AND FORWARD YIELDS
In this chapter we extend the analysis introduced in Chapter 1 with a look at the zero-coupon or spot interest rate and the forward rate. We also look at the yield curve. Investors consider a bond yield and the general market yield curve when undertaking analysis to determine if the bond is worth buying; this is a form of what is known as relative value analysis. All investors will have a specific risk/reward profile that they are comfortable with, and a bond’s yield relative to its perceived risk will influence the decision to buy (or sell) it.
We consider the different types of yield curve, before considering a specific curve, the zero-coupon or spot yield curve. Yield curve construction itself requires some formidable mathematics and is outside the scope of this book; we consider here the basic techniques only. Interested readers who wish to study the topic further may wish to refer to the author’s book Analysing and Interpreting the Yield Curve.
THE YIELD CURVE
We have already considered the main measure of return associated with holding bonds, the yield-to-maturity or redemption yield. Much of the analysis and pricing activity that takes place in the bond markets revolves around the yield curve. The yield curve describes the relationship between a particular redemption yield and a bond’s maturity. Plotting the yields of bonds along the term structure will give us our yield curve. It is important that only bonds from ...