Chapter 5THE YIELD CURVE

Understanding and appreciating the yield curve is, or should be, important to all finance market participants. It is especially important to debt capital market participants, and even more especially important to bank practitioners. So, for anyone reading this book, it is safe to assume that the yield curve is a very important subject! This is a long chapter but well worth getting to grips with. In it, we discuss the basic concepts of the yield curve, as well as its uses and interpretation. We show how to calculate the zero‐coupon (or spot) and forward yield curve, and present the main theories that seek to explain its shape and behaviour. We will see that the spread of one different curve to another, such as the swap curve compared with the government curve, is itself important. We begin with an introduction to the curve and interest rates.

IMPORTANCE OF THE YIELD CURVE

Banks deal in interest rates and credit risk. These are two fundamental tenets of banking – just as fundamental today as they were when banking first began. The first of these – interest rates – is an explicit measure of the cost of borrowing money and is encapsulated in the yield curve. For bankers, understanding the behaviour and properties of the yield curve is an essential part of the loan pricing and asset‐liability management (ALM) process. The following are some, but not all, of the reasons that this is so:

  • Changes in interest rates have a direct impact on bank revenue, measured ...

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