An Introduction to Repo Markets, Third Edition

Chapter 7

REPO AND THE YIELD CURVE

In Chapter 6 we discussed how the shape of the curve and interest-rate expectations drive the funding decision. In this chapter we present further essential background information on zero-coupon (spot) and forward interest rates. Repo market participants should be aware of the concepts discussed in this chapter.

ZERO-COUPON RATES

Zero (or spot), par and forward rates are closely linked. This section will explain and derive the different interest rates and explain their application in the markets.

The term ‘zero-coupon’ originates from the bond market and describes a bond which has no coupons. The yield on a zero-coupon bond can be viewed as a true yield, if the paper is held to maturity as no re-investment is involved and there are no interim cash flows vulnerable to a change in interest rates. Note the following:

• a set of zero-coupon rates exists for every major currency;

• zero-coupon rates can be used to value any future cash flow.

Where zero-coupon bonds are traded the yield on a zero-coupon bond of a particular maturity is the zero-coupon rate for that maturity. However, it is not necessary to have zero-coupon bonds in order to deduce zero-coupon rates. It is possible to calculate zero-coupon rates from a range of market rates and prices, including coupon bonds, interest-rate futures and currency deposit. The price of a zero-coupon bond of a particular maturity defines directly the value today of a cash flow due on the bond’s redemption ...