Analysing and Interpreting the Yield Curve, 2nd Edition

CHAPTER 2A Further Look at Spot and Forward Rates

In this chapter, we continue the analysis from Chapter 1, using more technical terminology. First we illustrate basic concepts, which is followed by a discussion of yield curve analysis and the term structure of interest rates.

We are familiar with two types of fixed income securities, zero‐coupon bonds, also known as discount bonds or strips, and coupon bonds. A zero‐coupon bond makes a single payment on its maturity date, while a coupon bond makes regular interest payments at regular dates up to and including its maturity date. A coupon bond may be regarded as a set of strips, with each coupon payment and the redemption payment on maturity being equivalent to a zero‐coupon bond maturing on that date. This is not a purely academic concept, which is illustrated by events that occurred before the advent of the formal market in US Treasury strips, when a number of investment banks traded the cash flows of Treasury securities as separate zero‐coupon securities.¹ The literature we review in this section is set in a market of default‐free bonds, whether they are zero‐coupon bonds or coupon bonds. The market is assumed to be liquid so that bonds may be freely bought and sold. Prices of bonds are determined by the economy‐wide supply and demand for the bonds at any time, so they are macroeconomic and not set by individual bond issuers or traders.

ZERO‐COUPON BONDS

A zero‐coupon bond is the simplest form of fixed income security. ...