Analysing and Interpreting the Yield Curve, 2nd Edition

CHAPTER 12Yield Curves and Relative Value

Bond market participants take a keen interest in both cash and zero‐coupon (spot) yield curves. In markets where an active zero‐coupon bond market exists, much analysis is undertaken into the relative spreads between derived and actual zero‐coupon yields. In this chapter, we review how yield curve analysis are used in the market, with respect to bonds that are default‐free, such as US and UK government bonds. We then look at a specific case study example in the next (and final) chapter.

THE DETERMINANTS OF GOVERNMENT BOND YIELDS

Market‐makers in government bond markets analyse various factors in the market in deciding how to run their book. Customer business apart, decisions to purchase or sell securities is a function of their views on:

• market direction itself, that is the direction in which short‐term and long‐term interest rates are headed;
• which maturity point along the entire term structure offers the best value;
• which specific issue within a particular maturity point offers the best value;
• how best to hedge the market and credit risk exposures that arise as a result of undertaking the customer business mentioned above.

All these areas are related but react differently to certain pieces of information. A report on the projected size of the government's budget deficit, for example, will not have too much effect on two‐year bond yields, whereas if the expectations come as a surprise to the market it may have an adverse effect on ...