YIELD MEASURES, SPOT RATES, AND FORWARD RATES
Frequently, investors assess the relative value of a security by some yield or yield spread measure quoted in the market. These measures are based on assumptions that limit their use to gauge relative value. This chapter explains the various yield and yield spread measures and their limitations.
In this chapter, we will see a basic approach to computing the spot rates from the on-the-run Treasury issues. We will see the limitations of the nominal spread measure and explain two measures that overcome these limitations—zero-volatility spread and option-adjusted spread.
II. SOURCES OF RETURN
When an investor purchases a fixed income security, he or she can expect to receive a dollar return from one or more of the following sources:
1. the coupon interest payments made by the issuer
2. any capital gain (or capital loss—a negative dollar return) when the security matures, is called, or is sold
3. income from reinvestment of interim cash flows (interest and/or principal payments prior to stated maturity)
Any yield measure that purports to measure the potential return from a fixed income security should consider all three sources of return described above.
A. Coupon Interest Payments
The most obvious source of return on a bond is the periodic coupon interest payments. For zero-coupon instruments, the return from this source is zero. By purchasing a security below its par value and receiving the full par value ...