Chapter 3

Returns, Spreads, and Yields

Spot, forward, and par rates, presented in Chapter 2, intuitively describe the time value of money embedded in market prices. To analyze the ex-post performance and the ex-ante relative attractiveness of individual securities, however, market participants rely on returns, spreads, and yields.

The first section of this chapter defines these terms. Horizon returns in the fixed income context have to account for intermediate cash flows and are often computed both on a gross basis and net of financing, but are otherwise similar to the returns calculated for any asset. Spreads measure the pricing of an individual fixed income security relative to a benchmark curve, usually of swaps or government bonds. Yield is a practical and intuitive way to quote price and is used extensively for quick insight and analysis. It cannot be used, however, as a precise measure of relative value. This first section concludes with a brief news excerpt about the sale of Greek government bonds that illustrates the convenience of speaking in terms of spreads and yields.

The second section of the chapter shows how the profit-and-loss (P&L) or return of a fixed income security can be decomposed into component parts. Such decompositions are defined differently by different market participants, but this book will define terms as follows. Cash carry is a security's coupon income minus its financing cost, a quantity that will be particularly useful in the context of forwards ...

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