Chapter 5

The Yield Curve

The art of banking, indeed all of finance, revolves around the yield curve. Understanding and appreciating the curve is important to all financial market participants. It is important to debt capital market participants, and especially important to bank ALM practitioners. So if one is reading this book it is safe to assume that the yield curve is a very important subject.

This is a long chapter but well worth the close attention of all bankers, irrespective of their function or seniority. In it, we discuss the main concepts behind the yield curve, as well as its uses and information content. An ability to interpret the yield curve is vital for all market practitioners. We discuss the zero-coupon (or spot) and forward yield curves, and present the main theories that seek to explain their shape and behaviour. We will see that the spread of different curves to another, such as the swap yield curve compared to the government yield curve, is also noteworthy and so we seek to explain the determinants of these spreads in this chapter.

We begin with an introduction to the curve and interest rates in general.

Importance of the Yield Curve

As we noted in Chapter 1, banks deal in interest rate and credit risk, as well as liquidity risk. These are the fundamental tenets of banking, as important today as they were when banking first began. The first of these, interest rates, is in effect an explicit measure of the cost of borrowing money, and is encapsulated in the ...

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