The Principles of Banking, 2nd Edition

CHAPTER 4The Yield Curve¹

Abstract

The yield curve is the key determinant in all banking and finance operations, being the baseline driver for all pricing and valuation processes. It is also an important analytical tool in its own right, as its shape and structure at any time provides pointers on market interest rate expectations. The chapter considers the different types of yield curve and the explanations behind their shape, as well as the concept of discount factors and the orthodox approach to constructing the discount function. We address the information content of the curve, and summarise the process for fitting a bank's internal yield curve.

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 commercial bankers, debt capital market participants, institutional investors, and especially important to bank ALM practitioners. So if you are 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 ...