Yield Curve

Yield Curve is a function of the creditworthiness of the issuing government, the central bank policy, the issuance of new treasuries, supply and demand, and economic cycle.

Steep upward sloping = Expectation of rising rates or high risk
Humped curve = Expectation of curve flattening or high volatility

The shape of the Yield Curve is influenced by
    • Rate Expectations – Rising inflation causes curve to steepen.
    • Risk Premium – Tends to increase steeply with duration  up to two years.
    • Convexity Bias – Positive convexity is desirable and adds to premium

High Forward Rate might mean long maturity sectors are cheap. One way to take advantage is to sell short maturity to finance buying of long maturity.

Expected Return differentials across bonds might reflect bonds’ characteristics not related to risk, but rather to liquidity, off-the-run vs. on-the-run, supply-demand imbalance.

Steep yield curve tends to be followed by high return; inverted yield leads to negative return.
Steep yield curve signals high risk thus high reward.
Steep yield curve has higher return when it coincides with a depressed stock market.
Steep yield curve in a strong stock market signals rates increase.

Swap Curve

<= 3m LIBOR
3m - 15m Eurodollar Future
2y+ interest rate swap

LIBOR = London Inter Bank Overnight Rate, set by British Banker’s Association, which surveys the rate at 11am and produces it at noon. LIBOR is a type of Forward Rate.

Swap

Not traded at an exchange.

Buyer pays Fixed, is long the swap, and betting on interest rate to rise.

Regular Swap = coupon swap = fixed for float
Basis Swap = float for float

Currency swap

Fixed-to-Fixed or Fixed-to-Float swap of cash flow in two different currencies.

Futures and Forward price components

    • Riskless rate + Storage cost + Income yield + Convenience yield
    • FRA = Pay fixed and receive float at expiration date. You receive the PV of the difference at maturity – that is, if you pay fixed 3% and receive float 4%, you would pay 1.5% and receive float 2% at 9 month. You get 0.5% profit discounted back 6 months at 4% rate.

Futures are referenced to a 3-mo LIBOR.
Futures are settled daily due to margin requirement of an exchange and thus are more volatile.
Forward is over-the-counter.