The Yield Curve

• Plots interest rates of bonds versus their maturities at a point in time

• The relationship between yields of bonds with different maturities is

the called the term structure of interest rates

• Yield curves should be plotted for similar bonds, but this is difficult as
bonds may have different coupon rate, liquidity, options
Yield Curve Shapes
 Term Structure of Interest Rates
1. Interest rates on bonds of different maturities move together over
time

2. Yield curves are more likely to have an upward slop when short-
term interest rates are low; yield curves are more like to have
downward slop and be inverted when short term interest rates are
high

3. Yield curves almost always slope upward

 Term Structure Theories
1. Expectation Theory: Yield for a particular maturity is an average of
the short-term rates that are expected in the future

2. Liquidity Premium Theory : In addition to expectations about future

short-term rates, investors require a risk premium for holding bonds

3. Segmented Market Theory: Supply of bonds and demand for bonds

determines yields for various maturity ranges
US Treasury Yield Curve
 Secondary Market Yield Curve

Source: Pakistan Economic Survey 2015-16

 Corporate Bonds Yield Curves
• Investors in corporate bonds face same risk as investors of
government bonds, such as rise in the interest rate and inflation

• In addition, there is the risk of the corporate going bankrupt

• Corporates are less creditworthy than governments

• “Spread” measures how much more a corporate pays to borrow

money than the government does
Yield Curve Spread
 Yield Spread Measures
• Absolute Yield Spread = Yield on the higher yield bond – yield on the
lower yield bond

• Yield Ratio = ___Subject bond yield____

benchmark bond yield

• Relative Yield Spread = ___Absolute Yield Spread____

yield on the benchmark bond
Price-Yield Relationship

• Inverse relationship

• Curve line - Convexity

 Interest Rate Risk Measurement - Duration

Duration can be interpreted in three different ways:

1. It is the slope of the price-yield curve at the bond’s current YTM

2. It is the weighted average of the time (in years) until each cash flow
will be received

3. It is the approximate percentage in price for a 1% change in yield

 Bond Characteristics Effects on Duration

• Higher coupon means lower duration

• Longer maturity means higher duration

• Higher market yield means lower duration

 Duration Formula

Duration = (bond price when yields fall – bond price when yields rise)
2 X (initial price) X (change in yield in decimal form)

Example: 10Y PIB, 8% semiannual coupon bond currently priced at Rs.

90.8 to yield 9%. If yield decline by 50 bps (8.5%) price will be Rs. 95.2,
and if yield increase by 50 bps (9.5%) price will decline to Rs. 86.6

Calculate duration of the 10Y PIB.

 Duration Example Calculation

10 Y PIB Duration = (95.2 – 86.6) = 9.471

2 X (90.8) X (0.005)

Portfolio Duration = w1 D1 + w2 D2 + . . . + wN DN

Where:
Wi = market value of bond i divided by market value of the portfolio
Di = the duration of bond i
N = the number of bonds in the portfolio