GC

9.c Yield Curve and Implied Forward Rates

Overview of the Yield Curve and Implied Forward Rates

  • Introduction to fixed income discussions continuing through the semester.

  • Focus on yield curve and implied forward rates as key concepts.

Definition of the Yield Curve

  • Yield Curve: A graph plotting yields (interest rates) of securities across different maturities.

    • Example yields:

      • 1-year Treasury bill: 0.5%

      • 5-year note: 1.2%

      • 10-year note: 1.8%

      • 30-year note: 2.5%

  • Term Structure: More technical term that refers specifically to zero-coupon instruments, yet it serves a similar function of comparing yields across maturities.

Importance of the Yield Curve Shape

  • Normal Upward Sloping Yield Curve: Longer maturities typically have higher yields due to maturity risk premium.

  • Types of Yield Curves:

    • Flat Yield Curve: Indicates similar interest rates for long and short term securities.

    • Inverted Yield Curve: Long-term rates lower than short-term rates, often seen as a sign of impending recession.

      • This shape signifies that investors expect lower future interest rates and potentially deflation.

Explaining the Yield Curve Shapes

  • Investor Expectations:

    • Expectations Theory: Suggests that yield curve shapes are determined by investor predictions about future interest rates.

    • Upward sloping curve reflects expectations of higher future rates due to anticipated inflation.

    • Inverted curve indicates expectations of lower future rates, deflation, and a potential recession.

Connection Between Interest Rates and Economic Conditions

  • Interest Rates in Recession:

    • In a recession, the Federal Reserve increases the money supply while the demand for money decreases, leading to lower interest rates.

    • Historical accuracy of inverted yield curve as a recession indicator: Accurate 80-90% of the time prior to recessions.

Deep Dive into Expectations Theory

  • Long-term Rates as Averages of Short-term Rates:

    • Example: If a two-year security is earning 8% and a one-year security earns 7%, the expectation is that the effective third year must yield 9% to maintain consistency with the yield curve.

    • Geometric Averages: More accurately represent compounding effects when calculating expected future rates.

Practical Implications of Implied Forward Rates

  • Calculating Future Interest Rates:

    • Companies can use implied forward rates to decide when to borrow money based on forecasts of future interest rates.

    • The ability to average together various rates over different maturities allows for complex forecasting of rates.

Conclusion and Next Steps

  • Encouragement to view the accompanying Bloomberg video for real-world application of yield curves and forward rates.

  • Understanding the yield curve's dynamics aids in making informed financial decisions, especially for businesses considering financing options.