15.63 - Understanding Yield Spreads

Front 1

15.63C - Theories of the yield curve and their implications for shape of the yield curve are:

1. Pure Expectations Theory

2. Liquidity Preference Theory

3. Market Segmentation Theory

Back 1

1. Argues that rates at longer maturities depend only on expectations of future ST rates and is consistent with any yield curve shape

2. Of the term structure states that longer-term rates reflect investors expectatons about future ST rates and an increasing liquidity premium to compensate investors for exposure to greater amounts of interest rate risk at longer maturities. The liquidity preference theory can be consistent with a downward sloping curve if an expected decrease in ST rates outweights the liquidy premium

3. Argues that lenders/borrowers have preferred maturity ranges and that the shape of the yield curve is determined by the supply/demand for securities within each maturity ranhe, independt of the yield in other maturiy ranges. It is consistent with any yield curve shape and in a somewhat weaker form is knowen as the preferred habitat theory.

Front 2

15.63B - Yield curves represent

Back 2

the plot of yield against maturity

Front 3

15.63B – The general yield curve shapes are

Back 3

Upward / Downward sloping / Flat / Humped

Front 4

15.63D – Treasury spot rates are the appropriate discount rates

Back 4

Single CF’s ( coupon or principal payments ) from a US Treasury security, given the time until the payment is to be received.

Front 5

15.63E - Types of yield spreads:
Absolute Yield Spread:

Relative Yield Spread:

Yield Ratio:

Back 5

Absolute Yield Spread is the difference between the yield on a particular security or sector and the yield of a reference (benchmark) security or sector, which is often on-the-run treasury securities of like maturity.

Relative Yield Spread is the absolute yield spread expressed as a percentage of the benchmark yield. This is arguably a superior measure to the absolute spread, since it will reflect changes in the level of interest rates even when the absolute spread remains constant.

Yield Ratio is the ratio of the yield on a security or sector to the yield on a benchmark security or sector; it is simply one plus the relative yield spread.

Front 6

15.63F - A credit spread is the

Back 6

Yield difference between two bond issues due to differences in their credit ratings.

Front 7

15.63F - Credit spreads narrow when

Back 7

The economy is healthy and expanding, while they increase during contractions/recessions reflecting a "flight to (higher) quality" by investors

Front 8

15.63G - Call options and prepayment options effect on yields and yield spreads?

Back 8

Increase yields and yield spreads compared to option-free bonds

Front 9

15.63G - Put options and prepayments options effect on yields and yield spreads?

Back 9

Decrease yields and yield spreads compared to option-free bonds

Front 10

15.63H - Bonds with less liquidty are less .... and must offer a ....

Back 10

Less desirable and must offer a higher yield. Larger bond issues are more liquid and other things equal, will have lower yield spreads.

Front 11

15.63J - LIBOR for various currencies is determined from rates at which

Back 11

large London banks loan money to each other and is the most important reference rate globally for floating-rate debt and ST loans of various maturities