The Us Treasury Yield Curve Essay

896 Words Mar 27th, 2013 4 Pages
Discuss and evaluate the major theories evaluating the shape of the yield curve. In your answer also discuss the uses of the yield curve in financial markets, why strips are used in the construction of yield curves and why investors would want to invest in zero coupon bonds or strips.

The yield curve is a graph that plots the yields of similar-quality bonds against their maturities, ranging from shortest to longest. The relationship between yield and maturity is referred to as the term structure of interest rates. The Treasury yield curve is the base or benchmark for pricing bonds and setting yields in other areas of the debt market. Moreover, the shape of the yield curve is constructed from U.S Treasury strips which are zero-coupon
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Zero- coupon bonds are different from regular bonds since they are sold at a discount to face value. The interest in compounded throughout the duration of the bond then made at maturity. However, maturity can be as long as thirty (30) years but these bonds can be bought or sold by investors prior to maturity. At present, the most popular form of zero-coupon bonds is sold by the U.S government (T-Bills).
As a result of the discount rate and the flexibility of zero-coupon bonds or strips, investors would want to invest in them. They allow investors to make forecast on future interest rates using forward spot rates. Moreover, institutional investors such as financial institutions purchase bonds, then “strips” out the interest payments creating two distinct payments; a zero-coupon bond and a collection of interest coupons which can be sold separately. For example, pension funds and insurance companies would invest in long maturity zeros because of the complicated valuation concept known as the duration. Resulting from the high duration of zeros, they are used to mitigate interest rate risk associated with investments with futuristic maturities. (Insurance policies, pensions, etc.)
In conclusion, the analysis of the yield curve is essential to the efficiency of financial markets in setting the benchmark for pricing bonds in addition to other areas of the debt

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