Slide 6 – The Yield Curve 101 (The New York Times – 2015)

The Yield curve shows how much its costs the federal government to borrow money for a
given amount of time, revealing the relationship between long- and short-term interest rates.
It is, inherently, a forecast for what the economy holds in the future – how much inflation
there will be, for example, and how healthy growth will be over the years ahead – all
embodied in the price of money today, tomorrow and many years from now
Lecture:
 erratic shape of the 3D curve confirms variation over time in shape of the yield curve
with for the last decade we observe an upward sloping yield curve implying lower
rates for short-term maturities vs higher rates for longer maturities.
 The upward sloping yield curve, we consider to be the most natural shape of the yield
curve

Slide 7 – Yields in Germany are negative (The New York Times – 2015)
Some investors are betting that rates will be even lower in the future or that future exchange
rates will make them profitable. Some may be required to hold bonds by law. Others are just
willing to accept whatever it takes to invest in something safe. Still others are expecting
deflation, which can make real interest rates positive.
Last month, 10-year yields in Germany were even lower than those in Japan.
Lecture:
 Term structure of interest rates for Germany is in line with the US-curve upward
sloping for the most recent period (i.e. decade)
 different: Short-term rates have been negative for Germany (represented by red areas:
red areas mean the corresponding rates are negative)
o This is the consequence of the excess liquidity (cheap money) in the market,
which is due to the ECBs monetary policy to stimulate the economy

Slide 8 – A different shape in Japan (The New York Times – 2015)

Yields in Japan have been low for decades, as the country struggled with deflation.
With rates so low in Europe and Japan, the rates in the United States are actually among the
highest in the highly industrialized world.
The bond market expects slow growth and very low inflation for years to come.
Lecture:
 as compared to the yield curves of the US and Germany, you see a different pattern
emerging: the term structure of interest rates having an extremely flat shape since the
mid-1990s, this reflects the diligent attempts of the Japanese central bank to stimulate
 the economy by traditional monetary policy actions of pumping money in the market,
but up until now, without success.

Slide 20-21 – The yield curve: the liquidity preference theory (p. 479 – 480 BKM)
Upward sloping yield curve does not necessarily hide a upward sloping expectations curve!
Panel A: constant expected short rates. Liquidity premium of 1%. Result: a rising yield
curve

 Upward sloping yield curve, although the expectations curve is flat.

Panel B: declining expected short rates. Increasing liquidity premiums. Result: a rising
yield curve despite falling expected interest rates.

 Upward sloping yield curve, although the expectations curve is downwards.

Panel C: Declining expected short rates. Constant liquidity premiums. Result: a hump-
shaped yield curve

Panel D: increasing expected short rates. Increasing liquidity premiums. Result: a

sharply rising yield curve.
Slide 26 – Bond pricing relationships (p.496 BKM)

 Graph shows for a number of bonds how they react to a particular change in interest
rates
 Bond prices and yields are inversely related  hence, the negative slope of all of the
relations
 Relationship is curved  indicates that an increase in the bonds’ YTM will result in a
smaller price change than a decrease of the same size (relationships are to some extent
curved.)
 Comparison bond A and bond B (allows us to analyse the impact of maturity on
interest rate changes – all key characteristics are the same apart from maturity)
o Graph shows that there is a different behaviour for both bonds
o Bond A’s reaction to a change in interest rates (with YTM being limited) is
much smaller than Bond B’s reaction
 the longer maturity bond is more sensitive to changes in interest rates
than the shorter maturity bond
 Comparison bond B and bond C (allows us to analyse the impact of the coupon rate on
changes in interest rates)
o Bond C pays smaller coupon (a.c.t. Bond B) and this has a significant impact
on its interest rate reaction, in particular: lower coupons (Bond C) seem to
increase interest rate sensitive, its reaction is much bigger (a.c.t. the reaction
of Bond B)
 Comparison bond C and bond D (allows us to analyse the impact of the initial yield)
o Bond D (selling at low initial yield) is much more interest rate sensitive (a.c.t.
bond C)
Slide 43: graphical representation of modified duration (p. 506 BKM)
Bond price convexity: 30-year maturity, 8% coupon bond; initial yield to maturity = 8% .

 discrepancy
in results (prior slides) is due to the fact that the MACAULAY duration measures first
order or linear effects only
 concept of duration we derived, just focused on first order derivates
o formally, this means that only linear effects are accounted for
o graphically, summarized as follows:
 The straight line is the % price change predicted by the duration rule
 i.e. by focussing on linear effects we assume that relationship
between changes in yields and changes in prices is linear
 The slope of the straight line is the modified duration of the bond at its initial
YTM
 Is the modified duration an accurate proxy of interest rate risk?
 Is it reasonable to assume that the relationship is linear?
o Graph hints at the fact that this is not the case
o Actual price changes are not linear but curved (light blue curved function)
o we ignored the curvature effect up until now