Lesson 11 of 25 · 7 min
The yield curve as a set of prices, not a forecast
Every point on it is a rate someone will transact at today, which is why reading it as a prediction gets the arithmetic backwards.
A yield curve is commonly described as the market's forecast of future interest rates. It is better described as a menu of prices at which money can be committed today for each length of time, and the difference between those two descriptions changes what you can infer from it.
A price is transactable and a forecast is not. The curve's shape does contain expectations, but it also contains a term premium — the extra yield demanded for tying money up longer, which compensates for uncertainty rather than predicting anything. Backing a forecast out of the curve therefore requires subtracting a number that nobody publishes and everybody estimates differently.
Take an illustrative curve: 4.62 percent at one month, 4.55 at three, 4.41 at six, 4.08 at two years, 4.34 at ten and 4.61 at thirty. Six prices, all available at once, describing six different commitments. None of them is a statement about what will happen; each is a statement about what someone will pay now.
Your facility touches that curve at exactly one point, the very short end. Your collateral touches it somewhere else entirely, because an equity's value is a discounted stream running decades out. In a month when the one-month rate rose 0.18 of a point and the ten-year fell 0.12, both legs moved and they moved in opposite directions. On a $1,265,000 balance the short leg cost $189.75 over thirty days. On a $1,930,000 portfolio whose effective duration — the percentage it moves for each point of rate change — is 6.9, the long leg added 0.828 percent of value, or $15,980.40.
One curve, two legs, two different points on it. There is no reason for the two points to move together and frequent occasions on which they do not.
Key terms
- Yield curve
- The set of rates available today for committing money over different lengths of time. A menu of prices rather than a projection.
- Term premium
- The extra yield demanded for lending longer. It is compensation for uncertainty, so it contaminates any forecast read straight off the curve.
- Tenor
- The length of time a rate applies to. One month and ten years are different tenors of the same curve.
Worked example
One curve, two points, two directions
An illustrative curve and one month of movement, applied to a facility and the collateral behind it.
- One-month rate
- 4.62%
- Ten-year rate
- 4.34%
- Movement over one month
- +0.18 and −0.12
- Extra interest, 30 days on $1,265,000, Act/360
- $189.75
- Collateral gain, duration 6.9 on $1,930,000
- +$15,980.40
- Net effect on the facility
- Favourable, by a factor of eighty-four
The point the facility is priced from.
Closer to the rate the collateral is discounted at.
Short end up, long end down.
6.9 × 0.12 = 0.828 percent.
The leg that rose cost $189.75 and the leg that fell was worth nearly $16,000. Both came off the same curve in the same month, at points that are not obliged to agree.
Check yourself
In one month the one-month rate falls 0.30 of a point and the ten-year rises 0.44. A $2,680,000 portfolio has an effective duration of 7.2 and the drawn balance is $980,000. What happens to each leg?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.