Understanding Yield Curves
In the post credit policy press conference held in the month of April, the Reserve Bank of India (RBI) governor, Dr C Rangarajan mentioned in reply to a question, that the new measures as part of the policy would facilitate a smooth yield curve. One of the scribes present sarcastically asked: Do we have a yield curve?
Even as the Indian financial markets grope with the concept of yield curve, its importance has been well recognised. But probably not the intricacies involved in its construction and interpretation. This book that should answer many of the questions relating to these aspects.
After the historical turmoil in the European Exchange Rate Mechanism (ERM) and following the exit of the Sterling from the system in September 1992, the UK authorities needed to decide on a new analytical framework on which to base its monetary policy. Instead of deciding on any one indicator, such as money supply, it was decided to take into consideration a wider range of parameters. These would be monitored on a monthly basis. One such indicator that clearly emerged out of the discussions was information derived from asset prices on marker expectations of future inflation and interest rates.
The modelling of the term structure of interest rates had for this purpose to be reviewed to include a host of factors which were ignored until nowprominent among them being comparisons of nominal and index-linked government debt prices . This in turn led to a review of techniques used to estimate the yield curve which had until then only been used to price new issues of government debt and to value loans to public corporations.
The authors of this book had carried out the review for Bank of England and have put together several aspects of the problem they had addressed. The result is a well- presented, cohesive reading on important aspects of the yield curve. And though the statistical analysis part looks a bit daunting, the underlying economic logic is straight and lucidly presented.
Beginning with the basic tools required for economic analysis of bonds market, the book goes on to analyse a number of issues regarding the estimation of term structure of interest rates. The second section of the book provides details on inclusion of market specific factors, such as taxation, options and index linking, in the estimation process. The role of market expectations in predicting the future behaviour of economic variables has been brought out in the last chapter.
While the academic media has dealt with the subject of yield curve at length, this book is a good attempt to bridge the gap between the academia and the practical world of finance. It provides a guide to theoretical techniques of pricing securities and modelling interest rates, while keeping the real world perspective in mind. Policy makers and market practitioners should find this book as useful for them as the academic world. As Indian markets move from pure vanilla products to futures and options and other complex instruments, prediction of interest rates would become more complicated. This book should serve a good reference point for market practitioners here.