Yield Analysis

The yield curve is simply a graphic representation of the relationship between the yields of securities with the same risk profile and different terms to maturity. For example, the rates of 1-30 year Government of Canada Bonds could be plotted on a curve. Depending on whether the 30-year rate was higher,equal to, or lower than the 1-year rate, you would see a normal, flat or inverted yield curve.

The shape of the yield curve will change depending on market expectations of future interest rates and inflation.

 
  Forward Rate Analysis

What is the market consensus about interest rates in the future? Unlocking this information requires the rudimentary, but exceptionally powerful,mathematics of compound interest. Compounding is an important issue in both money market and bond transactions.

Familiarity with compound interest analysis is useful to evaluate your projection of future interest rates and compare alternative borrowing or investing strategies. The prevailing yield curve reveals the precise degree that the market believes interest rates will move in the future. The following is an example to illustrate implied forward interest rates:

"Sample yield curve
"30 days: 8.75%	"	"r1
"60 days: 8.85%	"	"r2
"90 days: 8.90%	"	"r3
"180 days: 9.25%	"	"r 4
"365 days: 9.40%	"	"r 5

where r1,t1 and r2, t 2 are the rates and times to maturity of the respective instruments.

Thus, an investor with a two-month investment horizon must believe that one-month rates will be greater than 8.89% one month from now before he or she can justify investing money for one-month and then reinvesting the proceeds for another month. Otherwise, the investor would be better off investing for the two-month period (assuming investor preference between one and two month time horizons is not an issue). That is, if an investor invests in the one-month instrument and then upon maturity (one month into the future) invests the proceeds for another month, the investor would not have earned a return equivalent or better than an original two-month investment unless the future(one month into the future) one-month interest rate is at least 8.89%.

Clearly, a bearish investor should not automatically choose very short investment terms before quantifying how bearish he/she is relative to the market. For example, the calculations below illustrate that an investor for six months must believe that three month rates will rise almost 50 basis points(i.e. 9.39% versus 8.90%) before he or she is better off investing for three months rather than for the full six month term.

Present yield curve		Implied Forward rates
30 days:	8.75%	1 mth rate, 1 mth from now 8.89%
60 days:	8.85%	1 mth rate, 2 mths from now 8.87%
90 days:	"8.90%	2 mth rate, 1 mth from now 8.91%
180 days:	9.25%	3 mth rate, 3 mths from now 9.39%
365 days:	9.40%	6 mth rate, 6 mth from now 9.32%