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6.4 Yield Curve Movement and The Forward Curve

6.4.1 Describe the assumptions concerning the evolution of spot rates in relation to

forward rates implicit in active bond portfolio management.

  • An important observation about forward prices and the spot yield curve is that the forward contract price remains unchanged as long as future spot rates evolve as predicted by today's forward curve.
  • A change in the forward price reflects a deviation of the spot curve from that predicted by today's forward curve
  • If the spot rate curve is unchanged, then each bond "rolls down" the curve and earns the forward rate.
  • If one expects that the future spot rate will be lower/higher than what is predicted by the prevailing forward rate, the forward contract value is expected to increase/decrease.
  • To capitalize on this expectation, the trade would buy/sell the forward contract
  • If any one of the investor's expected future spot rates is lower than a quoted forward rate for the same maturity, then (all else being equal) the investor would perceive the bond to be undervalued in the sense that the market is effectively discounting the bond's payments at a higher rate than the investor is and the bond's market price is below the intrinsic value perceived by the investor.

6.4.2 The Strategy of Riding the Yield Curve.

  • The riding the yield curve strategy assumes an upward-sloping yield curve where the forward curve is always above the current spot curve.
  • When the yield curve slopes upward, as a bond approaches maturity, or "rolls down the yield curve," it is valued at successively lower yields and higher prices.
  • Using this strategy, a bond can be held for a period of time as it appreciates in price and then sold before maturity to realize a higher return.
  • If the trader does not believe that the yield curve will change its level and shape over an investment horizon, then buying bonds with a maturity longer than the investment horizon would provide a total return greater than the return on a maturity-matching strategy.
  • The total return of the bond will depend on:
  • Spread between the forward rate and the spot rate
  • The maturity of the bond

Lesson Wrap-Up

This lesson should leave you able to explain the yield curve movement and the forward curve in a fixed-income context and connect it to the decisions made by issuers, investors, or analysts.

Review Prompts

  1. Explain describe the assumptions concerning the evolution of spot rates in relation to in your own words.
  2. Explain the strategy of riding the yield curve. in your own words.
  3. State one exam-style risk, valuation, or market implication of the yield curve movement and the forward curve.