Cover
Foreword
Preface
Preface to the First Edition
Acknowledgments
About the Author
PART I: Introduction to the Yield Curve
1. CHAPTER 1: The Yield Curve
  1. THE YIELD CURVE FOR BEGINNERS
  2. YIELD TO MATURITY YIELD CURVE
  3. THE COUPON YIELD CURVE
  4. THE PAR YIELD CURVE
  5. THE ZERO‐COUPON (OR SPOT) YIELD CURVE
  6. USING SPOT RATES IN BOND ANALYSIS
  7. THE FORWARD YIELD CURVE
  8. ANALYSING AND INTERPRETING THE YIELD CURVE
  9. AN INTRODUCTION TO FITTING THE YIELD CURVE
  10. SPOT AND FORWARD RATES IN THE MARKET
  11. THE INTEREST‐RATE SWAP CURVE AND THE SOVEREIGN BOND CURVE
  12. APPENDIX: CUBIC SPLINE INTERPOLATION
  13. SELECTED BIBLIOGRAPHY AND REFERENCES
  14. NOTES
2. CHAPTER 2: A Further Look at Spot and Forward Rates
  1. ZERO‐COUPON BONDS
  2. COUPON BONDS
  3. BOND PRICE IN CONTINUOUS TIME
  4. INTRODUCTION TO BOND ANALYSIS USING SPOT RATES AND FORWARD RATES IN CONTINUOUS TIME
  5. APPENDICES
  6. SELECTED BIBLIOGRAPHY AND REFERENCES
  7. NOTES
PART II: Yield Curve Modelling and Post‐2008 Yield Curve Analytics
1. CHAPTER 3: Interest Rate Modelling I: Primer on Basic Concepts
  1. THE DYNAMICS OF THE YIELD CURVE
  2. TERM STRUCTURE MODELLING
  3. BASIC CONCEPTS
  4. ITÔ'S LEMMA
  5. APPROACHES TO MODELLING
  6. ONE‐FACTOR, TWO‐FACTOR AND MULTI‐FACTOR MODELS
  7. THE SHORT‐TERM RATE AND THE YIELD CURVE
  8. APPENDICES
  9. SELECTED BIBLIOGRAPHY AND REFERENCES
  10. NOTES
2. CHAPTER 4: Interest Rate Modelling II: The Dynamic of Asset Prices
  1. THE BEHAVIOUR OF ASSET PRICES
  2. STOCHASTIC PROCESSES
  3. WIENER PROCESS OR BROWNIAN MOTION
  4. THE MARTINGALE PROPERTY
  5. GENERALISED WIENER PROCESS
  6. A MODEL OF THE DYNAMICS OF ASSET PRICES
  7. STOCHASTIC CALCULUS MODELS: BROWNIAN MOTION AND ITÔ CALCULUS
  8. BROWNIAN MOTION
  9. STOCHASTIC CALCULUS
  10. UNCERTAINTY OF INTEREST RATES
  11. APPENDICES
  12. SELECTED BIBLIOGRAPHY AND REFERENCES
  13. NOTES
3. CHAPTER 5: Interest Rate Models I
  1. INTEREST RATE MODELS
  2. INTEREST RATE PROCESSES
  3. ONE‐FACTOR MODELS
  4. THE VASICEK MODEL
  5. THE MERTON MODEL
  6. THE COX–INGERSOLL–ROSS MODEL
  7. ARBITRAGE‐FREE MODELS
  8. THE HO AND LEE MODEL
  9. THE HULL–WHITE MODEL
  10. THE BLACK–DERMAN–TOY MODEL
  11. FITTING THE MODEL
  12. SUMMARY
  13. SELECTED BIBLIOGRAPHY AND REFERENCES
4. CHAPTER 6: Interest Rate Models II
  1. MULTI‐FACTOR TERM STRUCTURE MODELS
  2. THE MULTI‐FACTOR HEATH–JARROW–MORTON MODEL
  3. JUMP MODELS
  4. ASSESSING ONE‐FACTOR AND MULTI‐FACTOR MODELS
  5. CHOOSING A TERM STRUCTURE MODEL
  6. IMPORTANCE OF PRACTICALITY
  7. SELECTED BIBLIOGRAPHY AND REFERENCES
  8. REFERENCES ON ESTIMATION METHOD
  9. NOTES
5. CHAPTER 7: The Index‐Linked Bond Yield Curve
  1. INDEX‐LINKED BONDS AND REAL YIELDS
  2. THE REAL TERM STRUCTURE OF INTEREST RATES
  3. THE TERM STRUCTURE OF IMPLIED FORWARD INFLATION RATES
  4. ESTIMATING THE REAL TERM STRUCTURE
  5. FITTING THE DISCOUNT FUNCTION
  6. DERIVING THE TERM STRUCTURE OF INFLATION EXPECTATIONS
  7. APPLICATION
  8. SELECTED BIBLIOGRAPHY AND REFERENCES
  9. NOTES
6. CHAPTER 8: Yield Curve Analytics in the Post‐2008 Era
  1. OVERNIGHT INDEX SWAP (OIA) YIELD CURVE
  2. POST‐CRASH DISCOUNTING PRINCIPLES FOR YIELD‐CURVE CONSTRUCTION
  3. FOUR CURVES: SOVEREIGN, LIBOR, OIS, AND INTERNAL FUNDING CURVE
  4. APPENDIX
  5. REFERENCES
  6. NOTES
7. CHAPTER 9: Negative Interest Rate Analytics
  1. THE DISCOUNT FACTOR
  2. EXAMPLE ILLUSTRATIONS
  3. THE YIELD TO MATURITY
  4. SELECTED BIBLIOGRAPHY AND REFERENCES
  5. NOTE
PART III: Fitting the Yield Curve
1. CHAPTER 10: Estimating and Fitting the Yield Curve I
  1. YIELD CURVE SMOOTHING
  2. SMOOTHING TECHNIQUES
  3. USING A CUBIC POLYNOMIAL
  4. NON‐PARAMETRIC METHODS
  5. SPLINE‐BASED METHODS
  6. NELSON AND SIEGEL CURVES
  7. COMPARING CURVES
  8. APPENDICES
  9. SELECTED BIBLIOGRAPHY AND REFERENCES
  10. NOTES
2. CHAPTER 11: Estimating and Fitting the Yield Curve II
  1. RECAP: BOND MARKET INFORMATION
  2. ESTIMATING YIELD CURVE FUNCTIONS
  3. CURVE‐FITTING TECHNIQUES: PARAMETRIC
  4. PARAMETRIC TECHNIQUES
  5. PARAMETERISED YIELD CURVES
  6. THE CUBIC SPLINE METHOD FOR ESTIMATING AND FITTING THE YIELD CURVE
  7. USING A CUBIC SPLINE: THE WAGGONER MODEL
  8. THE ANDERSON–SLEATH MODEL
  9. APPLICATIONS
  10. THE ANDERSON–SLEATH EVALUATION
  11. REPO AND ESTIMATING THE SHORT END OF THE YIELD CURVE
  12. APPENDIX 11.1 THE MCCULLOCH CUBIC SPLINE MODEL
  13. SELECTED BIBLIOGRAPHY AND REFERENCES
  14. NOTES
PART IV: Yield Curves and Relative Value Trading
1. CHAPTER 12: Yield Curves and Relative Value
  1. THE DETERMINANTS OF GOVERNMENT BOND YIELDS
  2. CHARACTERISING THE COMPLETE TERM STRUCTURE
  3. IDENTIFYING RELATIVE VALUE IN GOVERNMENT BONDS
  4. YIELD SPREAD TRADES
  5. BOND SPREAD WEIGHTING
  6. TYPES OF BOND SPREADS
  7. NOTES
2. CHAPTER 13: Identifying Relative Value in the US Treasury Market: Acquiring New Benchmark Definitions from an Ancillary Yield Curve
  1. THE NATURE OF THE UNDERLYING OPTIMISATION: CONVERTING THE PRESENT VALUE APPARATUS INTO A MULTINOMIAL POLYNOMIAL OPTIMISATION
  2. AN APPROACH TO TREATING UNCERTAINTY QUANTIFICATION
  3. TWO COALESCING YIELD CURVES PRODUCING POSSIBLE TRADING OPPORTUNITIES ON OCTOBER 18, 2017
  4. IMPLICATIONS FOR YIELD SPREAD TRADES
  5. A PROPOSED BUTTERFLY TRADE WITH THE SHORT POSITION STEMMING FROM THE ANCILLARY BOND: 01.868 TABLE 13.4
  6. WHAT TO EXPECT WHEN BILLS ARE EXCLUDED FROM THE FITTING COMPUTATIONS
  7. APPENDIX: GEOMETRIC PROGRAMMING
  8. WEBSITE
  9. ADDENDUM: EXPERIMENTS FROM 17/12/2018
  10. SELECTED BIBLIOGRAPHY AND REFERENCES
  11. NOTES
APPENDIX: Bond Yield Measurement
1. CURRENT YIELD
2. SIMPLE YIELD TO MATURITY
3. YIELD TO MATURITY
4. MODIFYING BOND YIELDS
5. CONVERTING BOND YIELDS
6. SUMMARY
7. NOTES
Index
End User License Agreement

List of Tables

Chapter 1
1. TABLE 1.1 Gilt yields
2. TABLE 1.2 Coupon, spot, and forward yields
3. TABLE 1.3 Positive yield curve with constant expected future interest rat...
Chapter 2
1. TABLE 2.1 Confirming the forward rate arbitrage
2. TABLE 2.2 Hypothetical zero‐coupon yield and forward rates
Chapter 8
1. TABLE 8.1 Constructing the OIS curve.
Chapter 9
1. TABLE 9.1 First example results
2. TABLE 9.2 Second example results
Chapter 11
1. TABLE 11.1 Spot rate values using Nelson–Siegel model and user‐ ...
2. TABLE 11.2 Gilt redemption yields used to fit curve in Figure 11.1
Chapter 12
1. TABLE 12.1 Duration and yield comparisons for bonds in a hypothetical inv...
2. TABLE 12.2 Yields and excess yield spreads for selected gilts, 22 October...
3. TABLE 12.3 Bond basis point value, 22 October 1999
Chapter 13
1. TABLE 13.1 Interest Earned from a Treasury Bond 4% Annual Interest
2. TABLE 13.2 T‐Bill Pricing Formula: 360 Day Convention
3. TABLE 13.3 BEY on Bill Data: DTM = days to maturity; 9/27/02
4. TABLE 13.4 29 Bonds and Notes 10/18/17 when Bills used in Curve Fitting
5. TABLE 13.5 Excerpts from 258 Notes and Bonds 18/10/2017
6. TABLE 13.6 Comparing IRRs: Ancillary and Benchmark
7. TABLE 13.7 LP Unique Solution
8. TABLE 13.8 31 Bonds and Notes: No Bills 18 October 2017
Appendix
1. TABLE A.1 Discounted margin calculation for an FRN. Calculation carried out on...

List of Illustrations

Chapter 1
1. FIGURE 1.1 Creating a yield curve in Excel.
2. FIGURE 1.2 Yield to maturity yield curves.
3. FIGURE 1.3 UK gilt yield curves as at 18 June 2003.
4. FIGURE 1.4 UK gilt yield curve and sterling interest rate swap curve as at 18...
5. FIGURE 1.5 French and German government yield curves, 18 June 2003.
6. FIGURE 1.6 Treasury yield curve as at 18 June 2003.
7. FIGURE 1.7 Screen FMC, menu of corporate and government bond yield curves.
8. FIGURE 1.8 Screen FMC, AAA‐, A‐, and BBB‐rated corporate...
9. FIGURE 1.9 Screen SWCV, selected for sterling swap curve as at 18 June 2003. ...
10. FIGURE 1.10 Coupon yield curves.
11. FIGURE 1.11 Average yield spreads of UK corporate bonds versus gilts, 2001...
12. FIGURE 1.12 Redemption, spot, and forward yield curves: traditional analysis.
13. FIGURE 1.13 UK gilt redemption yield curves.
14. FIGURE 1.14 Yield curve explained by expectations hypothesis and liquidity pr...
15. FIGURE 1.15 Polynomial curve‐fitting.
16. FIGURE 1.16 Grid point allocation in regression analysis.
17. FIGURE 1.17 US Treasury and US dollar interest rate swap curves, 30 April 201...
18. FIGURE 1.18 Cubic spline interpolation matrix.
Chapter 2
1. FIGURE 2.1 US Treasury zero‐coupon yield curve in September 2000.
2. FIGURE 2.2 UK gilt zero‐coupon yield curve, September 2000.
3. FIGURE 2.3 French OAT zero‐coupon yield curve.
4. FIGURE 2.4(a) Hypothetical zero‐coupon and forward yield curves.
5. FIGURE 2.4(b) Hypothetical spot and forward yield curves.
6. FIGURE 2.5 Hypothetical par, spot, and forward yield curves.
7. FIGURE 2.6 Diagrammatic representation of the relationship between the spot a...
8. FIGURE 2.7 Diagrammatic representation of calculating area from applying inte...
Chapter 3
1. FIGURE 3.1 Evolution of Brownian or Wiener process.
Chapter 4
1. FIGURE 4.1 An example of a Wiener process.
2. FIGURE 4.2 An example of a Poisson process.
3. FIGURE 4.3 Standard and generalised Wiener processes.
Chapter 5
1. FIGURE 5.1 Distribution of future interest rates implied by different process...
2. FIGURE 5.2 Zero‐coupon bond price curves at and .
3. FIGURE 5.3 Forward rate curves with and .
4. FIGURE 5.4 Forward rate curves standard deviations of 0.02 and 0.06.
5. FIGURE 5.5 Forward rate curves under high standard deviation.
Chapter 7
1. FIGURE 7.1 UK market nominal and real term structure of interest rates, July ...
Chapter 8
1. FIGURE 8.1 GBP SONIA and GBP Swap curves, 13 October 2016.
2. FIGURE 8.2 Three‐month Euribor and EONIA spread, 2002–2017.
3. FIGURE 8.3 Illustration of example curve construction calculations.
4. FIGURE 8.4 Example of a multi‐currency curve.
5. FIGURE 8.5 Derivatives book modelled funding profile.
6. FIGURE 8.6 Example of forward curve oscillation arising from using flat term ...
7. FIGURE 8.7 Bank COF curves.
Chapter 9
1. FIGURE 9.1 Discount factors.
2. FIGURE 9.2 Compounding effect.
3. FIGURE 9.3 Compounding effect difference.
4. FIGURE 9.4 Continuously compounding.
5. FIGURE 9.5 YTM of Eidgenossen.
6. FIGURE 9.6 Convertible bond negative yields.
7. FIGURE 9.7 Convertible bond payoff profile.
Chapter 10
1. FIGURE 10.1 Gilt gross redemption yields, 12 June 2000.
2. FIGURE 10.2 Discount factors from gilt prices, 12 June 2000.
3. FIGURE 10.3 Zero‐coupon (spot) and forward rates obtained from gilt...
4. FIGURE 10.4 Linear interpolation of bond yields, 26 June 1997.
5. FIGURE 10.5 Spot and forward rates implied from Figure 10.4.
6. FIGURE 10.6 Cubic spline with knot points at 0, 2, 5, 10 and 25 year tenors.
7. FIGURE 10.7 Regression line passing through value of and .
8. FIGURE 10.8 Piecewise linear regression
9. FIGURE 10.9 Illustrating knot points
Chapter 11
1. FIGURE 11.1 A Nelson and Siegel fitted yield curve and gilt redemption yield ...
2. FIGURE 11.2 Suggested node points.
3. FIGURE 11.3 Yield curves fitted using cubic spline method and Svensson parame...
4. FIGURE 11.4 Effect on fitted yield curves of change in long‐dated bond....
5. FIGURE 11.5 Comparison of fitted spot yield curve to observed spot yield curv...
6. FIGURE 11.6 Fitted yield curves and observed strip yield curve, July 1998.
7. FIGURE 11.7 Fitting short‐term yield curves using government repo rates.
Chapter 12
1. FIGURE 12.1 Yield and duration of gilts, 21 October 1999.
2. FIGURE 12.2 T‐bill and par yield curve, October 1999.
3. FIGURE 12.3 Structure of bond yields, October 1999.
4. FIGURE 12.4 2‐year and 10‐year spread, UK gilt market March 1999.
Chapter 13
1. FIGURE 13.1 Ancillary & Benchmark Curves including Bills, 18 October 2017.
2. FIGURE 13.2 Ancillary Curve: No Bills, 18 October 2017.
3. FIGURE 13.3 Results from December 2018 (i)
4. FIGURE 13.4 Results from December 2018 (ii)
Appendix
1. FIGURE A.1 Comparing yield measures for a 6% bond with five years to maturity.
2. FIGURE A.2 The bond price/yield relationship.

First published 2004

Second Edition published 2019

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The views, thoughts and opinions expressed in this book are those of the author in his individual private capacity and should not in any way be attributed to any employing firm, or to Moorad Choudhry as a representative, officer, or employee of any employing institution or affiliated firm.

Whilst every effort has been made to ensure accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of reading any material in this book can be accepted by the author, publisher or any named person or corporate entity. The author may or may not hold, or have held, any security identified in this book.

Library of Congress Cataloging‐in‐Publication Data

Names: Choudhry, Moorad.

Title: Analysing and interpreting the yield curve / Moorad Choudhry.

Other titles: Analysing & interpreting the yield curve | Analyzing and interpreting the yield curve

Description: Second edition. | Chichester, UK : Wiley, 2019. | Series: Wiley finance | Revised edition of the author's Analysing and interpreting the yield curve, c2004. | Includes bibliographical references and index. |

Identifiers: LCCN 2018056454 (print) | LCCN 2018057854 (ebook) | ISBN 9781119141068 (AdobePDF) | ISBN 9781119141051 (ePub) | ISBN 9781119141044 (hardback)

Subjects: LCSH: Bonds—Valuation—Econometric models. | BISAC: BUSINESS & ECONOMICS / Banks & Banking.

Classification: LCC HG4651 (ebook) | LCC HG4651 .C6793 2019 (print) | DDC 332.63/23—dc23

LC record available at https://lccn.loc.gov/2018056454

Cover Design: Wiley

Cover Images: top: © Gen Epic Solutions/Shutterstock, bottom: © hywards/shutterstock

Foreword

It is an honour to be asked to contribute a few words at the beginning of this publication.

Moorad and I first met back in 2010. We were both attending the Group Balance Sheet Management Committee at The Royal Bank of Scotland, our employer at the time. Although I forget the specific theme of the discussion, I remember our desire, incidentally which was not necessarily shared by the other committee members, to investigate and better understand a trend in the balance sheet of our organisation and in the wider economy.

Respecting each other's viewpoint, we quickly became good friends. However, we are like “chalk and cheese”. In Belbin's terminology, Moorad possesses many of the qualities of the “Plant” and “Resource Investigator”, being creative, imaginative and free‐thinking as well as outgoing and enthusiastic, whereas I am most comfortable in the role of the “Completer Finisher”.

Although our shared passion for the financial markets became evident at our first meeting, it was only later I realised Moorad also possesses a burning desire to pass on his knowledge, understanding and perceptive insights to others, by either delivering lectures and presentations or through the written word.

I first became aware of Moorad's teaching skills in 2014 when he invited me to speak to students studying for the Certificate of Bank Treasury Risk Management. This is a practitioner‐oriented professional qualification in bank asset‐liability management, which is delivered to a global audience and was developed by Moorad and the team from WBS Training Ltd. There are also his numerous short course and conference performances I could highlight, all with financial risk management as the enduring theme.

When it comes to writing, Moorad is both versatile and prolific. By my counting, this updated edition of Analysing and Interpreting the Yield Curve is his third book of the year so far. However, there's still a way to go to catch Corin Tellado, a renowned Spanish author who published over 4,000 novels in her lifetime. The comparison is probably unfair as it is doubtless a more difficult challenge to combine risk management theory, practice and current market developments in a captivating read, whilst also pursuing a full‐time career in banking!

Moorad is a past master at simplifying complex ideas and communicating them in an easy going and engaging manner. In these respects, this book is no different to all his other publications. Compared to the first edition, sections have been added for the latest developments in the financial markets, including: the multi‐currency yield curve, the SONIA curve, the interpretation of negative yield curves, a post‐crash discounting technique for the swap curve and how to use the theoretical and observed US Treasury curve as a means of identifying relative value in bond spread trades. These concepts will be of interest to anyone working in the bond markets, be they a trader, sales‐person, fund manager, research analyst, investor or issuer, or, like me, simply a student of the financial markets.

I commend this book to you, hope you enjoy the read and leave you with the words of Benjamin Franklin:

An investment in knowledge pays the best interest.

Chris Westcott

Former Treasurer, Retail and Wealth Division

The Royal Bank of Scotland

1 May 2018

Preface

The yield curve, and everything about it, was my first and most intense love in finance. It probably still is. I could talk about it for hours, at any time, day or night. I think it is the most significant topic in banking, the very foundation of finance. But it's interesting to me to observe how the perception, and indeed the requirement, for technical excellence in banking changes subtly the more senior the level of practitioner. The higher one rises in the profession, the less it would appear that one needs to know about subjects such as the curve, how to interpret it, how best to interpolate it, and how to understand and make sense of what it's trying to tell us. What I thought was the most important and vital issue in finance, something that absolutely everyone had to know about, turns out to be just one more arcane specialism that is not discussed that often at the bank's asset‐liability committee (ALCO), hardly at all at the executive management committee (EXCO), and fewer times still at the Board.

No matter, I still think that it's a very important topic and it's a pity that it isn't viewed in this way by everyone in banking. But that's their look out. The fact that you are reading this book shows that you agree that it's a worthwhile topic to get to grips with!

So, fully 15 years after the first edition, is there anything new to write about on the curve? As it happens, yes, a fair bit. The global financial markets are a very different beast today compared to what they were in 2003. Of course, the fundamentals of yield curve analysis, interpolation, and interpretation remain unchanged. But the behaviours of curves are different in various nuanced ways (and some not so nuanced, and in fact very much “in your face” – for example, the negative interest rate curves that are a commonplace in some countries in the eurozone). That’s why I think this book was worth updating, so that we might cover issues such as multi‐currency curves, the overnight index swap (OIS) curve, and key factors in post‐crash discounting of the swap curve. And speaking of interest‐rate swaps, it is routine to see (for example, in US dollar markets) the swap curve trading through the sovereign bond curve. That would have been inexplicable when I was working as a government bond primary dealer in the 1990s … but then again, negative interest rates as routine would also have been inexplicable. Plenty for us to be getting on with then. And in an era of ever more intensive regulator and compliance burden, having to deal with a purely technical subject may even come across as a breath of fresh air to some practitioners!

I always try to emphasise the practical and the user‐friendly in all my writing. There is such a disconnect between academia and practice in finance that there would be little value in me expounding purely on the theoretical. Unfortunately (or fortunately, depending on your point of view), the yield curve is one of those topics that it is difficult to leave the technical out of. That said, I hope the contents of the book are of relevance and practical value to the practitioner in banking and finance. This is not intended to be a textbook describing nothing that actually takes place in a bank, unlike some finance textbooks I have encountered over the years. Rather, it is meant for those who need to update the curve for use in internal funds transfer pricing, or to estimate the value to be derived from purchasing one bond in preference to another bond, or to price a new issue private placement structured product, or to have an idea of what the market thinks the state of the economy is. In other words, this book is for anyone that is using the yield curve for one or more of its myriad different practical applications in the financial markets.

Hence this second edition, which I hope you find of interest and of some use. As Ian MacDonald said in the preface to his final update of the majestic Revolution In The Head, no further editions will be forthcoming. Or as the last Oi! album proclaimed, “That's yer lot!”.

Comments on the text are welcome and should be sent to me via John Wiley & Sons Limited.

All the best.

Moorad Choudhry

Surrey, England

19 December 2018

A Solid Bond In Your Heart

Preface to the First Edition

As Sir Arthur Conan Doyle would have put it, so elementary a form of literature as the textbook on financial economics hardly deserves the dignity of a preface. It is possible though, to bring some instant clarity to the purpose of such a book if we open with a few words here.

In my book The Bond and Money Markets, I try to explain, from first principles, just how important the global debt market is, and describe the various participants that interact with each other in this market. Given the importance of the global bond market, one can never learn too much about it. But this is not a book about the bond market; rather it is about a very specific, and important part of the bond markets. In developed markets, as well as a fair number of developing ones, there is usually a large number of bonds trading at one time, at different yields and with varying terms to maturity. Investors and traders incessantly examine the relationship between the yields on bonds that are in the same class; plotting yields of bonds that differ only in their term to maturity produces what is known as the yield curve. The yield curve represents the bond market. It is sometimes referred to as the term structure of interest rates, but as we shall see later in this book, this expression refers to only one specific type of yield curve. There are lots of different yield curves. We shall examine them all in detail later.

Much of the analysis and pricing activity that takes place in the bond markets revolves around the yield curve. The primary yield curve in any domestic capital market is the government bond yield curve, so for example, in the US market it is the US Treasury yield curve. So in this book we will talk mainly, but not exclusively, about the government yield curve. And because the author spent over five years as a United Kingdom government bond trader (or gilt‐edged market maker), most of the examples will be from the gilt market. But the principles remain the same. It is the importance of the yield curve to just about every aspect of finance that has been the motivation behind writing this book. Our objective is to:

describe what the yield curve is;
explain what it tells us;
try to explain why it assumes certain shapes;
show how we can use it;
introduce how it is modelled;
show how it is fitted from market rates.

We begin with some basic description of bonds and bond mathematics, just to set the scene. We assume a basic knowledge and familiarity with bonds and market institutions, and concentrate on the yield curve. It is an arcane, specialist topic but well worth getting familiar with. We explain term structure theory, describe the most popular mathematical approaches used to model the yield curve, and show how to fit the yield curve using econometric techniques. This knowledge is of great use to just about anyone involved in the bond markets: traders, bond salespersons, fund managers, research analysts, issuers of bonds … in fact issuers, investors, and all the middlemen in between. Investors in the equity markets can also benefit from an understanding of the yield curve, as it enables one to gain a better insight into market sentiment.

We must necessarily be quite focused and specialist in our discussion of the yield curve. Hopefully the more technical material is presented in good order so that it remains accessible. There are any number of textbooks available for the complete beginner, which are recommended in end‐chapter reading lists, along with further reading.

Moorad Choudhry

Surrey, England

30 June 2003