Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries

THE YIELD CURVEIn the above sections, you have seen the pricing of simple forward contractsrelating to physical assets. The same principle can be applied to the pricingof equity related forwards. However, the pricing of interest rate andforeign exchange related contracts is slightly more complicated. Before wemove on to interest rate related derivatives, it is important to understandsome basics about the markets. The most important concept is the yieldcurve. Many people working in investment banks are paid "telephonenumber-like"salaries just for guessing and playing with the "shapes" of theyield curves and putting in trades in order to benefit from the movementsof these curves, so you would appreciate the importance of this.For a simple definition of a yield curve, though it is arguable, most peoplewould use one of the following: it is a plot of I) yield of governmentsecurities or 2) annual compounded interest rate (zero coupon yield, or theyield of a zero coupon bond) against time. For most currencies, you willsee interest rates for maturities of five years or more. An example is givenin the graph below.An example yield curve8.5% T4 5 6Time (years)10This graph is sometimes referred to as the "Term Structure of Interest Rates".In many markets, zero coupon rates of less than one year in maturity arequoted by different banks and brokers. However, rates for longer thanone.y ear maturity are not quoted. They are usually obtained from theprices of other traded instruments, for example interest rate futures andPricing of a Forward Contract and the Yield Curve