SVB Asset Management
The Forward Yield Curve

The forward yield curve is simply an arithmetic construct of what the market believes future interest rates will be. In that regard, there are no opinions, forecasts, spells, or incantations. Just numbers. Here's how it works. . . .

Suppose I wanted to invest money for two years. I could buy a 2-year bond OR I could buy a 1-year bond, let it mature and buy another 1-year bond. In order to decide what to do, I need to know what the 1-year bond will yield 12 months from today. Well, there is no way of knowing that, but I can figure out what the market expects it to be as follows:

Suppose the 1-year yields 2.75 percent and the 2-year 3.00 percent. What would be the rate on the 1-year, 12 months from now to make me indifferent?

(1.03)(1.03)

(1.0275)		 = 1.032506 (rate required on one-year 12 months from today)


Or, simply put, if I believe that the 1-year will yield 3.2506 percent in 12 months, then I could invest in either scenario with the same result. Arbitrageurs in the market will constantly buy or sell the 1-year or the 2-year to ensure that this is always true. Further, the market has contracts for "treasury futures" that, for a fee, give you the right to invest in the 1-year 12 months from now.

In a similar fashion, the market can determine any future rate. The forward yield curve is simply a construct of these future rates. The graph in the newsletter displays the future curve calculated for 3 months, 6 months, and 12 months from today.


Disclaimer
This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.
© 2006 SVB Asset Management

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