What are the condition for the strategy of riding the yield curve to be profitable?
In Fixed income - Akron, the guy said :
yield guy upward sloping
spot rates expect to maintain the same level and shape
spot rates rises as predicted by forward rate
I don’t understand how spot rate can rise AND be expect to maintain the same level. What I am misunderstanding?
Lets say you want to make an investment with a horizon of 5 years. You have some options:
An investor can buy a bond that matures in 5 years.
Alternatively, the investor can buy a bond that matures in lets say 10 years and sell it in 5 years.
Why might an investor do this? Well, the 10 year maturity bond, in an upward sloping yield curve (and if this still holds, *goes back to your points you referenced on spot rates are maintaing the same level), will be able to sell for more than the bond maturing in 5 years (declining yield). Think of the maintaing the same level and shape as the yield curve is still positive and goes with your expectations. So riding the yield curve means an investor will buy a longer term maturity bond in the hopes that the spot rate behavior maintains the status quo.
Lets say you want to make an investment with a horizon of 5 years. You have some options:
An investor can buy a bond that matures in 5 years.
Alternatively, the investor can buy a bond that matures in lets say 10 years and sell it in 5 years.
Why might an investor do this? Well, the 10 year maturity bond, in an upward sloping yield curve (and if this still holds, *goes back to your points you referenced on spot rates are maintaing the same level), will be able to sell for more than the bond maturing in 5 years (declining yield). Think of the maintaing the same level and shape as the yield curve is still positive and goes with your expectations. So riding the yield curve means an investor will buy a longer term maturity bond in the hopes that the spot rate behavior maintains the status quo.
So you are saying that the two conditions are identical. Basically “same level and shape” = “rise as predicted by the forward”, am I right ?
Does that means that forward rates never predict a change in level and shape?
Well if the forward rates hold lets say at time=0 when you are thinking about riding the yield curve,
Then at t=5 when you are at the end of your investment horizon, then essentially the yield curve has not changed since the forward rates have “come to fruition” or “have predicted the spot rates correctly”, if you will.
Obviously in a real word situation, the spot rates could very well change once you get to time t=5, but thats the general idea. You could still make a positive profit.