So the normal curve I’ve learned is that the curve slopes upward, but what if the 3 year bond has a lower interest rate than the 2 year bond? How would a situation like this come up? And if it did, what series of trades would you make to earn money?
Ok. It looks like just mistake from Yahoo. But hypothetically speaking, if that situation did come up, how would you arb that situation? (Crude analysis) Short the 2 year and go long on the 3 year. Either the 2 year has to fall or the 3 year has to go up. Correct?
There is no completely riskless trade. Suppose that we have 2 yr yielding 5%, 3 yr at 6%, 5 yr at 5%. All that says is that the forward rate from 2 to 3 years is much higher than the rate from 3 to 5 years. In a broad sense, that would be because there is demand for relatively short money but then the bond market thinks that there will be a recession. More likely, it would be because of some dislocation in the bond market or the curve isn’t modelled well. NB - A Treasury bond is more than just a time to maturity. A 3-yr Treasury might be a 27-year old 30 year bond with a 13% coupon or it might be the cheapest-to-deliver bond on the five year bond futures contract. A 5-yr bond could be an on-the-run bond in huge demand in the repo market or some illiquid obscure bond meant only for someone’s IRA. When you model yield curves, you need to be careful about mixing apples and oranges.
Borrow cheap at 3 years and deposit it for 2 years. DUHHHHH sorry I had to say it
Would work really well if you could borrow at Treasury rates. DUHHHHH Sorry I had to say it
Which is the assumption in all simplified models (EG put-call parity or Markowitz efficient frontier)
Are we talking about trading or simplified models? You can’t arb anything by pointing at Markowitz…
http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield_historical.shtml If you look at the rates on January 2, 2008, the 2 and 3 year yields were lower than the 1 mo, 3 mo, 6 mo, and 1 yr. Can someone explain this?
homie Wrote: ------------------------------------------------------- > http://www.ustreas.gov/offices/domestic-finance/de > bt-management/interest-rate/yield_historical.shtml > > > If you look at the rates on January 2, 2008, the 2 > and 3 year yields were lower than the 1 mo, 3 mo, > 6 mo, and 1 yr. > > Can someone explain this? This basically means that forward rates were lower from 1 - 3 years than the 1 mo, 3 mo, 6 mo, 1 yr spot rates at the time. One explanation is that the bond market anticipated a recession 1 - 2 years out which would bring about lower interest rates.
Wow, sorry about my B***chy last response, I guess 1 month to CFA exam was getting to me… There are different theories as to why the yield curve shifts: Pure expectations, Liquidity preference, and Market segmentation theory. You can find info on the differences here: http://en.wikipedia.org/wiki/Yield_curve The above poster’s explanation was using expectations theory. Since most were expecting a recession, future interest rates would likely fall. As for arbitrage with an inverted yield curve, theoretically you borrow at the cheaper long term rate and deposit and the higher short term rate. In practice this is impossible. Otherwise we would never actually see an inverted yield curve because it would immediately be arb’d away. Again sorry for my bi***iness 2 months ago, that is out of character.