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Term Structures - An Introduction

When the uninitiated enter the fixed income world the same questions arise time and time again, it seems:

  • What is the difference between annual and semi-annual compounding? And hey, what is compounding anyway?
  • What is a par curve and do I really need it?
  • Why don't people just quote zero curves?
  • What do I do when I don't have the 7.25-year swap rate - does it actually exist?

 

This is an introduction to the basic notions, conventions and applications of the term structure of interest rates, commonly called the yield curve This introduction grew over time as a handout for professionals who, although generally educated in a related field, were not fully acquainted with the fixed income area within finance. Here you will find a discussion of the basic notions like interest rate, discount factor zero, par and forward curve, and slightly more advanced topics. Section 2 gives a short introduction to the most important concepts. A more in depth presentation is given in section 3, along with immediate applications such as the swap curve and P&L (profit and loss) calculations for basic fixed income investments. Finally, section 4 describes a practical curve fitting method, the Vasicek-Fong spline.