Yield Curve

The yield curve is a graphic representation of market yield for a fixed income security plotted against the maturity of the security. The yield curve is positive when long-term rates are higher than short-term rates. (Source: CFTC)

In finance, the yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. For example, the current U.S. dollar interest rates paid on U.S. Treasury securities for various maturities are closely watched by many traders, and are commonly plotted on a graph such as the one on the right which is informally called "the yield curve." More formal mathematical descriptions of this relation are often called the term structure of interest rates.

The yield of a debt instrument is the annualized percentage increase in the value of the investment. For instance, a bank account that pays an interest rate of 4% per year has a 4% yield. In general the percentage per year that can be earned is dependent on the length of time that the money is invested. For example, a bank may offer a "savings rate" higher than the normal checking account rate if the customer is prepared to leave money untouched for five years. Investing for a period of time t gives a yield Y(t). This function Y is called the yield curve.

Y is often, but not always, an increasing function of t. Yield curves are used by fixed income analysts, who analyze bonds and related securities, to understand conditions in financial markets and to seek trading opportunities. Economists use the curves to understand economic conditions.The yield curve function Y is actually only known with certainty for a few specific maturity dates, the other maturities are calculated by interpolation.

Yield curves are usually upward sloping asymptotically; the longer the maturity, the higher the yield, with diminishing marginal growth. There are two common explanations for this phenomenon. First, it may be that the market is anticipating a rise in the risk-free rate. If investors hold off investing now, they may receive a better rate in the future. Therefore, under the arbitrage pricing theory, investors who are willing to lock their money in now need to be compensated for the anticipated rise in rates — thus the higher interest rate on long-term investments.

However, interest rates can fall just as they can rise. Another explanation is that longer maturities entail greater risks for the investor (i.e. the lender). Risk premium should be paid, since with longer maturities, more catastrophic events might occur that impact the investment. This explanation depends on the notion that economy faces more uncertainties in the distant future than in the near term, and the risk of future adverse events (such as default and higher short-term interest rates) is higher than the chance of future positive events (such as lower short-term interest rates). This effect is referred to as the liquidity spread. If the market expects more volatility in the future, even if interest rates are anticipated to decline, the increase in the risk premium can influence the spread and cause an increasing yield.

The opposite situation — short-term interest rates higher than long-term — also can occur. For instance, at November 2004, the yield curve for UK Government bonds (i.e. the bonds which the UK Government issues to borrow money - see gilts) was partially inverted. The yield for the 10 year bond stood at 4.68% but only 4.45% on the thirty year bond. The market's anticipation of falling interest rates causes such incidents. Negative liquidity premiums can exist, specifically if long-term investors dominate the market, but the prevailing view is that positive liquidity premium dominates, so only the anticipation of falling interest rates will cause an inverted yield curve. Strongly inverted yield curves have historically preceded economic depressions.

The yield curve may also be flat or hump-shaped, due to anticipated interest rates being steady, or short-term volatility outweighing long-term volatility.

Yield curves move on a daily basis; representing the market's reaction to news. A further "stylized fact" observed is that yield curves tend to move in parallel. That is, an increase in the cost of borrowing money for one year is frequently accompanied by a similar shift at points further along the curve.

Types of Yield Curve

There is no single yield curve describing the cost of money for everybody. The most important factor in determining a yield curve is the currency in which it is denominated. The economic situation of the countries and companies using each currency is primary in determining the yield curve. For example the sluggish economic growth of Japan throughout the late 1990s and early 2000s has meant the yen yield curve is very low (rising from virtually zero at the three month point to only 2% at the 30 year point). By contrast the British pound curve ranges from 4-5% along its curve.

Different institutions borrow money at different rates, depending on their creditworthiness. The yield curves corresponding to the bonds issued by governments in their own currency are called the government bond yield curve (government curve). Banks with high credit ratings (Aa/AA or above) borrow money from each other at the LIBOR rates. These yield curves are typically a little higher than government curves. They are the most important and widely used in the financial markets, and are known variously as the LIBOR curve or the swap curve. The construction of the swap curve is described below.

Besides the government curve and the LIBOR curve there are corporate (company) curves. These are constructed from the yields of bonds issued by corporates. As corporates have lower creditworthiness than governments and most large banks these yields are typically higher. Corporate yield curves are often quoted in terms of a "credit spread" over the relevant swap curve. For instance the five-year yield curve point for Vodafone might be quoted as LIBOR +0.25%, where 0.25% (often written as 25bps or 25 basis points) is the credit spread.

Normal Yield Curve

Through most of the post-Great Depression era to present the yield curve has been called "normal" when yields rise as maturity lengthens, that is, when the slope of the yield curve is positive. This positive slope reflects investor expectations for the economy to grow in the future and, importantly, for this growth to be associated with a greater risk that inflation rises in the future than falls. This expectation for higher inflation in the future than the present generates both an expectation that the central bank will tighten monetary policy by raising short term interest rates in the future to slow economic growth and dampen inflationary pressure and the need for a risk premium associated with the uncertainty about the future rate of inflation and the risk this poses to the future value of cash flows. Investors price these risks into the yield curve by demanding higher yields for maturities further into the future.

However, "normal" being associated with a positive slope has not always been the norm. Through much of the 19th century and early 20th century the US economy experienced trend growth with persistent deflation, not inflation. During this period the yield curve was typically inverted, reflecting the fact that deflation made current cash flows more valuable than future cash flows. During this period of persistent deflation, a 'normal' yield curve was negatively sloped.

Steep Yield Curve

Historically, the 20-year Treasury bond yield has averaged approximately two percentage points above that of three-month Treasury bills. In situations when this gap increases (e.g. 20-year Treasury yield rises relatively higher than the three-month Treasury yield), the economy is expected to improve quickly in the future. This type of curve can be seen at the beginning of an economic expansion (right after the end of a recession). Here, economic stagnation will have depressed short-term interest rates; however, rates begin to rise once the demand for capital is re-established by growing economic activity.

Flat or Humped Yield Curve

A flat curve is apparent when all maturities have same yields, whereas a humped curve results when short-term and long-term yields are equal and mid-term yields vary from those of the short-term and long-term. A flat curve sends signals of uncertainty in the economy. This mixed signal can revert back to a normal curve or could later result into an inverted curve.It cannot be explained by the Segmented Market theory.

Inverted Yield Curve

An inverted curve occurs when long-term yields fall below short-term yields. Under this abnormal and contradictory situation, long-term investors will settle for lower yields now if they think the economy will slow or even decline in the future. An inverted curve may indicate a worsening economic situation in the future. In addition to potentially signalling an economic decline, inverted yield curves also imply that the market believes inflation will remain low. This is because, even if there is a recession, a low bond yield will still be offset by low inflation. However, technical factors such as a flight-to-quality or global economic or currency situations may cause demand for bonds on the long end of the yield curve causing rates to fall. This was seen in 1998 during the Long Term Capital Management failure when there was a slight inversion on part of the curve. (Source: Wikipedia)

Key Terms: Bonds, Bond Markets, Bond Yield, Yield Curve

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Volatility

What is volatility?

Volatility is a statistical measurement of the rate of price change of a futures contract, security, or other instrument underlying an option.

Volatility trading consists of strategies designed to speculate on changes in the volatility of the market rather than the direction of the market. (Source: CFTC)

Volatility most frequently refers to the standard deviation of the change in value of a financial instrument with a specific time horizon. It is often used to quantify the risk of the instrument over that time period. Volatility is typically expressed in annualized terms, and it may either be an absolute number (5$) or a fraction of the initial value (5%).

For a financial instrument whose price follows a Gaussian random walk, or Wiener process, the volatility increases by the square-root of time as time increases. Conceptually, this is because there is an increasing probability that the instrument's price will be farther away from the initial price as time increases.

More broadly, volatility refers to the degree of (typically short-term) unpredictable change over time of a certain variable. It may be measured via the standard deviation of a sample, as mentioned above. However, price changes actually do not follow Gaussian distributions. Better distributions used to describe them actually have "fat tails" although their variance remains finite. Therefore, other metrics may be used to describe the degree of spread of the variable. As such, volatility reflects the degree of risk faced by someone with exposure to that variable.

Historical volatility is the volatility of a financial instrument based on historical returns. This phrase is used particularly when it is wished to distinguish between the actual volatility of an instrument in the past, and the current volatility implied by the market.

Volatility is often viewed as a negative in that it represents uncertainty and risk. However, volatility can be good in that if one shorts on the peaks, and buys on the lows one can make money, with greater money coming with greater volatility. The possibility for money to be made via volatile markets is how short term market players like day traders hope to make money, and is in contrast to the long term investment view of buy and hold.

It is also possible to trade volatility directly, through the use of derivative securities such as options.

Volatility does not imply direction. (This is due to the fact that all changes are squared.) An instrument that is more volatile is likely to increase or decrease in value more than one that is less volatile.

For example, a checking account has low volatility. It won't lose 50% in a year but neither will it gain 50%.

It's common knowledge that types of assets experience periods of high and low volatility. That is, during some periods prices go up and down quickly, while during other times, they can seem to move almost not at all for a long time.

Periods when prices fall quickly (a crash) are often followed by prices going down even more, or going up by an unusual amount. Also, a time when prices rise quickly (a bubble) may often be followed by prices going up even more, or going down by an unusual amount.

The converse is, 'doldrums' can last for a long time as well.

Most typically, extreme movements do not appear 'out of nowhere'; they're presaged by larger movements than usual. This is termed autoregressive conditional heteroskedasticity. Of course, whether such large movements have the same direction, or the opposite, is more difficult to say. And an increase in volatility does not always presage a further increase--the volatility may simply go back down again. (Source: Wikipedia)

Trends and Trendlines

What is a trend? What is a trendline?

A trend is the general direction, either upward or downward, in which prices have been moving. (Source: CFTC)

In investing, financial markets are commonly believed to have market trends that can be classified as primary trends, secondary trends (short-term), and secular trends (long-term). This belief is generally consistent with the non-scientific practice of technical analysis and broadly inconsistent with the efficient markets hypothesis.

A bull market is a prolonged period of time when prices are rising in a financial market faster than their historical average, in contrast to a bear market which is a prolonged period of time when prices are falling.

Investors can be described as having bullish or bearish sentiments. Market trends are witnessed when bulls (buyers) outnumber bears (sellers), or vice versa, consistently over time. In general, a bull or bear market refers to the market and sentiment as a whole but it can also be used to refer to specific securities, sectors, or similar ("bullish on IBM", "bullish on technology stocks" or "bearish on gold", for example). (Source: Wikipedia)

Trendlines

In charting, a trendline is a line drawn across the bottom or top of a price chart indicating the direction or trend of price movement. If up, the trendline is called bullish; if down, it is called bearish. (Source: CFTC)

A trend line is formed when you can draw a diagonal line between two or more price pivot points. They are commonly used to judge entry and exit investment timing when trading securities.

A trend line is a bounding line for the price movement of a security. A support trend line is formed when a securities price decreases and then rebounds at a pivot point that aligns with at least two previous support pivot points. Similarly a resistance trend line is formed when a securities price increases and then rebounds at a pivot point that aligns with at least two previous resistance pivot points.

Trend lines are a simple and widely used technical analysis approach to judging entry and exit investment timing. To establish a trend line historical data, typically presented in the format of a chart such as the above price chart, is required. Historically, trend lines have been drawn by hand on paper charts, but it is now more common to use charting software that enables trend lines to be drawn on computer based charts. There are some charting software that will automatically generate trend lines, however most traders prefer to draw their own trendlines.

When establishing trend lines it is important to choose a chart based on a price interval period that aligns with your trading strategy. Short term traders tend to use charts based on interval periods, such as 1 minute (i.e. the price of the security is plotted on the chart every 1 minute), with longer term traders using price charts based on hourly, daily, weekly and monthly interval periods.

Trend lines are typically used with price charts, however they can also be used with a range of technical analysis charts such as MACD and RSI. Trend lines can be used to identify positive and negative trending charts, whereby a positive trending chart forms an upsloping line when the support and the resistance pivots points are aligned, and a negative trending chart froms a downsloping line when the support and resistance pivot points are aligned.

Trend lines are used in many ways by traders. If a stock price is moving between support and resistance trendlines, then a basic investment strategy commonly used by traders, is to buy a stock at support and sell at resistance, then short at resistance and cover the short at support. The logic behind this, is that when the price returns to an existing principal trendline it may be an opportunity to open new positions in the direction of the trend, in the belief that the trendline will hold and the trend will continue further. A second way is that when price action breaks through the principal trendline of an existing trend, it is evidence that the trend may be going to fail, and a trader may consider trading in the opposite direction to the existing trend, or exiting positions in the direction of the trend. (Source: Wikipedia)

Support

What is support?

In technical analysis, support is a price area where new buying is likely to come in and stem any decline. (Source: CFTC)

A support level is a price point where a security’s price pivots and changes direction. They are formed when you can draw a horizontal line between two or more price pivot points.

The support level is the lowest price that a security trades at, over a period of time. The more frequently a support level is tested (i.e. hits a previous support level pivot point but does not fall below it), the stronger the support at that level. Some traders believe that the stronger the support at a given level, the less likely it is to break below that level in the future. It is said that if a security breaks prior levels of support only by a small portion, it will drop sharply until a new level of support is reached.

A support level can become a resistance level if the price of the security falls below the support level; similarly a resistance level can become a support level if the price of the security rises above the support level. (Source: Wikipedia)

See also:
Resistance

Retracement

What is retracement?

A retracement is a reversal within a major price trend.
(Source: CFTC)

In finance, a percent measure, indicating deviation of the current stock price from the maximum value. The price movement in the opposite direction of the previous trend. A zero retracement indicates a strong bullish movement. (Source: Wikipedia)

Resistance

What is resistance?

In technical analysis, resistance is a price area where new selling will emerge to dampen a continued rise. (Source: CFTC)

A resistance level is a price point where a security’s price pivots and changes direction. They are formed when you can draw a horizontal line between two or more pivot price points.

The resistance level is the highest price that a security trades at over a period of time. The more frequently a resistance level is tested (i.e. hits a previous resistance level pivot point but does not rise any further), the stronger the resistance at that level. For this reason, many traders believe that the stronger the resistance, the less likely the price will break through that level.

A resistance level can become a support level if the price of the security rises above the resistance level; similarly a support level can become a resistance level if the price of the security falls below the support level. (Source: Wikipedia)

See also:
Support

Overbought / Oversold

What do the terms "overbought" and "oversold" mean?

The term "overbought" expresses a technical opinion that the market price has risen too steeply and too fast in relation to underlying fundamental factors. Rank and file traders who were bullish and long have turned bearish and short.

The term "oversold" expresses a technical opinion that the market price has declined too steeply and too fast in relation to underlying fundamental factors; rank and file traders who were bearish and short have turned bullish. (Source: CFTC)

Momentum

What is momentum?

In technical analysis, momentum is the relative change in price over a specific time interval. Momentum is often equated with speed or velocity and considered in terms of relative strength. (Source: CFTC)

Momentum and rate of change (ROC) are simple technical analysis indicators showing the difference between today's closing price and the close N days ago.

"Momentum" in general refers to prices continuing to trend. The momentum and ROC indicators show that by remaining positive while an uptrend is sustained, or negative while a downtrend is sustained.

A crossing up through zero may be used as a signal to buy, or a crossing down through zero as a signal to sell. How high (or how low when negative) the indicators get shows how strong the trend is.

One can choose between looking at a move in dollar terms or proportional terms (price change in dollars vs. price change in percent from beginning of the trend). The zero crossings are the same in each, of course, but the highs or lows showing strength are on the respective different bases. (Source: Wikipedia)

Head and Shoulders Chart Pattern

What is the Head and Shoulders chart pattern?

In technical analysis, a chart formation that resembles a human head and shoulders and is generally considered to be predictive of a price reversal. A head and shoulders top (which is considered predictive of a price decline) consists of a high price, a decline to a support level, a rally to a higher price than the previous high price, a second decline to the support level, and a weaker rally to about the level of the first high price. The reverse (upside-down) formation is called a head and shoulders bottom (which is considered predictive of a price rally). (Source: CFTC)

Fibonacci Numbers

What are Fibonacci numbers?

A number sequence discovered by a thirteenth century Italian mathematician Leonardo Fibonacci (ca 1170-1250), who introduced Arabic numbers to Europe, in which the sum of any two consecutive numbers equals the next highest number – i.e., following this sequence: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55 and so on. The ratio of any number to its next highest number approaches 0.618 after the first four numbers. These numbers are used by technical analysts to determine price objectives from percentage retracements.
(Source: CFTC)

Elliott Waves and Elliott Wave Theory

What is an Elliott Wave? What is Elliott Wave Theory?

A theory named after Ralph Elliot, who contended that the stock market tends to move in discernible and predictable patterns reflecting the basic harmony of nature and extended by other technical analysts to futures markets.

In technical analysis, Elliott Waves are a charting method based on the belief that all prices act as waves, rising and falling rhythmically. (Source: CFTC)

The Elliott wave principle or wave principle is a form of technical analysis that investors use to forecast trends in the financial markets and other collective activities. Ralph Nelson Elliott, a professional accountant, developed a financial market model that he called The Wave Principle. He published his views of market behavior in the book The Wave Principle (1938), and in a series of articles in Financial World magazine in 1939. Elliott proposed that market prices unfold in specific patterns that he called waves. (Practitioners today call these components Elliott waves, or simply waves.)

In 1946 Elliott published his final major work, Nature's Law, which "includes almost every thought Elliott ever had concerning the theory of the Wave Principle." Elliott believed this law to be "the secret of the universe," and said that "because man is subject to rhythmical procedure, calculations having to do with his activities can be projected far into the future with a justification and certainty heretofore unattainable."

The wave principle begins with the premise that collective investor psychology (or crowd psychology) moves from optimism to pessimism and back again. These swings create patterns, as evidenced in the price movements of a market.

Elliott's model proposes that market prices alternate between five waves and three waves at all degrees of trend. As these waves develop, the larger price patterns unfold in a self-similar fractal geometry. Within the dominant trend, waves 1, 3, and 5 are called "motive" waves, and each motive wave itself subdivides in five waves. Waves 2 and 4 are "corrective" waves, and subdivide in three waves. In a bear market the dominant trend is downward, so the pattern is reversed -- five waves down and three up. Motive waves always move with the trend, while corrective waves move against it.

Elliott's market model relies heavily on looking at price charts. Practitioners study developing price moves to distinguish the waves and wave structures, and discern what prices may do next; thus the application of the wave principle is a form of pattern recognition.

The structures Elliott described also meet the common definition of a fractal, in that the patterns are self-similar at every degree of trend. Elliott wave practitioners say that just as naturally-occurring fractals often expand and grow more complex over time, the model shows that collective human psychology develops in natural patterns, via buying and selling decisions reflected in market prices: "It's as though we are somehow programmed by mathematics. Seashell, galaxy, snowflake or human: we're all bound by the same order." (Source: Wikipedia)

Related Resources:
Elliott Wave International (Website)
Elliott Wave Principle: Key to Market Behavior (Book)