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D. Murali

MR BADUR buys a bond with coupon of 10 per cent at Rs 110.79, with funds borrowed at 8.75 per cent via a special-rate credit card offer and holds the bond for three months. Has he made money during the course of the investment (ignoring transactions costs)? Most accountants, if at the receiving end of the question, may well wonder why Mr Badur is not doing something simpler, such as buying mangoes for Rs 10 and selling them for Rs 12, and so one could punch the calculator and say he made a profit of Rs 2, ignoring depreciation and tax.

But Badur's is one of the many examples that Moorad Choudhry provides in his book Analysing & Interpreting the Yield Curve, published by Wiley (www.wiley.com). "The yield curve is the defining indicator of the global debt capital markets, and an understanding of it is vital to the smooth running of the economy as a whole," states the blurb. "All participants in the market, be they issuers of capital, investors or banking intermediaries, will have a need to estimate, interpret and understand the yield curve. Fund managers that accurately predict the shape and direction of the curve will consistently outperform those that do not." In the preface, the author explains in simple terms how plotting yields of bonds that differ only in their term to maturity produces what is known as the yield curve, something that represents the bond market. "Much of the analysis and pricing activity that takes place in the bond market revolves around the yield curve." Yield becomes the yardstick for comparison in because bonds can have "complicated patterns of cash flows", and "bond's price does not actually tell us anything useful about what we are getting."

Isn't yield too big a picture for small investors? True, "the general opinion of the market manifests itself in the shape of the yield curve," says the author. But, remember that its shape can tell you many things; it reveals the market sentiment. For instance, "an inverted curve indicates that short-term interest rates are high, or that they are expected to increase in the near term." The author would entice you: "Forecasting is quick and simple if we use the yield curve, and does not require sophisticated analysis."

This is an `elementary' book on financial economics, with inputs on yield to maturity (YTM), Moosmuller yield, embedded options, equivalent life, floating rate notes (FRNs), expectations hypothesis, and so forth. At times, you may find yourself up against more than one concept, as when reading that "the other common explanation for humped curves is the preferred habitat theory"; or that "using a cubic spline produces a smoother curve for both the spot rates and the forward rates, while the derived forward curve will have fewer `kinks' in it".

A statement such as, "In addition to yield pick-up, the butterfly trade provides, in theory, a convexity gain which outperforms the short position irrespective of which direction interest rates move in, provided we have a parallel shift," may cause most accountants to shift in their seats rather than nod in understanding.

By chapter 4 you should be ready for working with Ito's lemma, which the dynamics of the bond price P in terms into a stochastic process; and geometric Brownian Motion as applied to security prices. "The level of mathematics required for a full understanding of even intermediate concepts in finance is frighteningly high," observes Choudhry. So, among `selected bibliography', you'd find titles such as `Financial Calculus', `Advanced Engineering Mathematics', and `Basic Econometrics.' Pity that the CA syllabus underplays economics and mathematics, unmindful that knowledge of finance would be incomplete without these.

Returning to Mr Badur, this is what the author would explain: "The running yield on the bond is 9.026 per cent, while Badur has paid interest on his borrowed funds at 8.75 per cent. Therefore, he has earned approximately 0.276 per cent net carry or funding return on his investment, ignoring any capital gain or loss he may have suffered when he sold the bond."

A book that promises useful yield, if only you know how to manage the learning curve.

ManageMentor@TheHindu.co.in

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