Introduction - Duke's Fuqua School of Business



YIELD CURVE AND STOCK RETURN

Midas Asset Management

OBJECTIVE

The yield curve is used to capture the overall movement of interest rates and has been a great predictor of future economic events. Securities with longer maturity's usually have a higher yield and this is referred to as a positive or normal yield curve. The reason it is "normal" is because you would expect slightly more risk for holding a bond for a longer period of time because there is greater risk of default. A flat yield curve shows the yields of bonds with short maturities equal to the yields of bonds with longer maturities. Finally, if short-term securities offer a higher yield, then the curve is defined as an inverted curve.

Professor Campbell Harvey demonstrated the interesting relationship between the yield curve and GDP growth. In this paper, we decided to take a slightly different angle by examining the interaction between the yield curve and stock returns.

METHODOLOGY

Data Gathering

• We gathered data on the monthly yield curve from year April 1953 to January 2002. More specifically, we calculated the spread between the following interest rates:

10 year T-note – 3 month T-bill

5 year T-note – 3 month T-bill

5 year T-note – 2 year

2 year T-note – 3 month T-bill

1 year T-note – 3 month T-bill

• In addition, we obtained data on the S&P 500 return from April 1953 to January 2002 and S&P 500 P/E ratio from January 1968 to January 2002.

• Finally, we obtained data on United Kingdom and Germany’s monthly yield curve (to be used for our final analysis utilizing logistic regression).

Yield Curve Analysis

Yield Curve and Stock Return

For each of the yield spreads, we looked at stock returns within the following categories:

1) Positive and Negative Yield Curve

• For each month, we calculated the average stock return for both positive and negative yield curves based on a one-month lag of the yield curve. For example, if the Jan YC = positive, then the Feb Stock Return was place under the positive YC (regardless of whether or not the stock return was positive or negative).

2) Slope Magnitude

• We broke down the positive and negative yield spreads further into YC>=2, 0= ................
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