Monday, August 31, 2009

Uses of the yield curve for detecting overpriced and under-priced securities

Yield curves can be used as an aid to investors in deciding which securities are temporarily overpriced or underpriced. This use of the curve derives from the fact that, in equilibrium, the yields on all securities of comparable risk should come to rest along the yield curve at their appropriate maturity levels. In an efficiently functioning market, however, any deviations of individual securities from the yield curve will be short-lived; so the investor must move quickly upon spotting a security whose yield lies temporarily above or blew the curve.
if a security‘s rate of return lies above the yield curve, this sends a signal to investors that that particular security is temporarily underpriced relative to other securities of the maturity. Other things equal, this is a buy signal which some investors will take advantage of, driving the price of the purchased security upward and its yield back down toward the yield curve. on the other hand, if a security‘s rate of return is temporarily below the yield curve, this indicates a temporarily overpriced financial instrument, because its yield is below that of securities bearing the same maturity. Some investors holding this security will sell it, pushing its price down and its yield back up toward the curve.

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