3. Arbitrage activities ensure that a bond’s present value is very similar when its cash-flows are discounted using the marketwide spot rates as when its cash-flows are discounted using the bond’s own yield-to-maturity. However, some deviations are possible because of transaction costs and other market imperfections. In other words, the term structure of spot rates gives a consistent set of discount rates for all government bonds, but all bonds’ market prices are not exactly consistent with these discount rates. Individual bonds may be rich or cheap relative to the curve because of bond-specific-liquidity, coupon, tax, or supply effects.

4. These curves can be computed directly by interpolating between on-the-run bond yields (approximate par curve) or between zero yields (spot curve). Because these assets have special liquidity characteristics, these curves may not be representative of the broad Treasury market. Therefore, the par, spot, or forward rate curve is typically estimated using a broad universe of coupon Treasury bond prices. There are many different curve-fitting techniques, but a common goal is to fit the prices well with a reasonably shaped curve. This chapter does not focus on yield-curve estimation but on the interpretation and practical uses of the curve once it has been estimated.