Yield Curve¶
Curve that shows the interest rate at different time horizons of holding a fixed-income security
Purpose¶
- Indicator of future yield levels, and help in setting the yield for all debt market instruments
- Measure and compare returns across maturity spectrum
- One more point
Types¶
| Causes | |
|---|---|
| Upward Sloping | |
| Flat | |
| Humped | |
| Downward Sloping/ Inverted | Present Future interest rate < Present Short-term interest rate Present Future interest rate < Future Short-term interest rate |
- Spot rate is the instantaneous rate
- Forward rate is the contract on a future rate
- Future rate is the spot rate in the future
Theories behind Yield Curves¶
Expectations Theory¶
(photo in gallery)
Risk Neutrality
Consequence: Shape of yield curve will depend on the expected returns
| Theory | Assumption | Advantages | Limitation | |
|---|---|---|---|---|
| Expectations | Investors are risk-neutral | Incorrect to assume that bonds with different maturities do not have different expected return Bond-investors are risk-averse, not risk-neutral | ||
| Liquidity-Premium | Investors are risk-averse Bonds are partial substitutes for each | Investors demand risk premium for - Maturity Risk Premium Premium - Liquidity Premium | Does not explain downward sloping/inverted curves | |
| Market Segmentation |
Maturity Risk Premium: With maturity, risk increases
Liquidity premium: