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Yield Curve AnalysisRahul ChhabraMBA, 3rd Sem

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What Does Yield Curve Mean?

• A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates

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Yield Curve …meaning

A yield curve is a graphical depiction of the relationship between the yield on a class of Securities for different maturities.

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Yield Curve …meaning

• The yield curve or the term structure of interest rates is the relationship between the cost of borrowing money and the amount of time the money is being borrowed for.

• Yield curves are used by fixed income analysts, who analyse bonds and related securities, to understand conditions in financial markets and to seek trading opportunities. Economists use the curves to understand economic conditions.

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Purposes of Using Yield Curves

There are several reasons as to why the yield curves are used:

• For comprehending the present situations of the financial markets

• For comprehending the economic situations

• For finding out chances to buy and sell

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Shapes of Yield Curve

• Normal Yield Curve• Flat or Humped Yield Curve• Steep Yield Curve• Inverted Yield Curve

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What Does Normal Yield Curve Mean?

• A yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality.

• This gives the yield curve an upward slope. This is the most often seen yield curve shape.

• Sometimes referred to as "positive yield curve".

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Normal Yield Curve

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What Does Flat Yield Curve Mean?

• A yield curve in which there is little difference between short-term and long-term rates for bonds of the same credit quality.

• This type of yield curve is often seen during transitions between normal and inverted curves.

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Flt Yield curve

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What Does Inverted Yield Curve Mean?

• An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality.

• This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.

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Inverted Yield Curve

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What Does Humped Yield Curve Mean?

• A relatively rare type of yield curve that results when the interest rates on medium-term fixed income securities are higher than the rates of both long and short-term instruments. 

• Humped yield curves are also known as bell-shaped curves.

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Humped Yield Curve

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Why the shape matters?

• In general, when the yield curve is positive, this indicates that investors require a higher rate of return for taking the added risk of lending money for a longer period of time.

• Many economists also believe that a steep positive curve indicates that investors expect strong future economic growth and higher future inflation (and thus higher interest rates).

• A sharply inverted yield curve means investors expect sluggish economic growth and lower inflation (and thus lower interest rates).

• A flat curve generally indicates that investors are unsure about future economic growth and inflation.

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Theories Explaining Shapes of Yield Curves:

There are several theories that are associated with yield curve. These theories try to describe the way the yields tend to keep changing following their maturity. Those theories are:

• Liquidity Preference Theory• Market Segmentation Theory• Market Expectations Hypothesis (Pure

Expectations)

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• Liquidity Preference Theory:

Investors prefer liquidity — upward sloping yield curve

• Pure Expections Theory

Term structure reflects market’s current expectation of future rates

• Market Segmentation Theory:

Shape is determined by supply of and demand for securities within each maturity sector

• Shape of the yield curve is best explained by a combination of the three aforementioned theories.

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External Factors Affecting yield Curve

• Central Bank Policy• Inflation Concerns• Liquidity Desires• Supply/Demand Conditions

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INTEREST RATE

• The basic commodity that the financial institutions deal and trade among themselves and with others is money, and the price of money is the interest rate.

• Interest rates affect the value of money and capital market instruments, both domestically and internationally.

• Changes in interest rates have certain predictable effects on the price of fixed income securities, or bonds.

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WHAT DETERMINES INTEREST RATES?

• The 3 theories of Yield curve are what affects and determines the Interest rate.

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Thank You