A yield curve depicts interest rates of bonds having different maturities, but same credit quality, at a specific point in time. The yield curve is mostly used to compare rates of different maturity government securities that range from three months to thirty years. This curve also acts as a yardstick for other fixed interest instruments including mortgages and bank loans. Moreover, investors can use this curve to estimate general economic conditions. This information can be used by the investors to make appropriate investment decisions.
Explanation of the Yield Curve
A yield curve is studied to gain an insight about the economic activities in a country during a specified period of time. The curve plots the yields and the time to maturity of the debts. Shape of the curve shows important characteristics of the fixed income instruments. Examining the yield curve helps individuals in estimating future rates and economic activities in a country.
Types of Yield Curve
There are different types of yield curves that show change in rates of different fixed income instruments. Yield curves that depict change in rates of government securities are known as government bond yield curve. Then there is the LIBOR yield curve that is the rate at which banks borrow from each other and which is relatively higher as compared to government bond yield curves. The corporate yield curve shows change in rates of corporate bonds.
Apart from different types of yield curves, there are different shapes of the curves. The three main types of curves include normal, inverted and humped (or flat) shaped curves.
Normally, the yields curve is positively sloped that represents a rise in the bond yields as it comes nearer to maturity. In this situation the yield of short-term debt are lower as compared to the same quality long-term debt instruments.
However, sometimes the yield curve is inverted that represents decrease in the bonds. This was the case during the 19th and early 20th century in the US when the economy experienced growth with deflationary trends. During this period the yield on long term debts is the small term debts have higher yields as compared to same quality long term debts.
The third type of curve that is humped or flat-shaped curve is rare and occurs when the rate on the medium term bonds are higher as compared to both short and long term fixed income instruments. This type of curve is sometimes also known as bell shaped yield curve.
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- The US Treasury yield curve: 1961 to the present – www.sciencedirect.com [PDF]
- The TIPS yield curve and inflation compensation – www.aeaweb.org [PDF]
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- Some lessons from the yield curve – www.aeaweb.org [PDF]
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- The yield curve as a leading indicator: Some practical issues – papers.ssrn.com [PDF]
- The yield curve and real activity – link.springer.com [PDF]
- Economic determinants of the nominal treasury yield curve – www.sciencedirect.com [PDF]