Yield curve

In finance, yield curve is the connection between cost of the borrowing or interest rate and the time to maturity of the debt for the given borrower in a given currency. For instance, US dollar the interest rates paid on the US Treasury securities for several maturities which are seen by several traders, and are generally drawn on a graph which is informally known as the yield curve. There are several types of yield curve such as normal yield curve, steep yield curve, humped or flat yield curve and inverted yield curve.

Yield Curve Used to Estimate Future Interest Rates

The slope of the yield curve mainly depends on two aspects: (a) expectations about future inflation and (b) effects of maturity on bonds’ risk.

Sometimes people could look at the yield curve and use information entrenched in it to estimate the market’s expectations about the future rise of price, short-term interest rates and risk. For example, suppose a company is in the midst of a 5 year expansion program and the treasurer knows that she will need to borrow short-term funds a year from now. She knows the current cost of 1-year money, she want to know the cost of 1-year money next year. That information could be “backed out” by analyzing the current yield curve.

The estimation process is straightforward provided we focus on Treasury bonds and assume that Treasury bonds contain no maturity risk premiums. This position is called the pure expectation theory of the term structure of interest rates, often simply referred to as the expectation theory. The expectation theory assumes that bond traders established bond prices and interest rates strictly on the basis of expectation for future interest rates and that they are indifferent to maturity because they do not view long-term bonds as being riskier  than short term bonds interest rates would simply be a weighted average of current and expected future short-term interest rates.

Questionnaire:

• What is Yield Curve?
• What are the types of Yield Curve?