 |
|
|
|
|
|
Yield Curve
The yield
curve is used in finance to display the relationship between the interest
rate and the time to maturity of a debt for a given borrower in a given
currency. The formal mathematical description of the relationship is
referred to as the term structure of interest rates.
Basics
of Personal Finance
Basics
of Business Finance
Basics
of State Finance
Experimental
Finance
Financial
Economics
Financial
Planner
Foreign
Exchange Market
Risk-free
interest rate
Yield
Curve
For example, the current interest rate paid on U.S. Treasury securities of varying maturities are commonly plotted on a graph that displays the yield curve.
The yield of a debt instrument is shown as the annualized percentage increase in the value of the investment. A bank account might pay an interest rate of 4% per year. The yield of the account is 4%. The potential percentage per year earned is typically dependent on the length of time that the money is invested.
A bank, for example, may offer a savings rate that is higher than the checking account rate if the customer will leave the money untouched for five years. Investing for a period of time results in a yield.
Time is referred to as t. The yield is noted as Y.
Y is usually an increasing function of t, although there are always exceptions. Yield curves are seen in the work of fixed income analysts in the analysis of bonds and other securities. The yield curves help analysts to understand financial markets and uncover trading opportunities. Economists use the curves to get an overview of economic conditions.
When unknown maturities are calculated the process is referred to as interpolation. This is because Y is only known with certainty for a small number of specific maturity dates.
The Shape of the Curve
Yield curves are most often upward sloping asymptotically. What is usually seen is that the longer the maturity time, the higher the yield. Marginal growth typically diminishes. The shape of the yield curve is explained in two ways. The first says that the market is expecting a rise in the risk-free rate. If investors wait to invest, they will receive a better rate. Under the arbitrage pricing theory, investors who are willing to lock in money now will need to be compensated for the expected increase in rates through a higher interest rate on long-term investments.
The other explanation says that it is not rising rates causing the shape. Instead, the greater risks for the investor are the cause. With longer maturities, the investment takes on more risk, which results in a risk premium. This explanation takes into account that the future is uncertain and adverse events are highly possible. This is called the liquidity spread. If the market is anticipated to be volatile in the future, the increase in risk premium will influence the spread and cause the increasing yield.
It is also possible to see short-term interest rates that are higher than long term rates. This is caused by the market anticipation of falling interest rates, causing an inverted yield curve. These curves have historically preceded economic depressions.
Yield curves can take on may shapes, from flat to hump. They are caused by the different anticipated interest rate situations. Will rates remain steady or will short-term volatility outweigh long-term volatility?
The shape of yield curves changes daily in representation of the market's reaction to news. They tend to move in parallel - the increase in the cost of borrowing money is often accompanied by a similar movement at points further along the curve.
Yield Curve Types
The most important factor in determining a yield curve is the currency being used. The economic situation of the countries using each currency takes a primary position in determining the yield curve.
For example, the yen yield curve for Japan is very low, after a sluggish economy of the past twenty years. The British pound curve is much higher along its curve.
When money is borrowed, it is borrowed at different rates. These rates are determined by the borrower creditworthiness. The yield curve that corresponds with the bonds issued by governments are called government bond yield curve. Banks with high credit ratings borrow money at LIBOR rates. Their yield curves are usually higher than government curves. The most widely used curve is the LIBOR curve, also known as the swap curve.
There are also corporate curves. These curves are constructed from the yield of bonds issued by corporations. These corporations usually have lower creditworthiness than governments and large banks. Therefore, their yields are higher. Corporate yield curves are often quoted by the "credit spread" over the swap curve. For example, a five-year yield curve for a corporation may be quoted as LIBOR +.25%, or 25 basis points. This is the credit spread.
A Normal Yield Curve
The yield curve is considered normal when yield rises as maturity lengthens, or the slope is positive. This slope reflects the expectation of the economy to grow in the future. The growth is associated with greater risk that inflation rises and doesn't fall. Higher inflation presents an expectation that the central bank will tighten monetary policy by raising short-term interest rates in order to slow economic growth and dampen inflationary pressure. Investor price the risk of risk premium into the yield curve by demanding higher yields for long-term maturities.
The idea of normal yield curve hasn't always been a positive slope. During the 19th century and the early 20th century, the US economy saw trend growth with persistent deflation. This resulted in an inverted yield curve that reflected the fact that deflation made future cash flows more valuable than current ones. During this period, the normal yield curve was a negative slope.
A Steep Yield Curve
The 20-year Treasury bond yield has historically averaged approximately 2% above that of three-month Treasury bills. When this gap increases, the economy is expected to improve in the future. A steep yield curve is often seen at the beginning of an economic expansion, following a recession. Rates will begin to increase once the demand for capital is seen through growing economic activity.
A Flat Yield Curve
Flat yield curves occur when all maturities have the same yields. Humped curves are evident when short-term and long-term yields are similar while mid-term yields are higher. A flat curve says that there is uncertainty in the economy. The curve will eventually turn into a normal curve or an inverted curve.
The Inverted Yield Curve
The inverted curve is apparent when long-term yields are
below short-term yields. In this situation, long-term investors settle for
lower yields now because they believe the economy will continue to decline
in the future. The inverted curve indicates a worsening economic
situation. It potentially signals economic decline and implies that the
market believes inflation will remain low.