Yield Curve:

The term structure of interest rates is the relationship between interest rates or bond yields and
different terms or maturities. The term structure of interest rates is also known as a yield curve,
and it plays a central role in an economy. A plot of the yields on bonds with differing terms to
maturity but the same risk, liquidity and tax considerations is called a yield curve. The term
structure reflects expectations of market participants about future changes in interest rates and
their assessment of monetary policy conditions.

The term structure of interest rates and the direction of the yield curve can be used to judge the
overall credit market environment. A flattening of the yield curve means longer-term rates are
falling in comparison to short-term rates, which could have implications for a recession. When
short-term rates begin to exceed long-term rates, the yield curve is inverted and a recession is
likely occurring or approaching.

When longer-term rates fall below shorter-term rates, the outlook for credit over the long term
is weak. This is often consistent with a weak or recessionary economy, which is defined by two
consecutive periods of negative growth in the gross domestic product (GDP).

Types of Yield Curve:

Normal yield curve

From the post-Great Depression era to the present, the yield curve has usually been "normal"
meaning that yields rise as maturity lengthens (i.e., the slope of the yield curve is positive). This
positive slope reflects investor expectations for the economy to grow in the future and,
importantly, for this growth to be associated with a greater expectation that inflation will rise in
the future rather than fall. This expectation of higher inflation leads to expectations that
the central bank will tighten monetary policy by raising short-term interest rates in the future to
slow economic growth and dampen inflationary pressure. It also creates a need for a risk
premium associated with the uncertainty about the future rate of inflation and the risk this poses
to the future value of cash flows. Investors price these risks into the yield curve by demanding
higher yields for maturities further into the future. In a positively sloped yield curve, lenders
profit from the passage of time since yields decrease as bonds get closer to maturity (as yield
decreases, price increases); this is known as rolldown and is a significant component of profit in
fixed-income investing (i.e., buying and selling, not necessarily holding to maturity), particularly
if the investing is leveraged.[2]
Flat or humped yield curve
A flat yield curve is observed when all maturities have similar yields, whereas a humped curve
results when short-term and long-term yields are equal and medium-term yields are higher than
those of the short-term and long-term. A flat curve sends signals of uncertainty in the economy.
This mixed signal can revert to a normal curve or could later result into an inverted curve. It
cannot be explained by the Segmented Market theory discussed below.

Inverted yield curve

An inverted yield curve occurs when long-term yields fall below short-term yields.
Under unusual circumstances, long-term investors will settle for lower yields now if they think
the economy will slow or even decline in the future.

2. Name and explain which interest rate theories that stand behind these components?
Market expectations (pure expectations) hypothesis
This hypothesis assumes that the various maturities are perfect substitutes and suggests that the
shape of the yield curve depends on market participants' expectations of future interest rates. It
assumes that market forces will cause the interest rates on various terms of bonds to be such
that the expected final value of a sequence of short-term investments will equal the known final
value of a single long-term investment. If this did not hold, the theory assumes that investors
would quickly demand more of the current short-term or long-term bonds (whichever gives the
higher expected long-term yield), and this would drive down the return on current bonds of that
term and drive up the yield on current bonds of the other term, so as to quickly make the
assumed equality of expected returns of the two investment approaches hold.
Using this, futures rates, along with the assumption that arbitrage opportunities will be minimal
in future markets, and that futures rates are unbiased estimates of forthcoming spot rates,
provide enough information to construct a complete expected yield curve. For example, if
investors have an expectation of what 1-year interest rates will be next year, the current 2-year
interest rate can be calculated as the compounding of this year's 1-year interest rate by next
year's expected 1-year interest rate. More generally, returns (1+ yield) on a long-term instrument
are assumed to equal the geometric mean of the expected returns on a series of short-term
instruments:

where ist and ilt are the expected short-term and actual long-term interest rates (but is
the actual observed short-term rate for the first year).
This theory is consistent with the observation that yields usually move together. However, it
fails to explain the persistence in the shape of the yield curve.
Shortcomings of expectations theory include that it neglects the interest rate risk inherent in
investing in bonds.

The expectations theory of the term structure states the following commonsense proposition:
The interest rate on a long-term bond will equal an average of short-term interest rates that
people expect to occur over the life of the long-term bond. For example, if people expect that
short-term interest rates will be 10% on average over the coming five years, the expectations
theory predicts that the interest rate on bonds with five years to maturity will be 10% too. If
short-term interest rates were expected to rise even higher after this five-year period so that the
average short-term interest rate over the coming 20 years is 11%, then the interest rate on 20-
year bonds would equal 11% and would be higher than the interest rate on five-year bonds.

The key assumption behind this theory is that buyers of bonds do not prefer bonds of one
maturity over another, so they will not hold any quantity of a bond if its expected return is less
than that of another bond with a different maturity. Bonds that have this characteristic are said
to be perfect substitutes. What this means in practice is that if bonds with different maturities
are perfect substitutes, the expected return on these bonds must be equal.

To see how the assumption that bonds with different maturities are perfect substitutes leads to the
expectations theory, let us consider the following two investment strategies:

1. Purchase a one-year bond, and when it matures in one year, purchase another one-year bond.
2. Purchase a two-year bond and hold it until maturity.
Because both strategies must have the same expected return if people are holding both one- and
two-year bonds, the interest rate on the two-year bond must equal the average of the two one-year
interest rates. For example, let’s say that the current interest rate on the one-year bond is 9% and
you expect the interest rate on the one-year bond next year to be 11%. If you pursue the first
strategy of buying the two one-year bonds, the expected return over the two years will average out
to be (9% _ 11%)/2 _ 10% per year. You will be willing to hold both the one- and two-year bonds
only if the expected return per year of the two-year bond equals this. Therefore, the interest rate on
the twoyear bond must equal 10%, the average interest rate on the two one-year bonds.

Liquidity premium theory

The liquidity premium theory is an offshoot of the pure expectations theory. The liquidity
premium theory asserts that long-term interest rates not only reflect investors' assumptions
about future interest rates but also include a premium for holding long-term bonds (investors
prefer short term bonds to long term bonds), called the term premium or the liquidity premium.
This premium compensates investors for the added risk of having their money tied up for a longer
period, including the greater price uncertainty. Because of the term premium, long-term bond
yields tend to be higher than short-term yields and the yield curve slopes upward. Long term
yields are also higher not just because of the liquidity premium, but also because of the risk
premium added by the risk of default from holding a security over the long term. The market
expectations hypothesis is combined with the liquidity premium theory:
Market segmentation theory
This theory is also called the segmented market hypothesis. In this theory, financial instruments
of different terms are not substitutable. As a result, the supply and demand in the markets for
short-term and long-term instruments is determined largely independently. Prospective
investors decide in advance whether they need short-term or long-term instruments. If investors
prefer their portfolio to be liquid, they will prefer short-term instruments to long-term
instruments. Therefore, the market for short-term instruments will receive a higher demand.
Higher demand for the instrument implies higher prices and lower yield. This explains the stylized
fact that short-term yields are usually lower than long-term yields. This theory explains the
predominance of the normal yield curve shape. However, because the supply and demand of the
two markets are independent, this theory fails to explain the observed fact that yields tend to
move together (i.e., upward and downward shifts in the curve).
Why may the shape of the yield curve predict the future development of economic growth and
inflation

The yield curve shows the various yields that are currently being offered on bonds of
different maturities. It enables investors at a quick glance to compare the yields offered by short-
term, medium-term and long-term bonds.

The yield curve can take three primary shapes. If short-term yields are lower than long-term
yields (the line is sloping upwards), then the curve is referred to a positive (or "normal") yield
curve. Below you'll find an example of a normal yield curve:

If short-term yields are higher than long-term yields (the line is sloping downwards), then the
curve is referred to as an inverted (or "negative") yield curve. Below you'll find an example of an
inverted yield curve:

Finally, a flat yield curve exists when there is little or no difference between short- and long-term
yields. Below you'll find an example of a flat yield curve:
It is important that only bonds of similar risk are plotted on the same yield curve. The most
common type of yield curve plots Treasury securities because they are considered risk-free and
are thus a benchmark for determining the yield on other types of debt.

WHY IT MATTERS:

In general, when the yield curve is positive, this indicates that investors require a higher rate of
returnfor 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), and that 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.

The expectations theory is an elegant theory that provides an explanation of why

the term structure of interest rates (as represented by yield curves) changes at different
times. When the yield curve is upward-sloping, the expectations theory suggests
that short-term interest rates are expected to rise in the future, as we have seen in our
numerical example. In this situation, in which the long-term rate is currently above
the short-term rate, the average of future short-term rates is expected to be higher
than the current short-term rate, which can occur only if short-term interest rates are
expected to rise. This is what we see in our numerical example. When the yield curve
is inverted (slopes downward), the average of future short-term interest rates is expected to be
below the current short-term rate, implying that short-term interest
rates are expected to fall, on average, in the future. Only when the yield curve is flat
does the expectations theory suggest that short-term interest rates are not expected to
change, on average, in the future.
The expectations theory also explains fact 1 that interest rates on bonds with different
maturities move together over time. Historically, short-term interest rates have
had the characteristic that if they increase today, they will tend to be higher in the
future. Hence a rise in short-term rates will raise people’s expectations of future shortterm
rates. Because long-term rates are the average of expected future short-term
rates, a rise in short-term rates will also raise long-term rates, causing short- and longterm
rates to move together.