The Slope and Shape of the Yield Curve - Example

Running Head: Yield Curve Name Course Lecturer Date Yield Curve A yield curve is a line that plots the interest rates, at a particular time, of investment bonds that have the same or equal quality of credit but with different date of maturity. A common yield curve is used as a benchmark for other debt instruments in the market both by the government and by private citizens such as bank lending rates and mortgage rates. The yield curve is also used to predict growth as well as changes in the economic output in an economy. In addition, the shape of this curve is carefully examined as it helps to provide ideas on changes in future interest rates and economic activities. There are three types of this curve namely the flat (or humped) curve, normal and inverted curves (Evans & Marshall, 2007). The yield curve is used by fixed income earners and investors to predict the relationship between bond returns and their maturities. Yield represents the annual return on an investment or portfolio. The bond yield is based on purchase price as well as the interest rate (also called payments received or coupon). In most cases, an investments coupon interest rate is usually fixed. For this reason, the price of the bond changes and fluctuates constantly in response to interest rates changes as well as the time to maturity, supply and demand, and quality of credit of the particular bond. After issuance, the investment bonds usually trade at discounts or premiums to their face values until their maturity. They also return to their true value after maturity (Cheridito et al., 2007). The shape of the yield curve is determined by two major factors. These are the certain risk premiums that the investors need to hold on to long term bonds. The other factor is the expectations of the investors for future interest rates. There are three theories that explain these two factors in detail. Theseare the pure expectations theory, the liquidity preference theory and the preferred habitat theory (Lando, 2009). The Pure Expectations Theory This theory provides that the slope of the yield curve reflect the expectations of the investors for future short term rates of interest. It holds that the investors’ expectations for future short term interest rates will favour their investment and hence reap huge returns. In man y cases, optimistic investors expect the interest rates to increase in future. The rise of interest rates accounts for the usual upward slope of the curve. The Liquidity Preference Theory This theory is a complete offshore of the above theory. It asserts that the long term interest rates reflect the assumptions of the investors about future interest rates. It also reflects a premium for holding on to long term investment bonds; these are known as the liquidity premium or the term premium. The premium is very important to the investors as it compensates them the added risk of having their finances tied up for longer time, this includes greater uncertainties of the price or risk of huge price fluctuations.The long term bonds tend to yield more than the short term bonds;this is because of the term or liquid premium. This makes the yield curve slope upwards. Preferred Habitat Theory This theory explains that the investors have different investment horizons and therefore they need a meaningful premium in order to purchase investment bonds that have maturities outside their preferred maturity period or habitat. This is in addition to the interest rates expectations. As such, this theory suggests that the short term investors are more prevalent in the market where there is fixed interest and therefore fixed income. Therefore, the short term rates tend to be lower than the long term rates. Essentially, the tree theories explains the shape and slope of the yield curve in terms of the expectations of the investors and the interest rates, all of them view the investor differently and therefore assert that the returns from investment will yield different returns. The short term and the long term investors earn premiums depending on the time period and the level of risk involved. The yield curve reflects the expectations of the investor for interest rates as well as the effects of risk premiums for the longer investment bonds. This makes interpretation of the yield curve complicated and hence it is only the elite and knowledgeable investors who are able to use it to gain valuable market information. In return, they benefit and reap huge benefits as a result of using the yield curve correctly. There are certain forces driving the yields at any given point on the yield curve, this has become one of the biggest efforts of the fixed income earners and economists in trying to understand the forces. This has seen then put a lot of efforts in digging out the forces.These are all other factors other that the investors expectation for interest rates and the impact of risk premiums for long term investment bonds. The slope of the yield curve changes when there is economic upturn. This is when the interest rates begin to increase significantly in the future. In such scenario, the investors demand more yields as the maturity extends (when they expect rapid growth of the economy brought about by associated risks such as high interest rates and inflation). These factors, interest rates and inflation, hurt bond yields. When inflation increases, the reserve bank increases or raises interest rates to fight the inflation. Increase in interest rates takes the excess money in the economy and hence stabilises the economy, that is if decreases the inflation. On the other side, a flat yield curve indicates a slowdown in economic growth. This is when the reserve bank increases interest rate in order to restrain a rapidly growing economy. This makes the short term yields to rise in reflection of the hike in interest rate. Likewise, the long term rates decrease as the expectations of inflation moderates (Gürkaynak et al., 2010). Uses of the Yield Curve Yield curve is very important; it provides a reference tool for comparison of bond yields and maturities. These can then be used for several purposes as explained below. Yield curve is one of the leading pointers of the economicconditions in a country. It provides an impressive record for alertinginvestors and business people to probable harsh economic conditions such as recession. This curve also signals an economic upturn and hence very useful to the business community as well as the investors. This has proved to be very important to the investment and economic side of a country as it has saved billions worth of investments that would have collapsed under harsh economic conditions. Another signifi1cant use of this yield curve is that it can be used as a bench mark for pricing securities with fixed interests. Securities such as the treasury bonds have no perceived credit risk and therefore many of the fixed interest rates securities that have credit risk are priced to yield more than even the treasury bonds. This is important as it provides unique investment opportunities for investors (Estrella, 2005). In this case, the yield curve presents itself in two very important forms to investors and the government as well. First, it acts as a predictor or a watchdog for investors concerning the future of the economic. It foretells what will happen to the economy. This cautions the investors against taking unnecessary risks. Second, the yield curve identifies investment opportunities for investors. Through the different market securities traded in the market every day, the yield curve provides investors with information about the most promising investments. As such, the investors with such information are able to take advantage and reap huge benefits from investing in such securities. However, such information provided by the yield curve is not available to all market players. It is available to few market players with diverse knowledge of the market as well as tools for analysing investment and economic conditions (Diebold et al., 2006). By predicting some movements in the yield curve, investors and market players earn above average yields on their bond portfolios. This proves the importance of the yield curve. They are also used to structure the maturity of different investment bonds. The maturity is important as the duration to maturity determines the returns or yields that the security will earn. One of the strategies used is bullet strategy. Using this strategy, an investment is structured so that the maturity of the investment will be highly concentrated at one point of the yield curve. For instance, most investment bonds in an investment or portfolio may mature in ten years’ time. Moreover, barbell strategy is very much in application. In this strategy, the maturity of an investment is concentrated at two extremes. This is in form of five years or twenty years’ time periods. Generally, the former strategy outperforms when the yield curve steepens while the later outperforms when the curve flattens. Therefore, they act incomplete opposite of the other. This indicates the market conditions of securities in a certain portfolio (Gürkaynak et al., 2007). References Cheridito, P., Filipović, D., & Kimmel, R. L. (2007). Market price of risk specifications for affine models: Theory and evidence. Journal of Financial Economics, 83(1), 123-170. Diebold, F. X., Rudebusch, G. D., &BoraganAruoba, S. (2006). The macroeconomy and the yield curve: a dynamic latent factor approach. Journal of econometrics, 131(1), 309-338. Estrella, A. (2005). Why Does the Yield Curve Predict Output and Inflation?*.The Economic Journal, 115(505), 722-744. Evans, C. L., & Marshall, D. A. (2007). Economic determinants of the nominal treasury yield curve. Journal of Monetary Economics, 54(7), 1986-2003. Gürkaynak, R. S., Sack, B., & Wright, J. H. (2007). The US Treasury yield curve: 1961 to the present. Journal of Monetary Economics, 54(8), 2291-2304. Gürkaynak, R. S., Sack, B., & Wright, J. H. (2010). The TIPS yield curve and inflation compensation. American Economic Journal: Macroeconomics, 70-92. Lando, D. (2009). Credit risk modeling: theory and applications. Princeton University Press. Read More