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Economics and The Time Value of Money - Yield Curve

Yield Curves
A yield curve is simply a graph that plots bond yields against their length of time to maturity. The curve will show whether short-term interest rates are higher or lower than long-term rates.
  • Normal Yield Curve
    • Most of the time, the yield curve will be positively sloped, which means lower interest rates are correlated with shorter maturities.
    • As maturity lengthens, interest rates increase.
    • For instance, if two-year Treasury notes yield 3%, five-year Treasury notes yield 4% and 10-year Treasury bonds yield 5.5%, then the yield curve will be sloped positively. This would be a normal yield curve.
    • The following diagram is of a normal yield curve, exhibiting a positive slope:

Figure 9.1: Normal Yield Curve

  • Inverted (or Negative) Yield Curve
    • Occurs when there is weak demand for bonds with short maturities, which drives yields up. A strong demand for long-term bonds drives these yields down.
    • An inverted yield curve means short-term interest rates are higher than long-term rates. This is an unusual situation, but it does happen.
    • An inverted yield curve may be an indication of economic decline.
    • For instance, an inverted yield curve would result if the two-year Treasury note yielded 3%, the five-year Treasury note 2.75% and the 10-year Treasury bond 2.5%.
    • This would occur if rates were high but expected to fall.
    • Consider the following diagram for a visual interpretation of an inverted yield curve:

Figure 9.2: Inverted Yield Curve



  • Flat Yield Curve
    • Occurs where yields are the same for short, intermediate, and long-term bonds.
    • This type of curve is a rare occurrence.

The flat yield curve is essentially a "flat" line.



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