Yield Curve or Term Structure of Interest Rates

Yield curve, also known as, term structure of interest rates is a graph that shows relationship between yield or interest rates and maturity. Yield curve is plotted for bonds with similar credit rating but with different maturity dates. Yield of a bond inversely varies to time to maturity (tenor). Long-term bonds carry more risk of default and liquidity risk compared to short-term bonds. Liquidity in short-term bonds is more because of less volatility in interest rates. Long-term bonds should offer short term interest rates plus risk and liquidity premiums. So usually yield of a 10 year treasury bond is more than that of a 1 year treasury bill. Read more

May 31, 2008 | Filed Under Bonds | Leave a Comment

Different types of Yield Curves

The following graphs show three different types of yield curves

Explanation of Yield Curves by Market Expectation Theory (Hypothesis) :

Normal Yield Curve:
When long term interest rates are more compared to short term interest rates, the shape of the yield curve is upward sloping.

Flat Yield Curve:
When there is no change in market outlook on interest rates then we get flat yield curve. This is because yields are almost same across tenors. Read more

May 31, 2008 | Filed Under Bonds | Leave a Comment

Constructing Yield Curve

In general we don’t have all the data points that needed to construct a yield curve because there is only fixed number of products in the market with varying coupon frequencies. So a yield curve is constructed by plotting yield to maturities of zero coupon bonds for short term and zero coupon rates derived from long term fixed coupon bonds. Deriving zero coupon rates from a long-term bond is called bootstrapping. To put it in clear terms, the first few values of yield curve are directly available as 1 year, 2 year zero coupon bonds are available in the market. Read more