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.

We can compare this with bank interest rates: banks offer more interest rate for long-term deposits compared to short-term deposits. In a yield curve maturity is plotted on x-axis and the corresponding yield values are plotted on y-axis. Yield curve tells us the market expectation of future interest rates, future economic growth and output. Yield curve influences bank rates and identifies arbitrage opportunities.

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