Yield Curve

Topics: Inflation, Monetary policy, Interest rate Pages: 9 (2996 words) Published: March 30, 2012

There are a variety of factors that impact the shape of the yield curve but monetary authorities influence greatly the shape of the yield curve .Monetary authorities influence the shape of the yield curve by initiating either a contractionary monetary policy or an expansionary monetary policy.A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity. There are three main types of yield curve shapes: normal, inverted and flat (or humped). A normal yield curve (pictured here) is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession. A flat (or humped) yield curve is one in which the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.

changes in the shape of the yield curve are often as important to the investment performance of fixed income securities. Yield curve notes have fixed maturities and provide coupon interest at a rate that varies inversely with the level of short-term interest rates. The price of a yield curve is more sensitive to changes in interest rates than a fixed-rate note with the same maturity. As such, yield curve notes provide a more effective means of reducing interest rate risk

FINDING THE COMMON FACTORS THAT CAUSE A CHANGE IN THE SHAPE OF THE YIELD CURVE Typically, the yield curve depicts a line that rises from lower interest rates on shorter-term bonds to higher interest rates on longer-term bonds. Researchers in finance have studied the yield curve

statistically and have found that shifts or changes
in the shape of the yield curve are attributable to
a few unobservable factors (Dai and Singleton 2000).
Specifically, empirical studies reveal that more than
99% of the movements of various Treasury bond
yields are captured by three factors, which are often
called “level,”“slope,” and “curvature” (Litterman and Scheinkman 1991).The names describe how
the yield curve shifts or changes shape in response
to a shock, as shown in Figure 1. Panel A of Figure
1 illustrates the influence of a shock to the “level”
factor on the yield curve.The solid line is the original
yield curve, and the dashed line is the yield
curve after the shock.A “level” shock changes the
interest rates of all maturities by almost identical
amounts, inducing a parallel shift that changes
the level of the whole yield curve. Panel B shows
the influence of the “slope” factor on yield curve.
The shock to the “slope” factor increases shortterm
interest rates by much larger amounts than
the long-term interest rates, so that the yield curve
becomes less steep and its slope decreases. Panel C
shows the response of the yield curve to a shock
to the “curvature” factor.The main effects of the
shock focus on medium-term interest rates, and
consequently the yield curve becomes more “humpshaped”
than before.

First, let’s look at some of the fundamentals. Officially, the monetary authority’s job is to manage inflation, and traditionally they do this by managing interest rates. Lower rates stimulate growth in the economy because borrowers can access capital at cheaper...
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