Unraveling the ‘Yield Curve’

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In finance, the yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency.

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Unraveling the ‘Yield Curve’

  1. 1. Unraveling the ‘Yield Curve’
  2. 2.  In finance, the yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. For example, the current U.S. dollar interest rates paid on U.S. Treasury securities for arious maturities are closely watched by many traders, and are commonly plotted on a graph informally called the ‘yield curve’ which is depicted in the previous slide.
  3. 3. So what is ‘yield’? The yield of a debt instrument is the annualized percentage increase in the value of the investment. For instance, a bank account that pays an interest rate of 4% per year has a 4% yield.
  4. 4. In general… The percentage per year that can be earned is dependent on the length of time that the money is invested. This earning for having invested your money in a particular investment instrument is called as ‘yield’. Also, it is important to understand that the yield is not directly proportional to the length of the investment. ( It is not a straight line relationship).
  5. 5. So what are the uses of the Yield Curve? Yield curves are used by fixed income analysts, who analyze bonds and related securities, to understand conditions in financial markets and to seek trading opportunities. Economists use the curves to understand economic conditions. The yield curve function Y is actually only known with certainty for a few specific maturity dates. The other maturities are calculated by interpolation.
  6. 6. The typical shape of a Yield Curve
  7. 7. Now…Yield curves are usually upward sloping i.e.the longer the maturity, the higher the yield,with diminishing marginal growth (whichmeans that after a point every increase induration will bring lesser incremental return).
  8. 8. This is because… It is easier to predict the near term as against the long term. Hence, short term papers are usually held by the investor till its maturity. And long term instruments are usually traded in the market as their returns get affected by changes in interest rates, which occur regularly in an economy.
  9. 9. Also… The yield curve can also be flat or even concave in shape where the short term yield is seen to be more than than the long term yield. This is being witnessed currently wherein overnight interest rates (call money rates) soared due to the liquidity crunch. Yield curves move on a daily basis, reflecting the markets reaction to news.

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