The Yield Curve
Yield Curve (Term Structure of
Interest Rates): A plot of the
interest rates of Treasury Bills and
Treasury Bonds versus their
maturities at a point in time.
Yield Curve: An Example
Term (years)
0.25
2.00
5.00
10.00
30.00
Interest Rate (%)
3.62
4.34
5.07
5.54
5.86
The Slope of the Yield Curve
Upward Sloping (Term  i) -- usual
case.
Downward Sloping (or Inverted) Yield
Curve (Term  i) -- occurs
periodically
What information can we get from the
yield curve?
Observed Phenomena -Yield Curve
The downward sloping (inverted)
yield curve is unusual but not rare.
Interest rates of bonds of all
maturities move together (are
positively correlated)
The downward sloping (inverted)
yield curve tends to occur when
interest rates in general are high.
Theories (Hypotheses)
Which Explain
Yield Curve Behavior
Key difference in assumptions:
How close of substitutes are
bonds of different maturities?
We will assess each hypothesis –
how well does it predict the three
observed phenomena?
(1) Expectations Hypothesis
The Expectations Hypothesis -- The
interest rate on a long-term bond will
be equal to the average of short-term
rates expected to occur over the
lifetime of the long-term bond.
Key assumption: Bonds of different
maturities are perfect substitutes.
Assessment:
Expectations Hypothesis
The downward sloping (inverted)
yield curve is unusual but not rare.
Fails to predict this occurrence.
(predicts 50-50 probability of
upward versus downward slope)
Expectations Hypothesis
Interest rates of bonds of all
maturities move together (are
positively correlated)
Accurately predicts this
occurrence.
(bonds are substitutes)
Expectations Hypothesis
The downward sloping (inverted) yield
curve tends to occur when interest
rates in general are high.
Accurately predicts this occurrence
(When are interest rates expected to
decrease?)
(2) The Market
Segmentation Hypothesis
The Market Segmentation
Hypothesis -- Each investor has
his/her preferred maturity sector
and stays within it. Consequently,
interest rates on bonds are
determined by independent
demand and supply conditions
within that sector.
Market Segmentation
Hypothesis: Assumption
Key Assumption: Bonds of
different maturities are not
substitutes at all.
Market Segmentation
Hypothesis: Predictions
Upward sloping yield curve is the
usual case -- more demand for
short-term bonds than long-term
bonds.
Downward sloping yield curve -contractionary Federal Reserve
policy, increases short-term rates
without affecting long-term rates.
Assessment: Market
Segmentation Hypothesis
The downward sloping (inverted) yield
curve is unusual but not rare.
Accurately predicts this occurrence.
(Highly contractionary monetary
policy)
Market Segmentation
Hypothesis
Interest rates of bonds of all maturities
move together (are positively
correlated)
Fails to predict this occurrence.
(Independently determined interest
rates should not move together)
Market Segmentation
Hypothesis
The downward sloping (inverted) yield
curve tends to occur when interest
rates in general are high.
Accurately predicts occurrence.
(High expected inflation,
contractionary monetary policy)
(3) The Preferred Habitat
Hypothesis
The Preferred Habitat Hypothesis
The interest rate on a long-term
bond equals the average of shortterm rates expected to occur over
the lifetime of the long-term bond
plus a risk premium due to higher
market risk in the long-term bond.
Preferred Habitat
Hypothesis: Assumption
Key assumption -- Bonds of
different maturities are close
substitutes but not perfect
substitutes.
Major non-price difference -longer term bonds have higher
market risk.
Assessment: Preferred
Habitat Hypothesis
The downward sloping (inverted) yield
curve is unusual but not rare.
Accurately predicts occurrence.
(Investors must expect interest
rates to decrease a lot in the
future.)
Preferred Habitat
Hypothesis
Interest rates of bonds of all
maturities move together (are
positively correlated)
Accurately predicts this
occurrence.
(Close substitutes)
Preferred Habitat
Hypothesis
The downward sloping (inverted) yield
curve tends to occur when interest
rates in general are high.
Accurately predicts occurrence
(When are interest rates expected
to decrease a lot?)
Intepretations
of a Yield Curve
Different theories attach different
interpretations based on
assumptions
Return to the
Curve Example
Term (years)
0.25
2.00
5.00
10.00
30.00
Yield
Interest Rate (%)
3.62
4.34
5.07
5.54
5.86
Interpretations of
Yield Curve from Example
Expectations Hypothesis – investors
expect interest rates to increase.
Market Segmentation Hypothesis –
normal bond market conditions.
Preferred Habitat Hypothesis –
investors expect interest rates in the
future to either increase, say level, or
decrease by a small amount.
The Yield Curve:
Additional Topics
The U-Shaped (or J-Shaped) Yield
Curve: different interpretations
depending upon underlying
hypothesis.
Is the inverted Yield Curve a good
predictor for recessions in the overall
economy?