INTRODUCTION

A yield curve is a graphic representation of the

relationship between yield and maturity of securities. The vertical axis of the graph represents the yield, and the horizontal axis represents the time to maturity. The relationship is also called term structure of interest rate. Yield curves are used to forecast market trends and help in decision making.

YIELD TO MATURITY
The YTM is the rate of return anticipated on a bond

if it is held until the maturity date. YTM is considered a long-term bond yield expressed as an annual rate. It is assumed that all coupons are reinvested at the same rate. YTM=Coupon + (Maturity Value - Purchase Price) Number Of Years To Maturity 0.60(Maturity Value)+0.40(Purchase Price)

TYPE OF YIELD CURVES

1)Normal Curve: The upward sloping curve is

historically the norm given the normal relationship that the longer the time to maturity, the higher the yield. The reason for yields being higher for the longer term as any lender would want and extra premium for taking the risk of higher duration. A steeply positive sloped yield curve is indicative of an economic recovery, and is often found at the end of recessions.

 Its shape reflects market expectations of a significant

increase in interest rates and the fact that the fed is keeping short-term rates low to aid a slumping economy recover.

Normal Curve
3.5 3 2.5 Yield(%) 2 1.5 1 0.5 0 0.173 2 Year 5 Year 10 Year Time To Maturity 30 Year 0.804 1.917 3.248

 The following graph is the current situation of the

American government bond market yields. In this kind of scenario, the investment strategy to be implementing is that longer duration bonds should be bought and shorter duration bonds sold.

 2)Inverted Curve: An inverted yield curve occurs

when long-term yields fall below short-term yields. It is also known as downward sloping curve. Under unusual circumstances, long-term investors will settle for lower yields now if they think the economy will slow or even decline in the future. An inverted curve has indicated a worsening economic situation in the future 6 out of 7 times since 1970.

 Technical factors, such as a flight to quality or global

economic or currency situations, may cause an increase in demand for bonds on the long end of the yield curve, causing long-term yields to fall. Inverted yield curves are rare. They are always followed by economic slowdown or outright recession as well as lower interest rates.

Inverted Curve
12.2 12 11.8 11.6 11.4 11.2 11 10.8 10.6 10.4 12.08

Yield(%)

11.42 11.02 11.04

11.43

3 Months

1 Year 2 Year 5 Year Time To Maturity

10 Year

 Brazilian bond market yields are showing an

inverted curve. In such a scenario, it is advisable to buy short term bonds which have a high yield and sell a long term bond which have shorter duration.

 3)Flat Curve: A flat yield curve is observed when all

maturities have similar yields. A flat curve sends signals of uncertainty in the economy. A flat curve is formed when there the yields on the 10 Year Bond is equal or marginally greater than the 2 Year Bond. This signifies that the bondholder does not want a greater premium for holding a longer term bond.

 This curve is predominately present in countries in

which there is predicted to be stagnation or relatively very less growth. Like Japan, which after The Lost Decade has never been able to attain its former glory and has been growing since then at a slow rate.

Flat Curve
1.2 1 Yields(%) 0.97

0.8
0.6 0.4 0.2 0 0.1 3 Months 0.12 1 Year 0.14 10 Year 0.35

2 Year 5 Year Time To Maturity

 In such a scenario wherein the yields are same for

different tenure, then it is advisable to buy the bond which has the least tenure.

 4)Hump Curve:A relatively rare type of yield curve

that results when the interest rates on medium-term fixed income securities are higher than the rates of both long and short-term instruments. Humped yield curves are also known as bell-shaped curves. A market with a humped yield curve could see rates of bonds with maturities of one to five years trumping those with maturities of less than one year or more than five years.

 However, this type of yield curve does not happen

very often. Although a humped yield curve is often an indicator of slowing economic growth it should not be confused with an inverted yield curve. This type of curve can be seen at the beginning of an economic expansion (or after the end of a recession). Take Greece ka Graph

IMPORTANT HYPOTHESIS
The most common known theories that attempt an

interpretation of the shape of the yield curve are: 1) Market segmentation theory: This theory is also called the segmented market hypothesis. In this theory, financial instruments of different terms are not substitutable. As a result, the supply and demand in the markets for short-term and long-term instruments is determined largely independently.

 Prospective investors decide in advance whether they

need short-term or long-term instruments. If investors prefer their portfolio to be liquid, they will prefer short-term instruments to long-term instruments. Therefore, the market for short-term instruments will receive a higher demand. Higher demand for the instrument implies higher prices and lower yield.

 This explains the fact that short-term yields are

usually lower than long-term yields. This theory explains the predominance of the normal yield curve shape. However, because the supply and demand of the two markets are independent, this theory fails to explain the observed fact that yields tend to move together (i.e., upward and downward shifts in the curve).

 2) Market expectations theory:

This hypothesis assumes that the various maturities are perfect substitutes and suggests that the shape of the yield curve depends on market participants expectations of future interest rates. These expected rates, along with an assumption that arbitrage opportunities will be minimal, is enough information to construct a complete yield curve

 This theory perfectly explains the observation that

yields usually move together. However, it fails to explain the persistence in the shape of the yield curve. Shortcomings of expectations theory: Neglects the risks inherent in investing in bonds (because forward rates are not perfect predictors of future rates). 1) Interest rate risk 2) Reinvestment rate risk

 Proponents of the expectation theory argue that the

shape of the yield curve is created by ignoring systematic factors and that the term structure of interest rates is solely derived by the market's current expectations. This theory is also known as pure hypothesis theory.

 3) Liquidity Theory: The Liquidity Theory asserts

that long-term interest rates not only reflect investors assumptions about future interest rates but also include a premium for holding long-term bonds (investors prefer short term bonds to long term bonds), called the term premium or the liquidity premium. This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty.

 Because of the term premium, long-term bond yields

tend to be higher than short-term yields, and the yield curve slopes upward. Long term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long term.

 The premium received normally increases at a

decreasing rate due to downward pressure from the decreasing volatility of interest rates as the term to maturity increases.

 4) Preferred habitat theory: Investors have distinct

investment horizons and require a meaningful premium to buy bonds with maturities outside their "preferred" maturity, or habitat. Proponents of this theory believe that short-term investors are more prevalent in the fixed-income market, and therefore longer-term rates tend to be higher than short-term rates, for the most part, but short-term rates can be higher than long-term rates occasionally.

 This theory is consistent with both the persistence of

the normal yield curve shape and the tendency of the yield curve to shift up and down while retaining its shape.