In the domain of finance, yield curve could be defined as the connection of the term period of the debt taken by a particular borrower in any currency and the rate of interest. In case of the yield curve the interest rate could be regarded as the expense incurred in borrowing the debt.
The Arbitrage Pricing Theory, for example, addresses the general theory of asset pricing. Proper asset pricing is necessary for the proper pricing of shares. The Arbitrage Pricing Theory states that the return that is expected from a financial asset can be presented as a linear function of various theoretical market indices and macro-economic factors. Here it is assumed that the factors considered are sensitive to changes, and that is represented by a factor-specific beta coefficient.
The Prospect Theory, on the other hand, takes into consideration the alternatives that come with uncertain outcomes. The model is descriptive by nature and attempts to represent real-life choices but not optimal decisions.
Modern Portfolio Theory (MPT) proposes how rational investors should use diversification in order to optimize their portfolios. It also discusses how a risky asset should be priced.
Term Structure of Interest Rates
The term structure interest rates are numerical representations of the yield curve. They are more formal in nature.
Yields of Debt Instruments
The percentage increase in the worth of an investment over the period of a year is referred to as the yield of the particular debt instrument. The percentage earnings for the particular year is normally decided by the time period of the particular investment.
Users of Yield Curves
The yield curves are widely employed by a variety of people related to the world of finance. The common users of Yield Curves include the following:
Analysts of Securities having Fixed Income
Purposes of Using Yield Curves
There are several reasons as to why the yield curves are used:
For comprehending the present situations of the financial markets
For comprehending the economic situations
For finding out chances to buy and sell
Kinds of Yield Curve
There are several kinds of yield curve:
Inverted Yield Curve
Normal Yield Curve
Flat or Humped Yield Curve
Steep Yield Curve
Theories of Yield Curve
There are several theories that are associated with yield curve. These theories try to describe the way the yields tend to keep changing following their maturity. Those theories are:
Preferred Habitat Theory
Market Expectations Hypothesis (Pure Expectations)
Market Segmentation Theory
Liquidity Preference Theory
Among the theories of yield curve two theories have taken up extreme stances. There is a third theory, which tries to explain the working of yield curves from a more balanced position.
Shapes of Yield Curves
The yield curves normally slope in an upward direction. They do so in an asymptotic manner. Normally the yield is directly proportional to the length of the maturity period.
Movements of Yield Curves
The yield curves keep changing every day. The movements of the yield curves show the reaction of the market to current news that is related to the trends of market.
Last Updated on : 1st July 2013