Basics of Corporate Finance

Yield Curve

Rates of return plotted on a graph

Interest rates on bonds of differing maturities are plotted on a graph to illustrate their relationship. A graphic representation of the term structure of interest rates is called a yield curve. "Yield" refers to the rate of return on an investment. For our term structure study, the yield of a security is the rate of interest paid on the security. The graph in Figure 2.1 shows yield curves for two different U.S. Treasury securities for two different dates. Remember, interest rates are always changing. The vertical axis represents the interest rate; the horizontal axis represents the number of years to maturity for the security. For instance, the interest rate paid to an investor on a one-year security in March of 1980 is 14% and the rate for a 20-year bond in January of 1987 is 7.6%. We have not plotted every point exactly, but we have plotted several common maturities and smoothed the curves to illustrate the trends.

Normal / abnormal yield curves

Let's examine the characteristics of the two curves. In March of 1980, all interest rates were at relatively high levels -- with long- term rates lower than short-term rates. The January 1987 curve has overall lower rates, with long-term rates slightly higher than short- term rates. An upward sloping yield curve is often called a normal yield curve, whereas a downward sloping yield curve is called an abnormal (inverted) yield curve.

Normal Yield Curve Theories
Upward curveconsidered normal

There are three prevailing theories that explain why the upward sloping yield curve is considered normal. These three theories are: the expectations theory, the market segmentation theory, and the liquidity preference theory.

1. Expectations Theory
The basis of the expectations theory is that the yield curve reflects lenders' and borrowers' expectations of inflation. Changes in these expectations cause changes in the shape of the yield curve. Remember, the inflation premium is a major component of interest rates.