Normal Yield Curve

What is Normal Yield Curve?

Normal Yield Curve or Positive Yield Curve arise when longer maturity debt instruments offer higher yield as compared to shorter maturity debt instrument carrying similar credit risks and credit quality. The yield curve is positive (upward sloping) because investor demands more money for locking up their money for a higher period.

Graphical Presentation of Normal Yield Curve

The yield curveYield CurveThe Yield Curve Slope is used to estimate the interest rates and changes in economic activities. It is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis).read more is created below on a graph by plotting yield on the vertical axis and time to maturity on the horizontal axis. When the curve is normal, the highest point is on the right.

Normal Yield Curve Graph

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Different Theories of Interest Rates

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#1 – Expectation Theory

Expectation theory which says that long term interest rates should reflect expected future short-term rates. It argues that forward interest rates corresponding to certain future periods must be equal to future zero interest rates of that period.

If the 1-year rate today is at 1%, and the 2-year rate is 2%, then the one-year rate after one year (1yr forward rate) is around 3% [1.02^2/1.01^1].

#2 – Market Segmentation Theory

There is no relationship between short-term, medium-term, and long-term interest rates. The interest rate at a particular segment is determined by demand and supply in the bond market of that segment. Under the theory, a major investment such as a large pension fundLarge Pension FundA pension fund refers to any plan or scheme set up by an employer which generates regular income for employees after their retirement. This pooled contribution from the pension plan is invested conservatively in government securities, blue-chip stocks, and investment-grade bonds to ensure that it generates sufficient returns.read more invests in a bond of a certain maturity and does not readily switch from one maturity to another.

#3 – Liquidity Preference Theory

Investor prefers to preserve liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read more and invests funds for a short period of time. On the other hand, Borrowers prefer to borrow at fixed rates for long periods f time. This leads to a situation where the forward rate is greater than the expected future zero rates. This theory is consistent with the empirical result that yield curve tends to be often upward sloping than they are downward sloping.

Changes or Shifts in Normal Yield Curve

  1. Parallel Shifts – Parallel shift in yield curve occurs if the yields across all the maturity horizon change (increase or decrease) by the same magnitude and similar direction. It represents when a general level of interest rate changes in an economy.
  2. Non Parallel Shifts – When the yield across different maturity horizon changes at a different level in both magnitude and direction.

Importance

It forecast the future direction of the interest rates:

Influence

Key Points to Remember

Recommended Articles

This has been a guide to what is a normal yield curve. Here we discuss different theories of interest rate, changes, or shift in the normal yield curve, its influence, and importance with a detailed explanation. You can learn more about fixed income from the following articles –

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