What Determines the Shape of the Yield Curve?
by MaestriSince maturity risk premiums are positive, then if other things were held constant, long-term bonds would have higher interest rates than short-term bonds. However, market interest rates also depend on expected in?ation, default risk, and liquidity, and each of these factors can vary with maturity.
Expected in?ation has an especially important effect on the yield curve’s shape. To see why, consider U.S. Treasury securities. Because Treasuries have essentially no default or liquidity risk, the yield on a Treasury bond that matures in t years can be found using the following equation:
rt r* IPt MRPt.
While the real risk-free rate, r*, may vary somewhat over time because of changes in the economy and demographics, these changes are random rather than predictable, so it is reasonable to assume that r* will remain constant. However, the in?ation premium, IP, does vary signi?cantly over time, and in a somewhat predictable manner. Recall that the in?ation premium is simply the average level of expected in?ation over the life of the bond. For example, during a recession in?ation is usually abnormally low. Investors will expect higher future in?ation, leading to higher in?ation premiums for long-term bonds. On the other hand, if the market expects in?ation to decline in the future, long-term bonds will have a smaller in?ation premium than short-term bonds. Finally, if investors consider long-term bonds to be riskier than short-term bonds, the maturity risk premium will increase with maturity.
Panel a of Figure 1-7 shows the yield curve when in?ation is expected to increase. Here long-term bonds have higher yields for two reasons: (1) In?ation is expected to be higher in the future, and (2) there is a positive maturity risk premium. Panel b of Figure 1-7 shows the yield curve when in?ation is expected to decline, causing the yield curve to be downward sloping. Downward sloping yield curves often foreshadoweconomic downturns, because weaker economic conditions tend to be correlated with declining in?ation, which in turn leads to lower long-term rates.
Taken From : Five-Minute MBA – Corporate Finance
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