Yield Curve Basics
6 Pages Posted: 21 Oct 2008
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Yield Curve Basics
Abstract
This technical note discusses risk and term premiums, prominent theories of the yield curve, and how to construct a yield curve.
Excerpt
UVA-BP-0491
Yield Curve Basics
The yield curve, or term structure of interest rates, plots the relationship among interest rates of bonds with different maturities. For example,
Aside: Risk Premiums
This note focuses on, for bonds with similar characteristics, how yields across a range of maturities differ. To start, however, we note that the yields on different types of bonds that have the same maturity—for example, a 2-year Aaa note versus a 2-year Baa note—will differ because of what is called a risk premium. The risk premium can be thought of as encompassing risk differentials that owe to default or credit risk (a Baa bond is riskier than a Aaa bond) but also to a liquidity premium. All else equal, investors should demand higher returns for less liquid securities. In the United States, the benchmark (risk-free) interest rate is that on an on-the-run Treasury security; all other debt securities should offer a premium relative to the benchmark rate, and risk spreads are usually quoted vis-à-vis a Treasury bond.,
Risk premiums can be time-varying; for example, to the extent that recessions are associated with an increase in corporate failures, the risk premium on a Baa bond might vary with the economic cycle. Significant events that signal to investors that default risks are increasing can also increase risk premiums. For example, when Enron declared bankruptcy in December 2001, investors worried that other firms might be in worse financial health than their accounting reports indicated; the Baa–Aaa spread promptly increased by 44 basis points (Mishkin, 2006).
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Keywords: yield curve
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