TASK > 1

Question . Explain the term structure of interest rate and yield curve.

Answer . Definition
Acurvethat shows therelationshipbetweenyieldsandmaturity datesfor asetof
similarbonds, usuallyTreasuries, at a given point intime.

What It Is:

Also known as the term structure of interest rates, the yield curve is a graph that plots the yields of
similar-quality bonds against their maturities, ranging from shortest to longest. (Note that the chart
does not plot coupon rates against a range of maturities -- that's called a spot curve.)

How It Works/Example:

The yield curve shows the various yields that are currently being offered on bonds of different
maturities. It enables investors at a quick glance to compare the yields offered by short-term,
medium-term and long-term bonds.

The yield curve can take three primary shapes. If short-term yields are lower than long-term yields
(the line is sloping upwards), then the curve is referred to a positive (or "normal") yield curve. Below
you'll find an example of a normal yield curve.

If short-term yields are higher than long-term yields (the line is sloping downwards), then the curve is
referred to as an inverted (or "negative") yield curve. Below you'll find an example of an inverted
yield curve.
Finally, a flat yield curve exists when there is little or no difference between short- and long-term
yields. Below you'll find an example of a flat unemployment rate.

It is important that only bonds of similar risk are plotted on the same yield curve. The most common
type of yield curve plots Treasury securities because they are considered risk-free and are thus
abenchmark for determining the yield on other types of debt.

The shape of the yield curve changes over time. Yield curves are calculated and published by The
Wall Street Journal, the Federal Reserve, and a variety of other financial institutions.

Why It Matters:

In general, when the yield curve is positive, this indicates that investors require a higher rate of
return for taking the added risk of lending money for a longer period of time. Many economists also
believe that a steep positive curve indicates that investors expect strong future economic growth and
higher future inflation (and thus higher interest rates), and that a sharply inverted yield curve means
investors expect sluggish economic growth and lower inflation (and thus lower interest rates). A flat
curve generally indicates that investors are unsure about future economic growth and inflation.

There are three main theories that attempt to explain why yield curves are shaped the way they are.
1. The "expectations theory" states that expectations of rising short-term interest rates are what
create a positive yield curve (and vice versa).

2. The "liquidity preference hypothesis" states that investors always prefer the higher liquidity of
short-term debt and therefore any deviance from a positive yield curve will only prove to be a
temporary phenomenon.

3. The "segmented market hypothesis" states that different investors confine themselves to certain
maturity segments, making the yield curve a reflection of prevailing investment policies.

Because the yield curve is generally indicative of future interest rates, which are indicative of
aneconomy's expansion or contraction, yield curves and changes in yield curves can convey a great
deal of information. In the 1990s, Duke University professor Campbell Harvey found that inverted
yield curves have preceded the last five U.S. recessions. Changes in the shape of the yield curve
can also have an impact on portfolio returns by making some bonds more or less valuable relative to
other bonds. These concepts are part of what motivates analysts and investors to study yield curves
carefully.

Term and Structure of Yield Curve Interest Rates

Usually, longer term interest rates are higher than shorter term interest rates. This is called a "normal
yield curve" and is thought to reflect the higher "inflation-risk premium" that investors demand for
longer term bonds. When interest rates change by the same amount for bonds of all terms, this is
called a "parallel shift" in the yield curve since the shape of the yield curve stays the same, although
interest rates are higher or lower "across the curve". A change in the shape of the yield curve is called
a "twist" and means that interest rates for bonds of some terms change differently than bond of other
terms.

A small or negligible difference between short and long term interest rates occurs later in the
economic cycle when interest rates increase due to higher inflation expectations and tighter monetary
policy. This is called a "shallow" or "flat" yield curve and higher short term rates reflect less available
money, as monetary policy is tightened, and higher inflation later in the economic cycle.

When the difference between long and short term interest rates is large, the yield curve is said to be
"steep". This is thought to reflect a "loose" monetary policy which means credit and money is readily
available in an economy. This situation usually develops early in the economic cycle when a country's
monetary authorities are trying to stimulate the economy after a recession or slowdown in economic
growth. The low short term interest rates reflect the easy availability of money and low or declining
inflation. Higher longer term interest rates reflect investors' fears of future inflation, recognizing that
future monetary policy and economic conditions could be much different.

Tight monetary policy results in short term interest rates being higher than longer term rates. This
occurs as a shortage of money and credit drives up the cost of short term capital. Longer term rates
stay lower, as investors see an eventual loosening of monetary policy and declining inflation. This
increases the demand for long term bonds which lock in the higher long term rates.

Economists and financial academics have developed theories to explain the shape of the yield curve.
The "expectations" theory states that sinces short term bonds can be combined for the same time
period as a longer term bond, the total interest earned should be equivalent, given the efficiency of
the market and the chance for arbitrage (speculators using opportunities to make money).
Mathematically, the yield curve can then be used to predict interest rates at future dates.
The "segmentation" theory explains the shape of the yield curve by investors' term preferences. Some
investors need to deploy their funds for specific periods of time, hence a preference for long or short
term bonds which is reflected in the shape of the yield curve. An inverted curve can then be seen to
reflect a definite investor preference for longer term bonds.

With powerful computers and mathematical techniques, investors and academics are constantly
striving to build models which explain the shape of the yield curve and hopefully provide insight into
the future direction of interest rates. This has given rise to "yield curve" strategies which are
employed by bond managers to add value to their portfolios.

TASK > 2

Question . Expalin the utility of interest rate analysis for financial institutions as well as for individuals.

Answer .