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Thursday, June 09, 2005

A Primer on Yield Curves

Lately there's been a lot of discussion about the "yield curve" (how it's getting flatter, what this could mean, etc...). But, many of Financial Rounds' non-professional readers might not know what a "yield curve" is. Fear not - here's a quick (and hopefully relatively painless) primer:

A yield curve is a visual (graphic) representation of the relationship between the maturities and interest rates on a given class of debt securities. The most commonly referred to yield curve is the one for U.S. Treasuries. To make one, simply plot the yields of the various treasury securities on on the "Y" (vertical) axis and the years to maturity in the "X" (horizontal) axis. The left hand side of the "X" axis has the shortest maturity security (the 3-month T-bill), and the maturity increases as you move rightward along the line.

Yield curves normally slope upward (i.e. interest rates on longer-term bonds are higher than those on shorter term ones), but not always. For an excellent description of the various shapes of the yield curve, go to a piece by Smart Money called One Bond Strategy: The Living Yield Curve.

It gives examples of times that yield curves have been upward-sloping (the "normal" yield curve), downward-sloping (also known as an "inverted" yield curve), flat (where long-term and short term rates don't differ much) or even "humped". It's also got an extremely cool applet that shows how the yield curve changes over time.

Hat tip to Barry Ritholtz at The Big Picture for the link.

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