Question

You work as a financial analyst at a large automobile corporation that occasionally makes acquisitions of smaller companies that specialize in the production and assembly of small component parts. In order to achieve vertical integration of its newest sports sedan model, the company is evaluating a few manufacturing companies that have experienced strong financial performance in the past few years. These companies would make excellent acquisitions due to the nature and quality of the product and the anticipated ease of transition. You have been tasked to evaluate these companies from a financial perspective and choose one. To do this, you need to brush up on a few concepts by addressing the following topics:

Define the relationship between yield curves and the term structure of interest rates

Answer 1

In general financial terms yields increase in line with maturity and this gives rise to an upward sloping yield curve. This is also known as a nominal yield curve. The yield curve is used to show the term structure of interest rates for standard U.S. government issued securities.

It should be kept in mind that term structure of interest rates is the variation of the yield of bonds that have similar risk profiles with terms of those bonds. The yield curve is nothing but the relationship that exists between YTM (or yield to maturity) of bonds to the time to maturity in general and more specifically to duration of bonds. Thus bonds with longer maturities usually have higher yields. Thus the relationship between yield curves and the term structure of interest rates is that the yield curve is used to show the term structure of interest rates for standard U.S. government issued securities.