Question

Draw a graph of a typical Treasury yield curve and discuss why it usually takes that shape

Answer 1

Solution:-

. I o I I w N - 0.5 1 2 3 5 7 10 15 20 25 30 Matwrity (years)

The above graph is a typical example of treasury yield curve showing an upward slope. Its shape is due to the following reasons:

• Upward slope shows that the expected returns in long-term are higher than short-term. This is due to the fact that the credit risk is far higher for an investor who is invested for longer term relative to an investor who has invested for shorter term
• The shape signifies that the interest rates are expected to be higher in future as compared to present. This shows the basic assumption that economy is continuing to grow higher, expansion resulting in inflation and hence higher interest rates

Thus, upward sloping yield curve just represents the market's expectations of growing economy, higher inflation, higher interest rates and thus higher required rates of returns in the long-term as compared to the short-term.