Question

2. What is a yield curve? Identify the three economic factors that determine its shape. Critically explain their roles.

Answer 1

Yield curve is a curve which plots yield of different bonds which have similar credit rating but different maturity dates.

This is a curve which reflect the comparison of bond yields of short-term and long-term maturities of different bonds.

3 economic factors that determine the shape are-

1. Interest rate-it is the major determinant of the yield curve as it is inversely related to to bond yields when the interest rate is high, the bond yield will fall and similarly when the interest rate will be low, the bond yield will be high.

2. Inflation is another factor which will determine the yield curve of various bonds as when there is a high inflation, it will Erode the purchasing power of bond and an investor will demand a higher rate of bond yield to compensate for the loss so higher inflation means higher bond yield.

3. Economic growth is another factor which is highly important while consideration of bond yield as when there is a growing economy, investor will generally demand higher bond yield, and it will help them tto keep themselves making higher rate of return in a growing economy in comparison to stocks.