Question

2.   Could you define what is the yield curve?
a.   What are the three main theories that attempt to explain the yield curve?
b.   What does it mean an inverted yield curve? How does it compare to a normal yield curve?

Answer 1

2. A yield curve is a curve which depicts the relationship between long term yields and short term yields. When there is is a normal curve, the long-term yield are higher than that of short term and when there is an inverted yield curve the long-term yield is lower than that of short term.

A. Three main theories which has attempted to explain the yield curve are

1. Pure expectation theory-this theory talks about the expectation of different investor with regards to bond yields

2. Market segmentation theory-this theory talks about different supply and demand determinants that exist for short term as well as long term.

3. Liquidity premium theory-this theory talks about the liquidity of different type of bonds and the premium attached to it. it is assumed that liquidity preference of investors is always of short-term and they must be compensated for Investment in long term bonds.

B. Normal yield curve is an yield curve when short-term bond yields are smaller than that of long-term.While in an Inverted yield curve the long term bond yield is smaller than short term bond yield. An Inverted yield curve is a sign of impending recession because there would be less bond yield and growth in future.