Term Structure of Interest Rates and Yield Curves

The structure of interest rates refers to the pattern of interest rates or how they change in response to changes in some variable.
- One variable influencing interest rates is credit risk, which is the likelihood that a borrower will default.

The term structure of interest rates specifically describes the pattern of interest rates and how they change based on the term to maturity.
This relationship is visually represented using a yield curve.

A yield curve is a graphical representation of the term structure of interest rates.
- The vertical axis displays the interest rate (or yield).
- The horizontal axis represents the term to maturity, typically ranging from short-term to medium-term to long-term.
The yield curve shows the interest rate or yield currently available for otherwise identical securities with different maturities.
The yield curve plots current interest rates or yields for investments of different terms and does not predict future rates.
Yield curves are typically plotted using government bonds because they are identical except for their yield to maturity.
- Including different types of securities would make the yield curve meaningless.

Upward Sloping Yield Curve (Positive or Normal):
- This is the most common shape.
- It indicates that longer-term bonds have higher yields than shorter-term bonds.
Flat Yield Curve:
- Occurs when there is little or no difference between short, medium, and long-term maturities' interest rates.
Downward Sloping Yield Curve (Negative or Inverted):
- Long-term interest rates are lower than short-term interest rates.
- This is the opposite of a normal yield curve.
Other Shapes:
- Various humps or twists can occur, generally due to changing interest rates or expectations about future interest rates.