constructed corporate curves and plotted them on Figure 1-6, they would have been
above those for Treasury securities because corporate yields include default risk pre-
miums. However, the corporate yield curves would have had the same general shape as
the Treasury curves. Also, the riskier the corporation, the higher its yield curve, so
Delta Airlines, which has a lower bond rating than either Exxon Mobil or IBM, would
have a higher yield curve than those of Exxon Mobil and IBM.
Historically, in most years long-term rates have been above short-term rates, so
the yield curve usually slopes upward. For this reason, people often call an upward-
sloping yield curve a“normal” yield curveand a yield curve that slopes downward
aninverted,or“abnormal,” curve.Thus, in Figure 1-6 the yield curve for March
1980wasinvertedandtheoneforOctober2001wasnormal.However,theFebruary
2000 curve ishumped,which means that interest rates on medium-term maturities
arehigherthanratesonbothshort-andlong-termmaturities.Weexplainindetailin
the next section why an upward slope is the normal situation, but briefly, the reason
is that short-term securities have less interest rate risk than longer-term securities,
hencesmallerMRPs.Therefore,short-termratesarenormallylowerthanlong-term
rates.
What is a yield curve, and what information would you need to draw this curve?
Explain the shapes of a “normal” yield curve, an “abnormal” curve, and a
“humped” curve.
What Determines the Shape of the Yield Curve?
Since maturity risk premiums are positive, then if other things were held constant,
long-term bonds would have higher interest rates than short-term bonds. However,
market interest rates also depend on expected inflation, default risk, and liquidity, and
each of these factors can vary with maturity.
Expected inflation has an especially important effect on the yield curve’s shape. To
see why, consider U.S. Treasury securities. Because Treasuries have essentially no de-
fault or liquidity risk, the yield on a Treasury bond that matures in t years can be found
using the following equation:
rtr* IPtMRPt.
While the real risk-free rate, r*, may vary somewhat over time because of changes in
the economy and demographics, these changes are random rather than predictable, so
it is reasonable to assume that r* will remain constant. However, the inflation pre-
mium, IP, does vary significantly over time, and in a somewhat predictable manner.
Recall that the inflation premium is simply the average level of expected inflation over
the life of the bond. For example, during a recession inflation is usually abnormally
low. Investors will expect higher future inflation, leading to higher inflation premiums
for long-term bonds. On the other hand, if the market expects inflation to decline in
the future, long-term bonds will have a smaller inflation premium than short-term
bonds. Finally, if investors consider long-term bonds to be riskier than short-term
bonds, the maturity risk premium will increase with maturity.
Panel a of Figure 1-7 shows the yield curve when inflation is expected to increase.
Here long-term bonds have higher yields for two reasons: (1) Inflation is expected to
be higher in the future, and (2) there is a positive maturity risk premium. Panel b of
Figure 1-7 shows the yield curve when inflation is expected to decline, causing the
yield curve to be downward sloping. Downward sloping yield curves often foreshadow
38 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment
36 An Overview of Corporate Finance and the Financial Environment
