176 Part 3 Financial Assets
As the! gure shows, the yield curve changes in position and in slope over time.
In March 1980, all rates were quite high because high in" ation was expected. How-
ever, the rate of in" ation was expected to decline; so short-term rates were higher
than long-term rates, and the yield curve was thus downward-sloping. By February
2000, in" ation had indeed declined; thus, all rates were lower, and the yield curve
had become humped—medium-term rates were higher than either short- or long-term
rates. By January 2008, all rates had fallen below the 2000 levels; and because short-
term rates had dropped below long-term rates, the yield curve was upward-sloping.
Figure 6-4 shows yield curves for U.S. Treasury securities; but we could have
constructed curves for bonds issued by GE, IBM, Delta Air Lines, or any other
company that borrows money over a range of maturities. Had we constructed
such corporate yield curves and plotted them on Figure 6-4, they would have been
above those for Treasury securities because corporate yields include default risk
premiums and somewhat higher liquidity premiums. Even so, 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, which has been " irting
with bankruptcy, would have a higher yield curve than GE or IBM.
Historically, long-term rates are generally above short-term rates because of
the maturity risk premium; so all yield curves usually slope upward. For this rea-
son, people often call an upward-sloping yield curve a “normal” yield curve and
a yield curve that slopes downward an inverted or “abnormal” curve. Thus, in
Figure 6-4, the yield curve for March 1980 was inverted, while the one for January
2008 was normal. However, the February 2000 curve was humped, which means
that interest rates on medium-term maturities were higher than rates on both
short- and long-term maturities. We will explain in detail why an upward slope is
the normal situation. Brie" y, however, the reason is that short-term securities have
less interest rate risk than longer-term securities; hence, they have smaller MRPs.
So short-term rates are normally lower than long-term rates.“Normal” Yield Curve
An upward-sloping yield
curve.
Inverted (“Abnormal”)
Yield Curve
A downward-sloping yield
curve.
Humped Yield Curve
A yield curve where
interest rates on medium-
term maturities are higher
than rates on both short-
and long-term maturities.“Normal” Yield Curve
An upward-sloping yield
curve.
Inverted (“Abnormal”)
Yield Curve
A downward-sloping yield
curve.
Humped Yield Curve
A yield curve where
interest rates on medium-
term maturities are higher
than rates on both short-
and long-term maturities.
SELF^ TEST What is a yield curve, and what information would you need to draw this curve?
Distinguish among the shapes of a “normal” yield curve, an “abnormal” curve,
and a “humped” curve.
If the interest rates on 1-, 5-, 10-, and 30-year bonds are 4%, 5%, 6%, and 7%,
respectively, how would you describe the yield curve? If the rates were re-
versed, how would you describe it?6-5 WHAT DETERMINES THE SHAPE OF THE YIELD CURVE?
Because maturity risk premiums are positive, if other things were held constant,
long-term bonds would always have higher interest rates than short-term bonds.
However, market interest rates also depend on expected in" ation, default risk, and
liquidity, each of which can vary with maturity.
Expected in" ation has an especially important effect on the yield curve’s
shape, especially the curve for U.S. Treasury securities. Treasuries have essentially
no default or liquidity risk, so the yield on a Treasury bond that matures in t years
can be expressed as follows:T-bond yield! r*t " IPt " MRPtWhile the real risk-free rate, r*, varies somewhat over time because of changes in
the economy and demographics, these changes are random rather than predictable.