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Trading and Investment Terminology

Yield Curve Risk

Yield curve risk is the probability of shifting yield curve in a manner that it affects the values of securities which are tied to interest rate, particularly bonds. When there is an adverse shift in market interest rate, the yield of fixed income instruments changes. This condition also affects the price of fixed income instruments. When market interest rate or yield increase, the price of bonds decrease and when market interest rate or yield decrease, the price of bonds increases. Investors of fixed income instruments pay close attention to yield curve because yield curve provides an indication of where economic growth and short-term interest rates are headed. Yield curve is the graphical representation of bond yield of various maturities and interest rate. It shows the relationship between interest rate and bond yield. Yield curve risk is associated with flattening or steepening of the yield curve. Flattening or steepening of the yield curve is a result of changing yields among comparable bonds with different maturities. When the yield curve shifts the price of the bond changes which was initially based on the initial yield curve. Flattening Yield Curve The flat yield curve represents that there is a little difference between the yield of short term and long term securities of same credit quality. This means the yield spread between short term and long term interest rates is narrowing down. This kind of curve usually can be seen during the transitions between normal and inverted curves. Flat curve is the signal of economic uncertainties. It indicates economy weakness and inflation and interest rates are expected to stay low. Steepening Yield Curve A steep yield curve shows that the spread between short term and long term interest rates is widening. Means the yield of long-term bonds is rising faster than the yield of short-term bonds or the yield of short-term bonds is falling as the yield of long-term bonds is rising. That is why the price of long-term bond decreases relative to short-term bonds. Steep yield curve shows that economy is expected to improve quickly. Strong economic activities and rising inflation lead to a higher interest rate. Interest rates rise when the demand for capital is re-established because of growing economic activities. During this phase, banks borrow at a lower interest rate and lend at a higher interest rate. Inverted Yield Curve When the yield on short-term bonds is higher than the yield on long-term bonds the yield curve becomes inverted. This happens on rare occasions and in these conditions long-term investors settle for lower yields. Inverted yield curve indicates that the investors will tolerate low rates now if they believe rates will fall even lower later on. At this time investors expect lower interest rates and inflation rates in future. Investors who are holding interest rate bearing securities are exposed to yield curve risk. To hedge against yield curve risk investors can build a portfolio which reacts in a certain way at the time of interest rate change. Investors who are able to predict the shift in yield curve can take the advantage of corresponding change in bond price.

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