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Yield Curves

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Economics
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University of the Cumberlands
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Running head: TYPES OF YIELD CURVES 1
Types of Yield Curves
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TYPES OF YIELD CURVES 2
Types of Yield Curves
The upward-sloping yield curve
A normal yield curve has an upward slope depicting a consistent rise in the interest rate
over time. The reason why an increase in the time to maturity attracts a higher interest is that the
risk of the debt increases with time (Martin and Ross, 2019). The more the time to maturity, the
higher the likelihood of the debt being affected by inflation, defaulting, or interest rate changes.
In buying a long term bond, an investor shoulders higher risk and therefore requires a
corresponding interest rate to justify their willingness to lend. The upward curve is also
consistent with the terms of the liquidity preference theory which posits that holders of long-term
securities demand higher compensation due to the wide array of risks that their investment is
prone to before the maturity date.
Flat yield curve
A flat yield curve arises due to convergence of the yield spread between short term and
long term bonds (US Treasury, 2020). In this case, investors do not earn additional compensation
for holding long term bonds. From a cost-benefit analysis perspective, a long-term bond is
undesirable during a flat yield curve because there is no benefit to justify the astronomical risk
that an investor is taking in buying a long term bond. The yield curve may also flatten if short
term interest rates rise at a faster rate than those of long term bonds or the interest rate of long-
term bonds declines more rapid than that of short term securities. During a flat yield curve,
investors may move from long term to short term securities to avoid the higher risks. A flat yield
curve may also arise when the market approaches a recession and economic growth has slowed
down or if there is no expectation of inflation in the future.

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Running head: TYPES OF YIELD CURVES 1 Types of Yield Curves Name Institution TYPES OF YIELD CURVES 2 Types of Yield Curves The upward-sloping yield curve A normal yield curve has an upward slope depicting a consistent rise in the interest rate over time. The reason why an increase in the time to maturity attracts a higher interest is that the risk of the debt increases with time (Martin and Ross, 2019). The more the time to maturity, the higher the likelihood of the debt being affected by inflation, defaulting, or interest rate changes. In buying a long term bond, an investor shoulders higher risk and therefore requires a corresponding interest rate to justify their willingness to lend. The upward curve is also consistent with the terms of the liquidity preference theory which posits that holders of long-term securities demand higher compensation due to the wide array of risks that their investment is prone to before the maturity date. Flat yield curve A flat yield curve arises due to convergence of the yield spread between short term and long term bonds (US Treasury, 2020). In this case, investors do not earn additional compensation for holding long term bonds. From a cost-b ...
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