The yield curve is the curve that tells the relationship between the time maturity of the bonds and the interest rates of return on the bonds as per their time maturity. The yield curve provides the investors with financial information about the companies and helps the companies to make their capital structure accordingly (CFI, 2019). In general, the theory states that the yield curves are positively sloped, this means as the maturity time of the bond increases, the return on the bond will increase, because it increases the risk of credibility, inflation, default, and so on. Although, there are some other shapes of the yield curves as well, that are steep, inverted, humped, and flat curves which occur due to any economic shock or downturn.
4 kinds of theories explain the shape of the yield curves, which are pure expectation theory, liquidity theory, market segmentation theory, and the preferred habitat theory. In the pure expectation theory, the yield curve depends on the expecattions of the investors and the way of their investments based on their expectations. According to it, the interest rates will be higher for long-maturity bonds as compared to the short-maturity bonds due to the inflation risk. In the liquidity theory, it mainly considers the interest rate risks and explains the normal, steep, and flat yield curves. In preferred habitat theory, studies the people’s preferences for the different maturity bonds with different interest rates, as per their risk-taking nature, such as risk avert person, risk lover person, or risk-neutral person (Jan, O., 2019).
Part (a) Date 28th March 2020
From the interest rate data on different maturity time-periods on a specific date, 28th March 2020, it can be seen that the yield curve for that specific day quite has fluctuations. One possible explanation for so many fluctuations may be the pandemic of covid-19. Looking at the overall picture, it can be concluded that as the maturity period of the bonds increases, the interest rate is either similar (giving a flat curve) or higher (giving a normal or a steeper curve), and vice-versa (inverted curve). When the maturity period falls from 3Y to 1Y, the interest rate fell from 0.575 to 0.173. Although, after that, the yield curve is either normal, steep, or flat. Looking at the table below the graph, it can be seen that for 2Y and 3Y the yield curve is quite a falt although, for 1Y to 2Y, 3Y to 30Y, the interest rates are increasing, among which, 3Y to 15Y it's a normal curve, as the slope is positively sloped and flattening eventually, but it got steeper for 15Y to 30Y maturity period of the bond. It can be said that the fluctuations in March 2020, is mainly due to pandemic situation, also, liquidity theory and preferred habitat theory plays a major role as well, as many people avoid to invest or if invest, so invest in short maturity bonds, as they became risk-averse a little.
Part (b) Date 28th July 2020
From the interest rate data on different maturity time-periods on a specific date, 28th July 2020, it can be seen that the yield curve for that specific day is having relatively quite a normal curve. One of the possible reasons for this may be due to the opening up of the economies after the lockdown due to the pandemic, which restarted the economic activities. The overall picture of the yield curve tells that the curve is relatively steeper at the initial stage and then it has become the flat curve. Looking at the yield curve tables, it can be seen that for an interest rate with maturity periods 1Y, 2Y and 3Y are approximately the same and hence, gives a flat yield curve. Beyond 3Y maturity bonds are having a steeper curves, as the slope of 3Y to 5Y is (0.414-0.279) / 2 = 0.0675, the slope of 5Y to 7Y is (0.6-0.414) / 2 = 0.93, and so on. Similarly, from 9Y to 12Y to 15Y, the yield curve is steeper and becomes flat beyond the 20Y maturity bond. The July 2020 yield curve can be explained by pure expectations, liquidity, and the preferred hypothesis theories, as people who love to take a risk, have invested during the pandemic in some markets, which they felt will give higher returns, which also might be a reason for a steeper curve.
Jan, O. (2019). Yield curve. Retrieved from Xplaind: https://xplaind.com/128027/yield-curve
CFI. (2019). What is the yield curve? Retrieved from: https://corporatefinanceinstitute.com/resources/knowledge/finance/yield-curve/
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