Yield Curves

Lesson

Yield curves are graphical representations of the interest rates on debt for a range of maturities. Yield curves show the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a borrower in a given currency. The yield curve can take three primary shapes: normal, inverted, and flat.

Practice Question #1

Which of the following best describes a normal yield curve?

A) Short-term interest rates are higher than long-term interest rates.

B) Long-term interest rates are higher than short-term interest rates.

C) All interest rates are the same, regardless of maturity.

D) The yield curve is downward sloping.

Select an option above to see an explanation here.

A) This describes an inverted yield curve. B) A normal yield curve has long-term interest rates higher than short-term interest rates. C) This describes a flat yield curve. D) This describes a downward-sloping yield curve, which is not a normal yield curve.

Terms

Yield Curve:: A graphical representation of the interest rates on debt for a range of maturities.
Normal Yield Curve:: A yield curve where longer-term debt instruments have a higher yield than shorter-term debt instruments.
Inverted Yield Curve:: A yield curve where shorter-term debt instruments have a higher yield than longer-term debt instruments.
Flat Yield Curve:: A yield curve where all debt instruments have similar yields, regardless of maturity.

Practice Question #2

What is the primary purpose of a yield curve?

A) To show the relationship between interest rates and the time to maturity of debt.

B) To indicate the credit quality of different bonds.

C) To determine the discount rate for commercial banks.

D) To set the federal funds rate.

Select an option above to see an explanation here.

A) The primary purpose of a yield curve is to show the relationship between interest rates and the time to maturity of debt. B) Credit spreads, not yield curves, indicate credit quality. C) The Federal Reserve sets the discount rate and is not determined by yield curves. D) The federal funds rate is also set by the Federal Reserve, not determined by yield curves.

Do Not Confuse With

Credit Spread:: The difference in yield between two bonds with different credit qualities.

Practice Question #3

Which of the following yield curve shapes is typically associated with an impending recession?

A) Normal yield curve

B) Inverted yield curve

C) Flat yield curve

D) Upward-sloping yield curve

Select an option above to see an explanation here.

A) A normal yield curve is associated with a healthy economy. B) An inverted yield curve, where short-term interest rates are higher than long-term interest rates, is typically associated with an impending recession. C) A flat yield curve can indicate economic uncertainty but is not necessarily a sign of an impending recession. D) An upward-sloping yield curve is not a typical shape for a yield curve.

Historical Example

In the early 2000s, the yield curve inverted, with short-term interest rates rising above long-term interest rates. This inversion signaled an impending recession, which eventually occurred in 2008 with the global financial crisis.