The Yield Curve shows the expected movement of yield rate in the future with the time to maturity as the reference. Here yield is plotted along the Y-Axis and time to maturity is plotted along the X-axis.
The Treasury bill yield rate is used as the reference for any country’s yield curve. Yield curve for other bonds can also be plotted using the base yield curve and the credit spread. Credit spread denotes the difference in yield between the bonds issued by the corporate or other entities with the government treasury securities. This is the extra rate of return more than the benchmark government Treasury bill rate of return the bond issuers have to provide to compensate the higher credit and other risks involved.
There are three main theories which describe the yield curve. They are
Pure Expectation Theory
As per the pure expectation theory the yield is decided based on the short term exchange rate. If the short term rate is expected to rise in the future, it will reduce the demand of the bonds in the market and decrease its price. So decrease in short term future interest rate will lead to decrease in yield in future. The converse case is also true.
So if the short terms interest rate is expected to increase in the future, the yield of the longer maturity bonds will be higher than the yield on the shorter maturity bonds. In this case, the yield curve will be upward sloping if we plot it with reference to the time to maturity. If the short term interest rate is expected to fall in future, the yield curve will be downward sloping to indicate the decrease in yield rate.
As per this theory
Liquidity Preference Theory
As per the liquidity preference theory, investors need higher rate of return for holding the bond for longer term. This is mainly because of different risks involved in holding the bonds which get increased with longer duration. This liquidity premium or higher rate of return will increase with the maturity of the bond and the yield curve will bend upward to denote the more yield along with the time to maturity.
Market Segmentation Theory
As per the market segmentation theory, the yield and market price of the bonds are decided based on the supply and demand of a particular group of bonds with same maturity duration. Every bondholder has demand for particular type of bonds which satisfy its business needs. Like insurance companies prefer bonds with longer maturity to cater their future liquidity demand and banks prefer shorter maturity bonds to meet their immediate liquidity requirement. Under this theory the total demand and supply of a particular group of bonds with same maturity defines the equilibrium yield and equilibrium price.