Yield Curves

Question 1

True or false: The yield curve includes credit risk, with more risky instruments demanding a higher
interest rate.

Answer 1

False. The yield curve is a credit-risk free curve that indicates the relationship between interest rates
and different maturities.

Question 2

Explain why the yield curve is normally upward sloping. Start by indicating what the yield curve is.

Answer 2

The yield curve is a credit-risk free curve that indicates the relationship between interest rates and different maturities

An upward sloping yield curve implies that longer maturity interest rates are
higher than short maturity interest rates

This can be understood in terms of risk and uncertainty.
The future further out is more uncertain than time closer to the present and a higher return is demanded

Question 3

Explain why the yield curve tends to invert during a crisis.

Answer 3

Cash is the safest asset to hold during a crisis and has no maturity Thus, demand for cash and other
short maturity assets increase during a crisis in the flight to safety , increasing the price or interest
rate required to hold those assets (1).

At the same time people do not want to hold as many risky assets, increasing supply of longer maturity assets, and driving its price or interest rate down (1).

Thus, an inverted yield curve is where the interest rate on short maturity instruments is higher than the
interest rate on long maturity instruments

Question 4

Explain how a bank can profit by utilizing the upwards sloping yield curve.

Answer 4

The bank can fund itself by raising deposits at the short end of the yield curve for a lower interest rate and then make loans at the long end of the yield curve for a higher interest rate. The interest
earned on loans less the interest paid on deposits earns the banks an interest margin.

Question 5

However, the interest margin possibility discussed in above exposes a bank to risk. What risk?

Answer 5

Liquidity risk