The yield curve is a graph of the relationship between yield to maturity and time to maturity for bonds, which are identical except for time to maturity

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The yield curve is a graph of the relationship between yield to maturity and time to maturity for bonds, which are identical except for time to maturity. Explain two main uses of the yield curve.

The yield curve can be used to price bonds. If a yield curve can be constructed for risk-free bonds then a risk-free yield can be approximated from this curve.

The risk-free yield is then adjusted for risk, giving the yield for the bond. Once the bond yield is obtained it can be used to discount the bond cash flows to price the bond.

The yield curve can also be used in forming predictions about future yields but this does require the assumption that the expectations hypothesis applies to interest rates or at least that the term structure process is known.

For example the estimate will be less accurate where time changing liquidity premiums exist. If a 12-month forecast of the six-month rate was required this could be obtained from the yield curve. The 18-month and 12-month yields are all that is required to obtain this estimate.

Bench Partner
Oct 9, 2021

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