The yield curve is a graphical representation of how the Yield-to-Maturity (YTM) of bonds with similar risk and different maturity dates behave. The yield curve can take different forms but it should be an upward slope, as, under normal circumstances, investors ask for a higher return on bonds that have a longer maturity date, considering that they are exposed to a wide range of risks involved in holding the security for long periods of time.
How is The Yield Curve Constructed?
The yield curve can be easily plotted with data obtained from the financial markets. Investors commonly use the U.S. Treasury Bills, also known as T-Bills, to build a model for the overall market’s yield curve, as this asset class provides instruments with different maturity dates. The graphic consists of a Y-axis with different levels of Yield-to-Maturity and an X-axis with different maturity dates.
Which are the Most Common Forms of the Yield Curve?
Under normal conditions, the yield curve should have an upward sloped form that illustrates how investors are willing to hold the T-bills for a longer period of time only if they are provided with higher returns. On the other hand, during periods of interest rate increases, inflation risks or pessimistic long-term outlooks, the yield curve could be inverted, taking a downward sloped form, usually as a result of interest rate hikes on short-term interest rates promoted by the Federal Reserve.
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Why is the Yield Curve an Important Indicator for Traders and Investors?
The yield curve has been often described by investment professionals as the market’s ‘crystal ball’. The reason for this is that positively sloped yield curves have been followed by subsequent years of economic growth and positive market performance, while inverted yield curves have been often preceded by recessions and market downturns. This is the main reason why investors and traders closely follow the evolution of the yield curve over time.
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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
