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Known more familiarly as the yield curve, the term structure of interest rates plots the relationship between time, or term, to maturity and the yields to maturity of a range of fixed income debt securities. The term structure of interest rates is a reflection of market participant outlook on economic activity and inflation rates as well as supply and demand conditions in the debt securities markets. Considered risk-free and liquid, the yields to maturity of the most recent U.S. Treasury security issues, from three months to thirty years to maturity, are typically used to produce a benchmark term structure of interest rates. This yield curve, or a variation thereof known as the spot yield curve, is used to price debt securities of all types using discounted cash flow analysis. The term structure of interest rates also serves as a benchmark for pricing and evaluating other debt securities and interest rates, such as corporate bonds, mortgage-backed securities, and interbank lending rates.
Interpolation techniques are used to create a smooth yield curve by filling in the gaps between discrete points. The shape of the term structure of interest rates changes continually with variations in the demand and supply for U.S. Treasury securities and derivatives contracts. Generally, some form of what's known as a "normal" yield curve prevails, however. A normal yield curve is upward sloping, i.e., interest rates are higher the longer the term to maturity. This reflects a "normal" expectation on the part of investors for higher yields given the greater uncertainty and risk assumed as terms to maturity lengthen.
At times, the term structure of interest rates may take on a flat aspect, known as a flat yield curve. This may indicate investor uncertainty as to the future course and direction of interest rates or a period of transition driven by changing expectations. Flattening of the yield curve typically occurs when short-term interest rates rise while long-term rates fall. When the yield curve is flat, investors can optimize the trade-off between risk and return by purchasing fixed income securities with the least risk or highest credit quality.
An inverted yield curve is a rare occurrence in which yields of short-term fixed income U.S. Treasury securities are higher than their long-term counterparts. An inverted yield curve indicates that the market expects interest rates to decline the farther out into the future time progresses. Also characteristic of such an environment is rising rates of short-term U.S. Treasury securities, typically due to significant tightening of monetary policy by the Federal Reserve. Inverted yield curves are also interpreted as a sign of an impending economic slowdown or contraction.
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