Important Uses of the yield curve are as follows:
The controversy surrounding the determinants of the yield curve should not obscure the fact that this curve can be an extremely useful tool for investors.
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Forecasting Interest Rates:
First, if the expectations hypothesis is correct, the yield curve gives the investor a clue concerning the future course of interest rates.
If the curve has an upward slope, the investor may be well advised to look for opportunities to move away from bonds and other long-term securities into investments whose market price is less sensitive to interest-rate changes.
A downward-sloping yield curve, on the other hand, suggests the likelihood of near-term declines in interest rates and a rally in bond prices if the market’s forecast of lower rates turns out to be true.
Uses for Financial Intermediaries:
The slope of the yield curve is critical for financial intermediaries, especially commercial banks, savings and loan associations, and savings banks.
A rising yield curve is generally favorable for the these institutions because they borrow most of their funds by selling short- term deposits and lend a major portion of those funds long term.
The more steeply the yield curve slopes upward, the wider the spread between borrowing and lending rates and the greater the potential profit for a financial intermediary.
However, if the yield curve begins to flatten out or slope downward, this should serve as a warning signal to portfolio managers of these institutions.
A flattening or downward-sloping yield curve squeezes the earnings of financial inter-mediaries and calls for an entirely different portfolio-management strategy than an upward-sloping curve.
For example, if an upward-sloping yield curve starts to flatten out, portfolio managers of financial institutions might try to “lock in” relatively cheap sources of funds by getting long-term commitments from depositors and other funds-supplying customers.
Borrowers, on the other hand, might be encouraged to take out long-term loans at fixed rates of interest.
Of course, the financial institution’s customers also may be aware of impending changes in the yield curve and resist taking on long-term loans or deposit contracts at potentially unfavourable interest rates.
Detecting Overpriced and Underpriced Securities:
Yield curves can be used as an aid to investors in deciding which securities are temporarily overpriced or underpriced.
This use of the curve derives from the fact that, in equilibrium, the yields on all securities of comparable risk should come to rest along the yield curve at their appropriate maturity levels.
In an efficiently functioning market, however, any deviations of individual securities from the yield curve will be short-lived; so the investor must move quickly upon spotting a security whose yield lies temporarily above or below the curve.
If a security’s rate of return lies above the yield curve, this sends a signal to investors that particular security is temporarily underpriced relative to other securities of the same maturity.
Other things equal, this is a buy signal which some investors will take advantage of, driving the price of the purchased security upward and its yield back down toward the yield curve.
On the other hand, if a security’s rate of return is temporarily below the yield curve, this indicates a temporarily overpriced financial instrument, because its yield is below that of securities bearing the same maturity.
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Some investors holding this security will sell it, pushing its price down and its yield back up toward the curve.
Indicating Trade-Offs between Maturity and Yield:
Still another use of the yield curve is to indicate the current trade-off between maturity and yield confronting the investor.
If the investor wishes to alter the maturity of a portfolio, the yield curve indicates what gain or loss in rate of return may be expected for each change in the portfolio’s average maturity.
With an upward-sloping yield curve, for example, an investor may be able to increase a bond portfolio’s expected annual yield by extending the portfolio’s average maturity.
However, the prices of longer-term bonds are more volatile, creating greater risk of capital loss.
Moreover, longer-term securities tend to be less liquid and less marketable than shorter-term securities. Therefore, the investor must weigh the gain in yield from extending the maturity of his or her portfolio against added price, liquidity, and marketability risk.
Because yield curves tend to flatten out for the longest maturities, the investor bent on lengthening the average maturity of a portfolio eventually discovers that gains in yield get smaller and smaller for each additional unit of maturity.
The yield curve - Stocks and bonds - Finance & Capital Markets - Khan Academy
At some point along the yield curve it dearly does not pay to further extend the maturity of a portfolio.
Riding the Yield Curve:
Finally, some active security investors, especially dealers in government securities, have learned to “ride” the yield curve for profit.
If the curve is positively sloped, with a slope steep enough to offset transactions costs from buying and selling securities, the investor may gain by timely portfolio switching.
For example, if a securities dealer purchases securities six months from maturity, holds them for three months, converts the securities into cash, and buys new six-month securities, he or she can profit in two ways from a positively sloped yield curve.
Because the yield is lower on three-month than on six-month security, the dealer experiences a capital gain on the sale.
Second, the purchase of new six- month securities replaces a lower-yielding security with a higher- yielding one at a lower price.
Riding the yield curve can be risky, however, since yield curves are constantly changing their shape. If the curve gets flatter or turns down, a potential gain can be turned into a realized loss. Experience and good judgment are indispensables in using the yield curve for investment decision making.