Principles of Finance/Section 1/Chapter 4/Bonds/The Yield Curve

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The "Yield curve" plots the yield (return) of a financial instrument [e.g. bond] as a function of time. Usually, the yield curve has an "S" shape and sometimes refered to as the "S curve" (which helps junior students to remember its shape). This emphasizes two characteristics, namely as time increases, diminishing returns sets in, indicated by the asympotic shape. The other influencing factor is that the curve is monotonically non-decreasing, indicating that one expects a better return on an investment the longer the investment is held [under non-Giffen market conditions]. Given that consumers behave rationally and that there are no other influencing factors, the yield curve reflects the status that consumers prefer to get a better return on an investment. If the curve was not increasing, then a consumer is expected to pull out his money at the peak and then reinvest at some later time.

According to Keynesian economics, a "Giffen market condition" is one in which demand increases as price decreases and interest rates are positive. Historically, there are times when this supply-demand curve was not followed, e.g. during the Irish potatoe famine. During that time, prices of potatoes went up as the demand decreased. However, there were many government induced factors in the economy going on during those times. A negative interest rates implies that one would get less money back at the return than at the time of the investment.

Yield curve.jpg