1. Explain how the Term Structure of Interest Rates (Yield Curve) can serve as a signalling tool in the financial system. Give clear examples of its use in forecasting future inflation rates, interest rates and economic activity.
Yield curve is a graph that plots similar bonds with time to
maturity on x axis and yield on y axis. It allows the investor to
compare short term yields with long term and medium term yields.
The yield curve's shape gives us an idea of the future of the
economy.
There are three main types of yield curve shapes:
1. Normal- longer maturity bonds have a higher yield compared to
shorter-term bonds. This represents the risks incorporated with
time i.e. maturity risk, inflation risk etc. It is a sign of
economic expansion
2. Inverted- shorter-term yields are higher than the longer-term
yields, which can be a sign of upcoming recession
3. Flat- Sign of an economic transition. It can be from expansion
to recession or vice versa.
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