What is the ‘Yield Curve Risk’
The yield curve risk is the risk of experiencing an adverse shift in market interest rates associated with investing in a fixed income instrument. The risk is associated with either a flattening or steepening of the yield curve, which is a result of changing yields among comparable bonds with different maturities.
When market yields change, this will impact the price of a fixed-income instrument. When market interest rates, or yields, increase, the price of a bond will decrease and vice versa.
Explaining ‘Yield Curve Risk’
When the yield curve shifts, the price of the bond, which was initially priced based on the initial yield curve, will change in price. If the yield curve flattens, then the yield spread between long- and short-term interest rates narrows, and the price of the bond will change accordingly. If the bond is a short-term bond maturing in three years and the three-year yield decreases, the price of this bond will increase.
If the yield curve steepens, this means that the spread between long- and short-term interest rates increases. Therefore, long-term bond prices will decrease relative to short-term bonds. Changes in the yield curve are based on bond risk premiums and expectations of future interest rates.
Further Reading
- Yield curve risk factors: domestic and global contexts – books.google.com [PDF]
- Alternative models for hedging yield curve risk: An empirical comparison – www.sciencedirect.com [PDF]
- Decomposing the yield curve – papers.ssrn.com [PDF]
- How to read the future: the yield curve, affect, and financial prediction – read.dukeupress.edu [PDF]
- Yield curve risk in Japanese government bond markets – onlinelibrary.wiley.com [PDF]
- What does the yield curve tell us about exchange rate predictability? – www.mitpressjournals.org [PDF]
- The TIPS yield curve and inflation compensation – www.aeaweb.org [PDF]
- Some lessons from the yield curve – www.aeaweb.org [PDF]
- A three-factor yield curve model: non-affine structure, systematic risk sources, and generalized duration – papers.ssrn.com [PDF]
- Yield curve predictors of foreign exchange returns – papers.ssrn.com [PDF]
