What do you understand by yield curve and by the term structure of interest rates?

What do you understand by yield curve and by the term structure of interest rates? 

Ans. In finance, the yield curve is a curve showing several yields or interest rates across different contract lengths (2 month, 2 year, 20 year, etc...) for a similar debt contract. Yield Curve (Term Structure of Interest Rates): A plot of the interest rates of Treasury Bills and Treasury Bonds versus their maturities at a point in time. 

         Term (years)                               Interest Rate (%)

           0.25                                            3.62 

           2.00                                             4.34 

           5.00                                             5.07 

       10.00                                               5.54 

       30.00                                               5.86 

It can be upward sloping or downward sloping. 

Upward Sloping (Term  i) -- usual case. 

Downward Sloping (or Inverted) Yield Curve (Term  i) -- occurs periodically 

The curve shows the relation between the (level of) interest rate (or cost of borrowing) and the time to maturity, known as the “term”, of the debt for a given borrower in a given currency. Interest paid on some securities for various maturities are closely watched by many traders, and are commonly plotted on a graph such as the one on the right which is informally called “the yield curve.” More formal mathematical descriptions of this relation are often called the term structure of interest rates. 

The yield of a debt instrument is the overall rate of return available on the investment. In general the percentage per year that can be earned is dependent on the length of time that the money is invested. For example, a bank may offer a “savings rate” higher than the normal checking account rate if the customer is prepared to leave money untouched for five years. Investing for a period of time t gives a yield Y(t).

 

This function Y is called the yield curve, and it is often, but not always, an increasing function of t. Yield curves are used by fixed income analysts, who analyze bonds and related securities, to understand conditions in financial markets and to seek trading opportunities. Economists use the curves to understand economic conditions. 

The yield curve function Y is actually only known with certainty for a few specific maturity dates, while the other maturities are calculated by interpolation.