Question
Define yield curve. How is it constructed? How does interest rate risk influence the yield curve?
Answer :
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A yield curve is a graphical representation that shows the relationship between the interest rates (or yields) of debt securities and their maturities at a specific point in time. It is an essential tool in international business finance because it reflects market expectations about future interest rates, inflation, and economic activity. Typically, the yield curve plots government securities, such as Treasury bonds or bills, on the vertical axis with the yield and on the horizontal axis with the time to maturity. It is widely used by investors, policymakers, and corporate finance managers to make informed decisions regarding borrowing, lending, and investment strategies. The construction of a yield curve begins with the collection of market data for debt instruments with varying maturities, typically from short-term instruments like Treasury bills to long-term bonds. Each instrument’s yield, often represented as the yield to maturity, is determined based on its current market price and expected cash flows. These yields are then plotted against their respective maturities to form the curve. There
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