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Forces that shape the yield curve: Parts 1 and 2

Listed author(s):
  • Mark Fisher

The yield curve is shaped by (1) expectations of the future path of short-term interest rates and (2) uncertainty about the path. Uncertainty affects the yield curve through two channels: (1) investors’ attitudes toward risk as reflected in risk premia, and (2) the nonlinear relation between yields and bond prices (known as convexity). The way in which these forces simultaneously work to shape the yield curve can be understood in terms of the conditions that guarantee the absence of arbitrage opportunities. ; The purpose of this paper is to provide an introduction to the modern theory of the term structure of interest rates using high-school algebra. In order to present the theory correctly, one must take uncertainty seriously. Nevertheless, the source of uncertainty can be modeled quite simply: All uncertainty is resolved by a single flip of a coin. In this setting, the author can rigorously present all three forces that shape the yield curve: expectations, risk aversion, and convexity. The analysis is organized around the conditions that guarantee the absence of arbitrage opportunities.

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Paper provided by Federal Reserve Bank of Atlanta in its series FRB Atlanta Working Paper with number 2001-3.

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Date of creation: 2001
Handle: RePEc:fip:fedawp:2001-3
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  1. Mark Fisher & Christian Gilles, 1998. "Around and Around: The Expectations Hypothesis," Journal of Finance, American Finance Association, vol. 53(1), pages 365-383, February.
  2. Mark Fisher, 2001. "Forces that shape the yield curve," Economic Review, Federal Reserve Bank of Atlanta, issue Q1, pages 1-15.
  3. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
  4. Dybvig, Philip H & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1996. "Long Forward and Zero-Coupon Rates Can Never Fall," The Journal of Business, University of Chicago Press, vol. 69(1), pages 1-25, January.
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