Certified Financial Management Specialist Practice Exam

What relationship does a yield curve illustrate in general?

1. The correlation between stock prices and interest rates

2. The correlation between economic growth and inflation

3. The relationship between interest rates and time to maturity

4. The relationship between savings rates and investment rates

The correct answer is: The relationship between interest rates and time to maturity

A yield curve illustrates the relationship between interest rates and the time to maturity for a set of bonds with similar credit quality. Typically, the yield curve shows how yields on bonds vary with different maturities, reflecting investor expectations about future interest rates, inflation, and economic conditions. When plotted, the curve usually slopes upward, indicating that longer-term bonds typically offer higher yields than shorter-term bonds. This is primarily due to the increased risk and uncertainty associated with holding bonds over a longer period. Investors require a higher yield for tying up their capital for an extended time, which compensates them for the risks of inflation, interest rate changes, and other economic factors over that period. Understanding the shape and shifts in the yield curve can provide insights into market sentiment regarding future economic activity, as an inverted yield curve, for example, may signal an upcoming recession, while a steep curve may indicate an expectation of robust economic growth. Thus, the yield curve is a critical tool for both investors and economists in assessing the financial landscape.