YIELD CURVE (Encyclopedia)

The term structure of interest rates is a function that links interest rates on specific assets to their maturity. In order to define this term structure, the market usually considers government bonds issued by highly rated countries, because of their low default risk: in this way, we focus specifically on the relation between rates and different maturities. Another way to compute the term structure is via the swap market (i.e., by using swap rates adopted by major banks in the inter-banking market, which implies a AA rating).
Actually, “yield curve” is the name attributed to a graph that describes the yield of bonds of the same quality but for different maturities (i.e., US government bonds that mature in the next 30 years).
Graphically, interest rates are on the y-axis, whereas maturities appear on the x-axis.
Short-term rates reflect the expectation of investors over a short-term horizon. When they go down, it means that investors prefer to be liquid and safe. 
Long-term rates reflect, instead, the expectation of investors over a long-term horizon. When they go up, it means that investors are worried about inflation and long-term uncertainty.
We distinguish between three different shapes of the yield curve:
1. normal yield curve: in a quiet world, all the rate curves would appear like the following one approximately. Bonds with short maturity would be linked to lower rates because of their lower risk (since life to maturity is lower). Higher rates correspond to higher maturities (uncertainty increases because of inflation risk, etc.): investors receive a premium for the higher risk they bear (hence, a higher rate).

2. flat yield curve: in this case, investors get approximately the same rate if they buy short-term, medium-term or long-term bonds. With a flat yield curve, it would be better to buy short-term bonds since you do not receive a premium corresponding to higher rates if you buy longer bonds.

3. inverted yield curve: in this case, short-term bonds have higher yields than the longer ones. It is a less frequent scenario and sometimes it tells us that a relevant economic change is going to happen (e.g., depression). At first sight, we should be interested in buying only short-term bonds if this scenario takes place. But, in general, an inverted yield curve changes its shape very quickly, turning back to a normal yield curve, and you could miss the chance to lock a high yield linked to longer maturities. For instance, in the 1980s, we had an inverted yield curve and very high rates for all the maturities. Given the shape of the curve, risk-averse investors overbought 6-month deposit certificates missing the chance to lock a long-term yield of 15% related to long-term treasury bonds.

Hull, J. C., "Options, futures and other derivatives" 7th edition, Prentice Hall, 2008 
Fabozzi, F. J., "Bond markets, analysis and strategies", 2004, Pearson Education 
Baxter, M., Rennie, A., "Financial Calculus: An Introduction to Derivative Pricing", Cambridge University Press, 2006
Editor: Ugo TRENTA