Question

In: Finance

Suppose an investor observes a downward term structure of interest rate.   According to the expectation hypothesis,...

  1. Suppose an investor observes a downward term structure of interest rate.  
    1. According to the expectation hypothesis, what will be the investor’s forecast about future change of interest rate (increase, decrease or unchanged)? Explain your argument. (10 marks).

Solutions

Expert Solution

When the investor will be observing the downward structure of the interest rate, it will mean that there will be an expectation of decrease in the future interest rate as he will be expecting long term interest rate in future to be lower than the the expectations and there will be lower growth in the economy.

As per the expectations theory, when there will be a downward term structure of interest rate, it will be a reflection of impending reception as it will be reflecting that the long-term interest rates are going to be lower at per the lower growth and it is reflecting that the expectation of investor is negative about the growth of the economy and the growth of the company, so there will be a lower expectation of higher interest rate in future and it will mean that the yield curve will be sloping downwards and the interest rate of future is going to decrease because there is a clear downward Yield curve which is reflected and it is expected that long-term interest rate are going to be lower as per the expectation of the investor.

Whenever there is a downward Yield curve, it will mean that investor age expecting the long-term growth of the economy to be downside and hence the rate of interest of the long-term will be lower and hence it can be said that the future projection of the investor about the interest rate is decreasing.


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