Answer the following, a. If expectations of future short-term interest rates suddenly increased, what would happen...

Answer the following,

a. If expectations of future short-term interest rates suddenly increased, what would happen to the slope of the yield curve?

b. In the last 10 years, inflation and interest rates have become less volatile, what would you expect to see happen to the slope of the yield curve? In the space below draw, the yield curve showing how it will change.

Solutions

Expert Solution

Hi,

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Question:

Answer:

a). Answer:

Yield:

Yield is the return or annual net profit an investor realize on the bond.

Yield = Coupon rate/Bond price

Coupon rate is constant during the term of the bond but yield is flexible in nature and change with the price of the bond. When price of bond increase yield decrease and vice versa. Bond price is directly affected by the interest rate and move in opposite direction. When interest rate rise then demand of existing bond decrease that decrease the price of bond and increase yield and vice versa.

Yield Curve:

A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. There are there type of yield curve: normal, inverted and flat.

Normal Yield Curve: It is a normal curve that is normally shows in the boom phase of the economy or economy grow in positive direction. Its indicate that yield on long term bond is higher than short term bond because of higher interest rate (increasing interest rate) risk.

Inverted Yield Curve: It is opposite of normal yield curve and showing in recession phase.

Flat Yield Curve: When there is no no or little gap between yield of long and short term bond.

If expectations of future short-term interest rates suddenly increased then it will decrease the price of existing short term bond and the increase yield resulting in a downward sloping yield curve.

b). Answer:

In the last 10 years, inflation and interest rates have become less volatile it means economy is in right direction and have stable growth. We have seen above that the interest rate and price move in opposite direction and price and yield also move in opposite direction. Here there is now big movement in interest and inflation so, central bank will not change interest rate further. So, yield curve will more Flattening than the previous curve.

Thank You

Rahul Sunny answered 1 year ago

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