Question

Using your own example over a period of eleven (11) years construct a downward sloping yield curve. Explain the shape of your yield curve using expectations theory. (5 Points)

Answer 1

Year Yield

As per above data for 11 years we have created a downward sloping yield curve.

Here we have shown that the long-term bond yields are lower than the short-term bonds. Since price is a decreasing function of yield, an interpretation is that long-term bonds are more expensive than short-term bonds. It is possible that investors believe that they will get a higher overall return from long-term bonds, despite the lower current yields, and the higher demand for long-term bonds has pushed up the price, which is equivalent to pushing down the yield, compared with short-term bonds.

As per Expectation Theory:

An expectation of a fall in interest rates makes short term investments less attractive and longer-term investments more attractive. In these circumstances yields on short-term investments rises and yields on long-term investments fall. An expectation of a rise in interest rates have the converse effect.

In the above case it seems that the demand for long-term bonds may be greater than for short term bonds, implying an expectation that interest rates will fall. By buying long-term bonds investors can continue getting higher rates after a future fall in interest rates, for the duration of the long bond.