Question

Please mark the only INCORRECT sentence about the term structure of interest rates (the yield curve)

	a.	If there is no liquidity risk premium and traders expect the Fed to keep Fed Funds unchanged for years to come, then the yield curve is likely to be flat
	b.	A zero coupon bond is equal to the sum of several coupon bonds of the same yield and the same maturity
	c.	If traders expect that the US economy will start growing quickly in 2021, raising employment, wages and inflation, then they would expect the yield curve to steepen
	d.	A downward sloping yield curve is a market indicator of a recession, because traders are pricing that it will require the Fed to cut interest rates vigorously in coming years.

Answer 1

Only sentence b) is incorrect i.e. Value of zero coupon bonds will not be equal to value of several coupon paying bonds with same yield and same maturity. The par value might be different and plays an important role in bond valuation.

sentence a. is correct i.e. If there is no liquidity risk premium and traders expect the Fed to keep Fed Funds unchanged for years to come, then the yield curve is likely to be flat. This is because no liquidity risk premium will make the longer duration interest rates almost similar to shorter duration interest rates.

Option c. is correct since raising employment and improving economic conditions result in steepening of yield curve.

Option d is correct since downward sloping yield curve indicates that short term rates are higher than long term rates which is a well known market indicator of recession.