Question

In: Finance

Which of the following is most likely to be TRUE about a downward sloping yield curve?...

Which of the following is most likely to be TRUE about a downward sloping yield curve?

It indicates that bond values are likely to fall in the future

It indicates that demand for long-term bonds is currently higher than demand for short-term bonds

It indicates that yields are currently relatively low

It indicates that inflation is likely to increase in the future

Solutions

Expert Solution

True Statement is: It indicates that demand for long-term bonds is currently higher than demand for short-term bonds.

Let us solve this question by eliminating the wrong answers and before we start, this is how inverted yield curve looks like:

Option 1. It indicates that bond values are likely to fall in the future. A inverted yield curve means interest rate will fall in future. Interest rates are inversely related to price of bond. So, when interest rates fall, prices will rise. Hence Option A is ruled out.

Option 3. It indicates that yields are currently relatively low. This can be ruled out while looking at the graph. You see the yield is lower at the longer maturity end.

Option 4. When interest rates are falling, this means there in no inflation. When there is normal inflation, yield curve would be upward sloping. Inflation demands hiking of interest rate (and not falling). hence eliminated.

Option B is correct. You can understand this from a demand supply fundamental as well. Higher demand for long-term bonds would mean higher prices (higher demand - higher price, lower demand - lower price). And as previously mentioned, interest rates are inversely proportional to price of bond. If price of bond is higher, yields would be lower. And that is the case presented to us.


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