Question

Please respond to the following:

Review the valuation principle and how it helps a financial manager make decisions. In the early 1980s, inflation was in the double digits and the yield curve sloped sharply downward. What did this yield curve suggest about the financial manager’s / investor’s expectations about future rates? Explain how a downward sloping yield curve affects the prices of existing long-term bonds and stocks trading in the secondary market, assuming this change in the yield curve is the only change that occurs. Would you characterize the change in the yield curve as a systematic or unsystematic risk?

Answer 1

The era of early 1980s was an era of one of the highest interest rates in the US economy, as the rates hit double digits in response to double digit inflation in the economy. Let's look at the meaning of upward and downward sloping yield curves:

• Upward sloping yield curve: Generally the inflation is caused by a booming economy with high growth rates in the economy such that the demand and consumption shoots up and central banks raise interest rates to control high inflation. This is what an upward sloping yield curve represents, that economy is expected to grow in future and that central banks would raise interest rates to counter the inflationary pressures.
• Downward sloping yield curves: On the opposite, a downward sloping yield curve represents expectations of lower GDP growth in the future resulting in decreased interest rates to stimulate the economy

1) Based on above explanations, it can be said that a downward sloping yield curve represents investor's expectations that interest rates will go down in the future

2) The downward sloping yield curve has similar impacts on the prices of long-term bonds and stocks. Let's take a look at both

• Impact on long term bonds prices is positive because bond prices go up in anticipation of fall in interest rates. Bonds are valued based on their yields which are benchmarked to interest rates. When interest rates fall, bond prices go up to adjust their yields downwards in line with reduced interest rates. Therefore, a downward sloping curve has a bullish impact on long-term bond prices
• Impact on stock prices is also bullish. Stocks, as an asset class, are valued relative to the risk free rate in the economy. So, expected earnings yield/dividend yield/cash flow yields from stocks are benchmarked to the prevailing interest rates as adjusted for their risk profiles. Therefore, when interest rates go down, the stock prices go up to adjust their yields downwards in line with reduced interest rates. Therefore, a downward sloping yield curve is bullish for existing stock prices as it represents that if it holds true and interest rates go down, the stock prices will go up

3) Change in yield curve would be classified as a systematic risk as changes in expectations of future interest rates (resulting in change in yield curve) impact the valuation of all assets in the economy and will thus impact the economy / market as a whole