Question

In: Finance

Yield curve, by defination, is the plot of relationship between bond yields and maturity. 1) What...

Yield curve, by defination, is the plot of relationship between bond yields and maturity.

1) What is the common shape of yield curve? (Hint: Is it upward sloping or downward sloping?)

2) Explain why it is shaped the way you describe in 1)? (Hint: specify the risk associated with the yield curve)

3) What is inverted yield curve? Please explain why it shapes like that.

4) What is the implication of inverted yield curve? So basically what can we learn once inverted yield curve is identifed.

Solutions

Expert Solution

1. The common shape of yield curve age upward sloping because in general the long-term bond yields are greater than short term bond yields.this is because the duration of long term bonds are higher and the risk associated with long term bonds are also higher.

2. The yield curve is upward sloping because there is higher level of risk related to investment in long term bonds so investors demands a greater yield as there is is higher level of risk involved with investment in long term bonds and there is lower risk involved with investment into short term bonds.the duration of long term bonds are higher and the duration of short term bonds are lower

3. An inverted yield curve in which the yields of short term bonds are higher than yields of long term bonds this is because investors are expecting adverse economic situations in future and do not expect much of return on longer time frame.

4. An inverted yield curve is taken as warning sign for an impending recession because when investors expect no return in the longer time frame then the yield of the long term bonds goes below the rates of the short term bonds.


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