Yield curve construction itself requires some formidable mathematics and is outside the scope of this book; we consider here the basic techniques only. An issuer of a bond is more likely to exercise a call option on the bond after. Upward sloping yield curves are a natural extension of the higher risks associated with long maturities. When the yield curve is upward sloping, which is the majority of the time, long-term rates are higher than short-term rates, due to the increased inflation risk of longer maturities. Most consumers prefer to pay lower prices for the goods and services they want. When the economy is expanding, investors risk a rise in yields as the Fed increases interest rates in response to rising inflationary pressures. During a recession, investors should stay away from high yield bonds (HYG), as the credit risk associated with these bonds is generally higher during a recession. Why might this observation be true? c. yields by maturity of securities with similar default risk. Under the preferred habitat theory of interest rates, b. the long term spot rate is an average of the current and expected future short term interest rates, 15.A two-year interest rate is 7% and a one-year forward rate one year from now is. In normal conditions, the yield curve is upward-sloping. Suppose a firm wants to take advantage of an upward-sloping yield curve. If the firm believes that interest rates will stay constant and it wants to use the current yield curve to bolster profits, which approach should the firm follow? An investor earned 12 percent last year, a year when actual inflation. The longer time to recover the principal leads to a higher risk to bondholders, as the bonds become more susceptible to interest rate changes than shorter-term bonds. Why does the "premium" represent the "expected default loss rate"? With reference to the data above, of the ones given below, which security did the market view as having the greatest default risk? There are two common explanations for upward sloping yield curves. Since investors are concerned with the after-tax yield earned, they will bid up the prices (lower the yields) of municipal bonds compared to corporate bonds. First, it may be that the market is anticipating a rise in the risk-free rate. The default risk premium, the difference between a risky security and a U.S. Treasury security of similar term, is the investors' expected default loss rate on a portfolio of similarly rated securities. Then for this question (4.18) : “When the zero curve is upward sloping, the zero rate for a particular maturity is greater than the par yield for that maturity. There are three basic shapes the yield curve can take, each with different implications regarding economic growth. Commercial banks, savings and loan associations, and finance companies traditionally have better profits when, 18. As a consequence, the suppliers hire fewer workers and produce a smaller quantity of good… D) why yield curves have been used to forecast business cycles. As bonds pay only interest (the coupon) until maturity and pay face value at maturity, investors take longer to recover their principal. Default risk premiums narrow with growth and expansion of the economy and widen duringrecessions because many more borrowers default on their debt during recessions. The steeper the curve is, the impression is that the economy is normal and not in a recession like a scenario anytime soon. Default risk premiums vary _______ with the ________ of the security. B. long-maturity bonds are priced above par value. B. humped. B. become flat. A downward- sloping, or “inverted,” yield curve is often thought to signal a future recession. 17. Assume that annualized yields of short-term and long-term securities are equal. Define the term default risk premium. D. be unaffected. Select one: A. become inverted. An upward-sloping yield curve supports the liquidity premium theory. As an upward-sloping yield curve is normal, the arbitrage opportunities it offers are limited. If investors suddenly believe interest rates will increase, their actions may cause the yield curve to. This is reflected in the normal yield curve, which slopes upward from left to right on the graph as maturities lengthen and yields rise. An upward-sloping labor supply curve represents a case in which the substitution effect of higher wages outweighs the income effect. B) why interest rates on bonds of different maturities tend to move together. C) why yield curves tend to slope upward when short-term interest rates are low and to be inverted when short-term interest rates are high. D. long-maturity bonds increase in price when interest rates increase. We'll explore these below and then take a look at the what the current yield curve is saying. The so-called "law of demand" in economics recognizes this, holding that higher prices reduce demand for a good, and vice versa, other factors being equal. b. The yields of longer-maturity bonds tend to be higher than the yields of shorter-maturity bonds since the longer maturity bonds are riskier. Bodie - Chapter 15 #12 Difficulty: Easy Can the Demand Curve Ever Be Upward Sloping?. In this basic competitive model, the real wage adjusts in labor markets to balance supply and demand. Default risk premiums are usually smaller during periods of high economic growth. Yield curves are usually upward sloping asymptotically: the longer the maturity, the higher the yield, with diminishing marginal increases (that is, as one moves to the right, the curve flattens out).. A yield curve is typically upward sloping; as the time to maturity increases, so does the associated interest rate. This means the marginal product will equal the real wage. A. normal. The reason for that is that debt issued for a longer term generally carries greater risk because of the greater likelihood of inflation or default in the long run. 14. The term structure of interest rates refers to the relationship between the yields and maturities of a set of bonds with the same credit rating. For the first question, the answer is true. 1. Note also that the steeper the slope of a yield curve, the faster interest rates rise as maturity lengthens. If 1-year Treasury bills have a yield to maturity of 7 percent, and 2-year Treasury bills have a yield to maturity of 8 percent, this implies the market believes that 1-year rates will be 7.5 percent one year from now. 12. The Fed has maintained an extremely low short-term interest rate regimen since 2008 to boost consumption, investments, and economic growth. An upward slope yield curve indicates that the economy may normally be functioning. Upward sloping yield curves are a natural extension of the higher risks associated with long maturities. Yield curves are usually upward sloping asymptotically: the longer the maturity, the higher the yield, with diminishing marginal increases (that is, as one moves to the right, the curve flattens out).. Investors will require a lower yield on bond __ and will pay ____ for the bond. d. Interest rate (price) risk is higher on short-term bonds, but reinvestment rate risk is higher on long-term bonds. Assume that annualized yields of short-term and long-term securities are equal. Why does the curve indicate the position of the economy? Yield curves generally slope upward. Explain how the term structure of interest ratescan be used to help forecast future interest rates. 13. Solution for An upward sloping yield curve is a(n) _____ yield curve. Which of the following statements explains the liquidity premium theory of the term structure of interest rates? List the five basic factors which explain the differences in interest rates on different securities at any point in time. With reference to the above data, at what marginal tax rate would an investor be indifferent between owning the corporate bond and the municipal bond? According to the expectations theory, long-term yields are geometric averages of current and expected short-term rates. If you take a 2-year bank loan, you would have to pay a lower rate of interest than a 5-year loan, which would be lesser than that of a 10-year loan. It cannot explain the usual upward slope of the yield curve. Because the curve can summarize where investors think interest rates are headed in the future, it can indicate their expectations for the economy. 10. Question 47. How a Parallel Shift in the Yield Curve Works . The slope of the yield curve has proven to be a good forecaster of economic growth. A. humped B. inverted C. normal D. flat E. None of the options are correct. If interest rates are expected to increase in the future, one would expect to see an upward sloping yield curve. As an upward-sloping yield curve is normal, the arbitrage opportunities it offers are limited. The normal upward-sloping yield curve follows the “Liquidity Preference Theory,” which suggests that investors wish to be compensated for holding longer-term securities. Interested readers who wish to study the topic further may wish to refer to the author’s book Analysing and Interpreting the Yield Curve. A) why yield curves usually tend to slope upward. If investors suddenly believe interest rates will increase, their actions may cause the yield curve to. Six (6) months ago, the yield curve exhibited a slight downward slope. An upward sloping yield curve is a(n) _____ yield curve. 11. Explain how the term structure of interest ratescan be used to help forecast future interest rates. 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