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Chapter 6: Q. 16 (page 188)

If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market鈥檚 predictions for the inflation rate in the future?

Short Answer

Expert verified

The yield of a bond, interest rate, and inflation rate always move together in the same direction. It implies that whenever the inflation rate rises, the interest rate also rises consequently.

Step by step solution

01

Step 1:Definition

The yield curve shows the different interest rates of bonds with equal credit quality but different maturity dates.

02

Explanation

Both the interest rates and the expected inflation rates are moved together. But, both of these two inflation rate and interest rates on bond moves in the opposite direction with the bond price. Since in this case it is found that the expected interest rate is going to rise in the future, so expected inflation rate also will rise. The yield curve recommends that the market assumes that inflation declines moderately in the upcoming future but increases in the later period.

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Most popular questions from this chapter

In 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond market graphs, compare the effects on the risk premium between U.S. Treasury debt and comparable-maturity Greek debt.

Figure 7 shows a number of yield curves at various points in time. Go to http://www.bloomberg.com/ markets/rates/index.html and find the data for U.S. Treasury yields for different maturities. Does the current yield curve fall above or below the most recent one listed in Figure 7? Is the current yield curve flatter or steeper than the most recent one reported in Figure 7?

If the yield curve suddenly became steeper, how would you revise your predictions of interest rates in the future?

Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to four years, and plot the resulting yield curves for the following paths of one-year interest rates over the next four years:

a. 4%, 6%, 11%, 15%

b. 3%, 5%, 13%, 15%

How would your yield curves change if people preferred shorter-term bonds to longer-term bonds?

Prior to 2008, mortgage lenders required a house inspection to assess a home鈥檚 value and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in 2008, mortgage lenders required a house inspection, but this inspection was arranged through a third party. How does the pre-2008 scenario illustrate a conflict of interest similar to the role that credit-rating agencies played in the global financial crisis?

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