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Chapter 6: Q. 17 (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’s predictions for the inflation rate in the future?

Short Answer

Expert verified

In the future as the interest rate rises, the expected inflation rate also may rise, and eventually, as the interest rate falls, the inflation rate is also expected to fall.

Step by step solution

01

Definition

Yield to maturity (YTM) is the total rate of return earned by a bond after it has made all interest payments and repaid the original principal.

02

Explanation

In the figure above, the yield curve initially moves upward and after a while starts falling down. The upward trend of the yield curve indicates that the predicted short-term interest rate will climb moderately in the near future. Also, the next downward section of this curve implies that in the future the short-term interest rate is expected to fall sharply.

We know that the interest rate and inflation rate move together in the same direction. As a result, in the near future, as the interest rate rises, the expected inflation rate also may rise. After some time as the interest rate falls, the inflation rate is also expected to fall.

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Most popular questions from this chapter

Which should have the higher risk premium on its interest rates, a corporate bond with a Moody’s Baa rating or a corporate bond with a C rating? Why?

Go to the St. Louis Federal Reserve FRED database, and find data on Moody’s Aaa corporate bond yield (AAA) and Moody’s Baa corporate bond yield (BAA). Download the data into a spreadsheet.

a. Calculate the spread (difference) between the Baa and Aaa corporate bond yields for the most recent month of data available. What does this difference represent?

b. Calculate the spread again, for the same month but one year prior, and compare the result to your answer to part (a). What do your answers say about how the risk premium has changed over the past year?

c. Identify the month of highest and lowest spreads since the beginning of the year 2000. How do these spreads compare to the most current spread data available? Interpret the results.

Predict what would happen to the risk premiums of municipal bonds if the federal government guarantees today that it will pay creditors if municipal governments default on their payments. Do you think that it will then make sense for municipal bonds to be exempt from income taxes?

Suppose the interest rates on one-, five-, and ten-year U.S. Treasury bonds are currently 3%,6%and 6%respectively. Investor A chooses to hold only one-year bonds, and Investor B is indifferent with regard to holding five- and ten-year bonds. How can you explain the behavior of Investors A and B?

The amount of additional interest investors receive due to various risk premiums changes over time. Sometimes risk premiums are much larger than at other times. For example, the default risk premium was very small in the late 1990s when the economy was so healthy that business failures were rare. This risk premium increases during recessions

Go to http://www.federalreserve.gov/releases/h15 (historical data), and find the following three interest rate listings for AAA- and Baa-rated bonds: the most current listing; the listing for January 5, 2018; and the listings for June 1, 2008, and June 1, 2007. Prepare a http://www.federalreserve.gov/Releases/h15/update/ The Federal Reserve reports the yields on different-maturity U.S. Treasury bonds. graph that shows the interest rate information for these bonds over these three time periods (see Figure 1 for an example). Are the risk premiums stable, or do they change over time?
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