Chapter 12: Bond yield curve

Question 1

What does the yield curve represent?

Answer 1

How bond yields vary with term to redemption

Question 2

Name and explain the four theories of the yield curve

LIME

Answer 2

1. Liquidity preference theory
   * Investors prefer liquid assets to illiquid ones. Long-dated stocks are less liquid than short-dated stocks.
   * Therefore, investors require a liquidity risk premium to compensate them for investing in longer-dated stocks
   * The yield curve should be more upwards sloping (or less downwards sloping than of the expectation theory alone
2. Inflation risk premium theory
   * Yield curve will slope upwards or be less downwards sloping because investors need a higher yield to compensate them for holding longer-dated stocks which are more vulnerable to inflation risk than short-dated stocks
3. Market segmentation theory
   * Yields at each term to redemption are determined by supply and demand from investors with liabilities of than term
   * Banks and GI influence demand for short-term bonds
   * Pension funds and LI influence demand for long-term bonds
4. Expectation theory
   * Describes the shape of the yield curve being determined by economic factors, which drive the market’s expectation for future short-term interest rates. * The government uses the short-term interest to influence inflation.
   * If short-term interest rates are expected to increase, the yield curve will be upwards sloping

Question 3

Factors influencing the yield curve

Answer 3

1. Inflation
2. ST interest rates
3. Exchange rates
4. Fiscal deficit
5. Returns on alternative investments
6. Institutional cashflows
7. Other economic factors (e.g., credit worthiness downgrading)
8. Overseas bonds