Yield Curves and Interest rate theory

Question 1

Why interest rates flucturate

Answer 1

Due to the term structure of interest rates e.g. the way in which the yield (return) curve varies over time

Question 2

Normal Yield Curve

Answer 2

Upward Sloping / = GRD on longer term to maturity is higher to compensate typing up capital for a longer period. Not steep. Interest rates not expected to rise, or rise gradually

Question 3

Inverse Yield Curve

Answer 3

Downward Sloping / = Expected with current high interest rates due to fall - indicator of recession. Yield lower on instruments with longer-term to maturity

Question 4

Steep Upward Yield Curve

Answer 4

Interest rates expected to rise. Longer-term = higher yield

Question 5

Reasons for Yield Curves:
Liquidity preference theory - Normal yield

Answer 5

Investors naturally want to hold cash even compared to low risk investments, therefore, higher yields must be offered to compensate for the loss of capital

Question 6

Reasons for Yield Curves:
Expectations theory - Steep or downward steep

Answer 6

Varies according to the expectations of future interest rates.
More demand for short-term as investors know they can still get high returns in the future and don’t need to tie up capital.

Price of short-term assets goes up, yield on short term falls
Price of long-term assets fall, yield on long-term goes up

Question 7

Market segmentation theory

Answer 7

Supply and demand forces. Investors are assumed to be risk averse e.g. Banks - short term, Pension funds - long term. Explains the wiggle where the two meet