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yield curve - maturity to yield

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LOS c, (Part 2): Describe the implications of each theory for the shape of the yield curve.fficeffice" />

Q1. Generally speaking, an upward-sloping yield curve can be expected when:

A)   the supply of long-term funds falls short of demand and investors begin to show a preference for more liquid/less risky short-term securities.

B)   the supply of long-term funds falls short of demand.

C)   inflationary expectations are beginning to subside and investors begin to show a preference for more liquid/less risky short-term securities.

Correct answer is A)

When demand for loanable funds outstrips supply, interest rates can be expected to rise in that (long-term) segment of the market; also, more preference for short-term securities can be expected to drive up long-term rates as the liquidity premium rises. Thus, both circumstances in the answer can be expected to put upward pressure on the long end of the yield curve.

 

Q2. The liquidity preference theory of the term structure of interest rates implies that the shape of the yield curve should be:

A)   variable.

B)   upward-sloping.

C)   flat or humped.

Correct answer is B)

The liquidity preference theory definitely puts upward pressure on the long end of the term structure and, by itself, would lead to an upward-sloping yield curve.

 

Q3. If the slope of the yield curve begins to rise sharply, it is usually an indication that:

A)   stocks are offering abnormally high rates of return.

B)   the rate of inflation is starting to increase or is expected to do so in the near future.

C)   the Fed has been aggressively driving up short-term interest rates.

Correct answer is B)

According to the expectations hypothesis, higher long-term interest rates and, therefore, upward-sloping yield curves will occur if the rate of inflation starts to heat up or is expected to do so in the near future.