13. 16. Define the term default risk premium. In normal conditions, the yield curve is upward-sloping. If three-year securities are yielding 6% and two-year securities are yielding 5.5%, future short-term rates are expected to ______, and outstanding security prices are expected to ______. Default risk premiums narrow with growth and expansion of the economy and widen duringrecessions because many more borrowers default on their debt during recessions. Most consumers prefer to pay lower prices for the goods and services they want. b. institutions choose investment maturities to match their liability maturities. 19. View this answer. If the investor in a portfolio of similarly rated securities lost the default risk premium every year, the realized yield would equal an investment return on a similar term U.S. Treasury security. A. short-maturity bonds offer high coupon rates. This is the how the yield curve normally looks, it has been referred to as the ‘normal yield curve’. 17. As an upward-sloping yield curve is normal, the arbitrage opportunities it offers are limited. E. none of the above. When the zero curve is downward sloping … With reference to the above data, at what marginal tax rate would an investor be indifferent between owning the corporate bond and the municipal bond? Monitoring Yield Curve Adjustments As an analyst of a bond rating agency, you have been asked to interpret the implications of the recent shift in the yield curve. The market segmentation theory assumes that investors are risk-neutral. Explain how and why default risk premiums vary over the business cycle. Question text Default risk premiums are usually smaller during periods of high economic growth. D. be unaffected. Question 2 What must be the annual coupon rate for a $1000 face value bond with four years until maturity, a price of $983.44, and a yield to maturity of 8%? AN UPWARD sloping yield curve was maintained throughout the year despite the further reductions in yields sustained by the Government of Ghana's money market instruments. Upward sloping yield curves are a natural extension of the higher risks associated with long maturities. c. yields by maturity of securities with similar default risk. The term structure of interest rates refers to the relationship between the yields and maturities of a set of bonds with the same credit rating. The Fed has maintained an extremely low short-term interest rate regimen since 2008 to boost consumption, investments, and economic growth. A graph of the term structure of interest rates is known as a yield curve.For example, the following table shows the term structure of interest rates for Treasury securities as of J… If the firm believes that interest rates will stay constant and it wants to use the current yield curve to bolster profits, which approach should the firm follow? The yield on a 5-year corporate bond should always exceed the yield on a 3-year Treasury bond. Yield curves generally slope upward. The normal yield curve is a yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. Upward sloping yield curves are a natural extension of the higher risks associated with long maturities. Since investors are concerned with the after-tax yield earned, they will bid up the prices (lower the yields) of municipal bonds compared to corporate bonds. If interest rates are expected to increase in the future, one would expect to see an upward sloping yield curve. The upward sloping yield curve is referred to as the normal yield curve, probably because, historically, the upward sloping yield curve is the shape that has been observed most frequently. Default risk premiums vary _______ with the ________ of the security. b. Yield curves are usually upward sloping, but short-term interest rates are as likely to fall as to rise. During a recession, investors should stay away from high yield bonds (HYG), as the credit risk associated with these bonds is generally higher during a recession. If the 1-year rate today is at 1%, and the 2-year rate is 2% then the one-year rate after one year (1yr forward rate) is around 3% [1.02^2/1.01^1]. It cannot explain the usual upward slope of the yield curve. According to the expectations theory of the term structure of interest rates, if the yield curve slopes _______, the markets expect short-term interest rates to _______ in the future. An investor earned 12 percent last year, a year when actual inflation. According to the expectations theory, long-term yields are geometric averages of current and expected short-term rates. That means when the price level falls, most firms cannot adjust wages immediately, which leads to an increase in real production costs. Which of the following statements explains the liquidity premium theory of the term structure of interest rates? Over the past six (6) months, long-term yields declined while short-term yields remained the same. Treasury and corporate security yields are often combined on the same yield curve. Parallel shifts are the most common during these normal yield curves. Expectation theory which says that long term interest rates should reflect expected future short-term rates. b. While short-term rates are low, yields are exhibiting an increasing trend with maturity. The demand curve … The longer time to recover the principal leads to a higher risk to bondholders, as the bonds become more susceptible to interest rate changes than shorter-term bonds. Long-Term Interest Rates: The Fed and the Shape of the Yield Curve D. long-maturity bonds increase in price when interest rates increase. C. inverted. A yield-curve inversion is among the most consistent recession indicators, but other metrics can support it or give a better sense of how intense, long, or far-reaching a recession will be. If investors suddenly believe interest rates will increase, their actions may cause the yield curve to. How a Parallel Shift in the Yield Curve Works . Question text Under the preferred habitat theory of interest rates, b. the long term spot rate is an average of the current and expected future short term interest rates, 15.A two-year interest rate is 7% and a one-year forward rate one year from now is. The normal upward-sloping yield curve follows the “Liquidity Preference Theory,” which suggests that investors wish to be compensated for holding longer-term securities. An upward sloping or normal yield curve may indicate that markets expect business-as-usual for the economy, no significant changes in inflation (price rise). A normal, upward sloping yield curve is shown below. An upward-sloping labor supply curve represents a case in which the substitution effect of higher wages outweighs the income effect. An upward slope yield curve indicates that the economy may normally be functioning. 15. Historically, the slope of the yield curve has been a good leading indicator of economic activity. Evidence explaining the trends of yields on the Ghanaian money market could best be explained by the shift of market preferences for long-dated higher yielding securities. 11. Interested readers who wish to study the topic further may wish to refer to the author’s book Analysing and Interpreting the Yield Curve. This movement of the yield curve would benefit investors, as bond prices rise with falling yields. Explain how the term structure of interest ratescan be used to help forecast future interest rates. A. humped B. inverted C. normal D. flat E. None of the options are correct. Typically, the term structure refers to Treasury securities but it can also refer to riskier securities, such as AA bonds. Commercial banks, savings and loan associations, and finance companies traditionally have better profits when, 18. Why might this observation be true? The reason is simple – longer the tenor, the riskier it is. You'll generally see this type of yield curve when bond investors expect the economy to grow at a normal pace, without significant changes in the rate of inflation or major interruptions in available credit. So, this prediction of the expectations theory is inconsistent with the real world evidence. Assume that annualized yields of short-term and long-term securities are equal. Assume that annualized yields of short-term and long-term securities are equal. In a growing economy, investors also demand higher yields at the long end of the curve … The so-called "law of demand" in economics recognizes this, holding that higher prices reduce demand for a good, and vice versa, other factors being equal. This means the marginal product will equal the real wage. The yields of longer-maturity bonds tend to be higher than the yields of shorter-maturity bonds since the longer maturity bonds are riskier. If a yield curve is upward sloping, it means that long-term interest rate is higher than the short-term... See full answer below. In this basic competitive model, the real wage adjusts in labor markets to balance supply and demand. As an upward-sloping yield curve is normal, the arbitrage opportunities it offers are limited. In normal conditions, the yield curve is upward-sloping. To learn about the flat yield curve, read on to the next part of this series. 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