Question

5. a. Describe the relationship between the interest rates on bonds of different maturities.

b. If we follow the Expectation Hypothesis, calculate the interest rate on a 3-year bond if

a 1-year bond has an interest rate of 2% and is expected to have an interest rate of 3% next year, and 5% in two years.

c. How does the Liquidity Premium Theory explain an upward-sloping yield curve during normal economic environment?

d. Explain the economic implications of an inverted yield curve.

Answer 1

Answer a) There is an inverse relationship between interest rates or Coupon rates of bonds and the bonds of diffirent maturities.

1) If Interest rate of bond higher then the bond maturity period will be lesser.

2) If interest rate of bond lesser then the mond maturity period tend be higher.

Generally, bonds with long maturities and low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations. Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment.