Question

Explain each of the following in one to three sentences.

1. Assume that there is a sudden expectation of lower interest rates in the future. What would be the effect on the yield curve and why?

2. Name and explain the two components of the risk-free rate of return.

3. Explain what is meant by the Expectations Theory of Interest rate Determination.

Answer 1

1. if there is an expectation of lower interest rates in near future that will mean that yield curve will be sloping downwards because the short term Bond yields will not be going down much but the long term bond is will start to go down and that may cause an inverted yield curve

2. Two component of risk free return would be

A. Security by the government as they are highly secured instruments and they are backed by government

B. They have very low probability of default as they have a high security attached to them

3. Expectation theory focuses that there would always be expectation of investment into short term bonds because it will be lesser risky, so there would be an expectation of risk premium into investment into long term bonds as their more risky