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Changes in Slope of the Yield Curve and its impact on the Economy 1
Money and Capital Markets
Changes in Slope of the Yield Curve and its impact on the Economy
Changes in Slope of the Yield Curve and its impact on the Economy 2
Letter of Transmittal
Executive Summary
Changes in Slope of the Yield Curve and its impact on the Economy 3
The yield curve has been an extremely reliable indicator of subsequent economic
activity. And while some economists like to joke that the yield curve has predicted 10 of
the last seven recession most agree that, like a canary in a coal mine, an inverted yield
curve often provides advance warning of future trouble—which investors ignore at their
peril.
In this paper, we will focus on analyzing different types of yield curve that represents the
structure of interest and how does yield curve impact the shape of the economy.
Changes in Slope of the Yield Curve and its impact on the Economy 4
Contents
Letter of Transmittal ........................................................................................................ 2
Executive Summary ........................................................................................................ 2
Introduction: .................................................................................................................... 5
Different yield curves: ...................................................................................................... 5
Yield curve during 2009 – 2011: ...................................................................................... 8
Prediction: ....................................................................................................................... 9
Monetary Policy and yield: .............................................................................................. 9
Conclusion: ................................................................................................................... 13
References: ................................................................................................................... 15
Changes in Slope of the Yield Curve and its impact on the Economy 5
Introduction:
The yield curve simply a graphical representation of the spread between yields on
similar bonds with different maturities. Yield curve has become one of the important
means of analyzing the economy of the country. A well-evaluated yield curve is
considered as the reflection of the economic condition and is considered as one of the
most important factors is analyzing the financial markets. It is important to analyze and
design the well evaluated yield curve to evaluate the economy of the country. (Ang, A.,
Piazzesi, M., Wei, M., 2006)
Different yield curves:
The term structure of interest rate, by which we mean the fluctuation of interest rate
depending on time to maturity, has been subject to research for more than a century in
countries with developed financial market. The relationship between yield to maturity
and time to maturity can be graphically presented by the yield curve. We distinguish
between four possible forms of yield curve: regular (rising), inverse (falling), straight and
winding. (Ang, A., Piazzesi, M., Wei, M., 2006)
Changes in Slope of the Yield Curve and its impact on the Economy 6
Although the rising form of the yield curve is the most frequent, and that is why it is
called regular or normal, the other forms described above can also be found in different
countries. It has been said that the knowledge of interest rates fluctuations, or the
knowledge of the current yield curve, on developed financial markets is almost a
question of general culture. A well-evaluated yield curve not only perfectly reflects the
current condition of some economy but also provides foresight. It is an unavoidable tool
for every financial intermediary or any participant in financial market activities.
Consequently, for more than a century, theories have been developed and applied to
approximate and forecast the yield curve. (Ang, A., Piazzesi, M., Wei, M., 2006)
The oldest, expectations theory is based on the assumption that investment is carried
out exclusively in accordance with investor's expectations on the future yield curve
fluctuation without taking into account time to maturity. According to this theory the
expected growth of short-term interest rates will result in the rising yield curve, while the
expected fall in the short-term interest rates will result in the falling yield curve.
Undoubtedly, the expectation elements have to be considered in the analysis of term
structure of interest rates. However, it cannot be the only element affecting the yield
curve form. (Ang, A., Piazzesi, M., Wei, M., 2006)
Changes in Slope of the Yield Curve and its impact on the Economy 7
Another theory not only considers interest rate expectations but also assumes that
investors and issuers take into account time to maturity, i.e. that in order to avoid risk
they prefer one term structure to another. According to this theory of preferred habitat
the formation of yield curve is significantly affected by the time premium, which reflects
the preferences of investors and issuers in terms of time to maturity. As for
expectations, they play the same role as in the expectations theory: the expected
increase of short-term interest rates will contribute to the rise of yield curve, while their
expected fall will contribute to its levelling or fall.
According to liquidity preference theory taking into account risks implied by different
term structures means that long-term bonds are for all investors riskier and less
attractive than the short-term ones. In order to encourage investors to buy longer-term
bonds issuers add a risk premium or liquidity premium to them....