Answer to Question #210745 in Finance for Dee Park

Question

A) Many economist also believe that a steed positive curve means that investors expect strong future economic growth with higher future inflation thus higher interest rates ,and that a sharply inverted curve means investors expect sluggish economic growth with lower future inflation (thus lower interest rate). A flat curve generally indicates that investors are unsure about future economic growth and inflation. Explain the three(3) central theories that attempt to give meaning to the shape of the yield curves.(9marks)

B) Distinguish between the norminal and real interest rates, and explain how the letter is related to the former.(3 Marks)

C) Describe factors making up the demand supply of loanable funds in an economy.(5 marks)

D) Write a general expression for the yield on any debt security (rd) and define these terms : real risk-free rate of interest (r*), inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). (8 marks)

[Total=25 marks]

Answer 1

A) There are different theories that attempt to explain the different shapes of the yield curve, namely, the pure expectations theory, the liquidity premium theory, the market segmentation theory, and the preferred habitat theory.

B) A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. A nominal interest rate refers to the interest rate before taking inflation into account.

C) Several factors affect the supply and demand of loanable funds more specifically, including monetary policy, private and public saving, and investment tax credits.

D) $rd=r*+IP+MRP+LP+DRP.$