Question

Q.1(a) Suppose investors prefer one-year bonds to two-year bonds and will

purchase a two-year bond only if they expect to receive an additional 2% over

the returns from holding one-year bonds. Currently, one-year bonds yield 6%,

but investors expect the yield to fall to 2% next year. (6)

(i) Which of the three models of term structure is relevant in this case?

(ii) What is the yield on a two-year bond?

(iii) Is the yield curve flat, downward sloping or upward sloping? Explain.

Answer 1

i) Inverted

II) $8\%$ the yield on a two-year bond

$\frac{100*1.06*1.02-100}{100}=0.0812=8.12\%$ the yield on a one-year bond

1. III) Downward sloping—short-term yields are higher than long-term yields. Dubbed as an "inverted" yield curve and signifies that the economy is in, or about to enter, a recessive period.