ApplicationEasyterm structure of interest rates

Suppose the current one-year interest rate is 4%, and financial markets expect the one-year interest rate next year to be 8%. According to the expectations hypothesis, what is the approximate yield to maturity on a two-year bond?

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Why

Tap an answer. The explanation will appear here, including why each wrong option is wrong.

Not quite. B is correct.

Under the expectations theory, the n-year interest rate is approximately the average of the current and expected future one-year interest rates over those n years: (4% + 8%) / 2 = 6%.

A: why it's wrongThis assumes the two-year yield equals the current one-year yield, neglecting expected future rate increases.

B: why it's wrongThe two-year yield is approximately the average of the current one-year rate and next year's expected one-year rate: (4% + 8%) / 2 = 6%.

Tap any option to see why it's right or wrong.

Not quite. B is correct.

Under the expectations theory, the n-year interest rate is approximately the average of the current and expected future one-year interest rates over those n years: (4% + 8%) / 2 = 6%.

A: why it's wrongThis assumes the two-year yield equals the current one-year yield, neglecting expected future rate increases.

C: why it's wrongThis assumes the two-year yield equals next year's expected short-term rate alone.

Tap any option to see why it's right or wrong.

Not quite. B is correct.

Under the expectations theory, the n-year interest rate is approximately the average of the current and expected future one-year interest rates over those n years: (4% + 8%) / 2 = 6%.

A: why it's wrongThis assumes the two-year yield equals the current one-year yield, neglecting expected future rate increases.

D: why it's wrongThis adds the two rates together instead of taking their average.

Tap any option to see why it's right or wrong.

Not quite. B is correct.

Under the expectations theory, the n-year interest rate is approximately the average of the current and expected future one-year interest rates over those n years: (4% + 8%) / 2 = 6%.

A: why it's wrongThis assumes the two-year yield equals the current one-year yield, neglecting expected future rate increases.

undefined: why it's wrongThis subtracts the current rate from the expected rate and divides by two, which is an incorrect calculation.

Tap any option to see why it's right or wrong.

Not quite. B is correct.

Under the expectations theory, the n-year interest rate is approximately the average of the current and expected future one-year interest rates over those n years: (4% + 8%) / 2 = 6%.

B: why it's wrongThe two-year yield is approximately the average of the current one-year rate and next year's expected one-year rate: (4% + 8%) / 2 = 6%.

Tap any option to see why it's right or wrong.

Not quite. B is correct.

Under the expectations theory, the n-year interest rate is approximately the average of the current and expected future one-year interest rates over those n years: (4% + 8%) / 2 = 6%.

B: why it's wrongThe two-year yield is approximately the average of the current one-year rate and next year's expected one-year rate: (4% + 8%) / 2 = 6%.

C: why it's wrongThis assumes the two-year yield equals next year's expected short-term rate alone.

Tap any option to see why it's right or wrong.

Not quite. B is correct.

Under the expectations theory, the n-year interest rate is approximately the average of the current and expected future one-year interest rates over those n years: (4% + 8%) / 2 = 6%.

B: why it's wrongThe two-year yield is approximately the average of the current one-year rate and next year's expected one-year rate: (4% + 8%) / 2 = 6%.

D: why it's wrongThis adds the two rates together instead of taking their average.

Tap any option to see why it's right or wrong.

Not quite. B is correct.

Under the expectations theory, the n-year interest rate is approximately the average of the current and expected future one-year interest rates over those n years: (4% + 8%) / 2 = 6%.

B: why it's wrongThe two-year yield is approximately the average of the current one-year rate and next year's expected one-year rate: (4% + 8%) / 2 = 6%.

undefined: why it's wrongThis subtracts the current rate from the expected rate and divides by two, which is an incorrect calculation.

Tap any option to see why it's right or wrong.

Not quite. B is correct.

Under the expectations theory, the n-year interest rate is approximately the average of the current and expected future one-year interest rates over those n years: (4% + 8%) / 2 = 6%.

C: why it's wrongThis assumes the two-year yield equals next year's expected short-term rate alone.

D: why it's wrongThis adds the two rates together instead of taking their average.

Tap any option to see why it's right or wrong.

Not quite. B is correct.

Under the expectations theory, the n-year interest rate is approximately the average of the current and expected future one-year interest rates over those n years: (4% + 8%) / 2 = 6%.

C: why it's wrongThis assumes the two-year yield equals next year's expected short-term rate alone.

undefined: why it's wrongThis subtracts the current rate from the expected rate and divides by two, which is an incorrect calculation.

Tap any option to see why it's right or wrong.

Not quite. B is correct.

Under the expectations theory, the n-year interest rate is approximately the average of the current and expected future one-year interest rates over those n years: (4% + 8%) / 2 = 6%.

D: why it's wrongThis adds the two rates together instead of taking their average.

undefined: why it's wrongThis subtracts the current rate from the expected rate and divides by two, which is an incorrect calculation.

Tap any option to see why it's right or wrong.

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RecallMediumbond markets and risk premiums

Which of the following is a defining characteristic of inflation-indexed bonds, such as Treasury Inflation-Protected Securities (TIPS)?

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Why

Tap an answer. The explanation will appear here, including why each wrong option is wrong.

Not quite. A is correct.

Inflation-indexed bonds protect investors from inflation by adjusting nominal payments and principal in accordance with an inflation index, thereby delivering a guaranteed real rate of return.

A: why it's wrongIndexed bonds adjust their principal or coupon payments directly with inflation, protecting investors against changes in the price level.

Tap any option to see why it's right or wrong.

Not quite. A is correct.

Inflation-indexed bonds protect investors from inflation by adjusting nominal payments and principal in accordance with an inflation index, thereby delivering a guaranteed real rate of return.

A: why it's wrongIndexed bonds adjust their principal or coupon payments directly with inflation, protecting investors against changes in the price level.

B: why it's wrongStandard nominal bonds have fixed nominal coupons; indexed bonds specifically eliminate purchasing-power risk.

Tap any option to see why it's right or wrong.

Not quite. A is correct.

Inflation-indexed bonds protect investors from inflation by adjusting nominal payments and principal in accordance with an inflation index, thereby delivering a guaranteed real rate of return.

A: why it's wrongIndexed bonds adjust their principal or coupon payments directly with inflation, protecting investors against changes in the price level.

C: why it's wrongThe real return on an indexed bond is fixed at issuance, while the nominal payments fluctuate with inflation.

Tap any option to see why it's right or wrong.

Not quite. A is correct.

Inflation-indexed bonds protect investors from inflation by adjusting nominal payments and principal in accordance with an inflation index, thereby delivering a guaranteed real rate of return.

A: why it's wrongIndexed bonds adjust their principal or coupon payments directly with inflation, protecting investors against changes in the price level.

D: why it's wrongIndexed bonds are predominantly issued by sovereign governments (such as the US Treasury and the UK Debt Management Office), not exclusively by corporations.

Tap any option to see why it's right or wrong.

Not quite. A is correct.

Inflation-indexed bonds protect investors from inflation by adjusting nominal payments and principal in accordance with an inflation index, thereby delivering a guaranteed real rate of return.

A: why it's wrongIndexed bonds adjust their principal or coupon payments directly with inflation, protecting investors against changes in the price level.

undefined: why it's wrongHigher inflation increases the nominal payments on indexed bonds, rather than lowering them.

Tap any option to see why it's right or wrong.

Not quite. A is correct.

Inflation-indexed bonds protect investors from inflation by adjusting nominal payments and principal in accordance with an inflation index, thereby delivering a guaranteed real rate of return.

B: why it's wrongStandard nominal bonds have fixed nominal coupons; indexed bonds specifically eliminate purchasing-power risk.

C: why it's wrongThe real return on an indexed bond is fixed at issuance, while the nominal payments fluctuate with inflation.

Tap any option to see why it's right or wrong.

Not quite. A is correct.

Inflation-indexed bonds protect investors from inflation by adjusting nominal payments and principal in accordance with an inflation index, thereby delivering a guaranteed real rate of return.

B: why it's wrongStandard nominal bonds have fixed nominal coupons; indexed bonds specifically eliminate purchasing-power risk.

D: why it's wrongIndexed bonds are predominantly issued by sovereign governments (such as the US Treasury and the UK Debt Management Office), not exclusively by corporations.

Tap any option to see why it's right or wrong.

Not quite. A is correct.

Inflation-indexed bonds protect investors from inflation by adjusting nominal payments and principal in accordance with an inflation index, thereby delivering a guaranteed real rate of return.

B: why it's wrongStandard nominal bonds have fixed nominal coupons; indexed bonds specifically eliminate purchasing-power risk.

undefined: why it's wrongHigher inflation increases the nominal payments on indexed bonds, rather than lowering them.

Tap any option to see why it's right or wrong.

Not quite. A is correct.

Inflation-indexed bonds protect investors from inflation by adjusting nominal payments and principal in accordance with an inflation index, thereby delivering a guaranteed real rate of return.

C: why it's wrongThe real return on an indexed bond is fixed at issuance, while the nominal payments fluctuate with inflation.

D: why it's wrongIndexed bonds are predominantly issued by sovereign governments (such as the US Treasury and the UK Debt Management Office), not exclusively by corporations.

Tap any option to see why it's right or wrong.

Not quite. A is correct.

Inflation-indexed bonds protect investors from inflation by adjusting nominal payments and principal in accordance with an inflation index, thereby delivering a guaranteed real rate of return.

C: why it's wrongThe real return on an indexed bond is fixed at issuance, while the nominal payments fluctuate with inflation.

undefined: why it's wrongHigher inflation increases the nominal payments on indexed bonds, rather than lowering them.

Tap any option to see why it's right or wrong.

Not quite. A is correct.

Inflation-indexed bonds protect investors from inflation by adjusting nominal payments and principal in accordance with an inflation index, thereby delivering a guaranteed real rate of return.

D: why it's wrongIndexed bonds are predominantly issued by sovereign governments (such as the US Treasury and the UK Debt Management Office), not exclusively by corporations.

Tap any option to see why it's right or wrong.

Not quite. A is correct.

Inflation-indexed bonds protect investors from inflation by adjusting nominal payments and principal in accordance with an inflation index, thereby delivering a guaranteed real rate of return.

D: why it's wrongIndexed bonds are predominantly issued by sovereign governments (such as the US Treasury and the UK Debt Management Office), not exclusively by corporations.

undefined: why it's wrongHigher inflation increases the nominal payments on indexed bonds, rather than lowering them.

Tap any option to see why it's right or wrong.

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AnalysisHardMonetary Policy and Financial Markets

Suppose the central bank conducts an expansionary monetary policy today that market participants view as strictly temporary and not expected to persist into future periods. Analyze the effect of this action on: (a) the shape and position of the yield curve, and (b) stock prices, distinguishing between an anticipated versus an unanticipated policy change.

Your answer

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Why

Write your answer, then tap Show model answer. The model answer and marking points will appear here.

Compare with your answer.

Model answer. (a) Yield curve: The current one-year interest rate falls as a result of the monetary expansion. Because the policy is not expected to continue in future periods, expected future short-term rates remain unchanged. Because the two-year rate is approximately the average of the current and expected future one-year rates, the two-year rate falls by roughly half as much as the one-year rate. Consequently, the yield curve shifts downward at the short end and becomes steeper (upward sloping).

(b) Stock prices: If the policy move was fully anticipated by market participants, stock prices will not react because the lower rates and associated higher economic activity were already priced in. If the monetary expansion was unexpected (or partially unexpected), stock prices will rise. This occurs because the discount rate applied to future dividends decreases (interest rate effect) and expected future profits/dividends increase due to temporarily higher output.

Explains that the current short-term interest rate falls while expected future short-term rates remain unchanged.
Concludes that the yield curve shifts down at the short end and becomes steeper (or that long-term rates fall by less than short-term rates).
Explains that if the expansion was fully anticipated, stock prices do not change.
Explains that if the expansion was unanticipated, stock prices increase due to lower discount rates and/or higher expected output/dividends.

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