Question

9) 15 pts. A lot of bonds are bought by insurance companies and banks. To pay off insurance claims, an insurance company might have to sell off some of its assets, including bonds. To pay off withdrawals of deposits, a bank might have to sell off some of its assets, including bonds. Banks and insurance companies are regulated by government agencies. Managers of insurance companies are punished if they cannot pay claims. Bank managers are punished if they cannot pay off withdrawals of deposits. After a hurricane, insurance companies receive a lot of claims all at once, and lots of people suddenly withdraw all their money from banks. Suppose that managers of banks and insurance companies receive news from scientists: global warming will increase the magnitude and frequency of hurricanes, starting now. What will be the immediate effect of this on the yield curve - will it tend to flatten the yield curve, or make it steeper, or have no effect? Assume the news has no effect on expectations of future overnight rates. Explain your answer.

Answer 1

Due to increase and frequency of hurricane, the number of claims will increase to the banks and insurance companies. It will cause these institutions to sell their bonds and get funds to settle the claims. Due to this selling process, supply of bonds increases in the market. It leads to the increase in the yield and yield curve getting steep in nature. It will happen due to increase in yield as a result of increased supply of bonds.