Question

Draw the yield curve described as follows: • Interest rates: 1% in year 1; 1.5% in year 2; 2% in year 3; 3.5% in year 4. • Term premiums: 0.5% for a one-year bond, rising by 0.25% for each additional year of maturity. What does this yield curve suggest is the predominant short to medium-term economic outlook among market participants?

Answer 1

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Question:

Answer:

Bond yield = Coupon Payment / Current Market Price of Bond

It means when bond price increase yield decrease and vice-versa. Bond price is inversely related with interest rate. When interest rate increase bond price decrease and vice-versa.

Yield Curve:

A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates that  gives an idea of future interest rate changes and economic activity.

Graphical Representation:

We can see in the yield curve that yield is increasing with time. It means higher the maturity, higher the yield. It means its indicating that bond price will decrease in the future and bond price will decrease means interest rate will increase in the future. Other side term premiums: 0.5% for a one-year bond, rising by 0.25% for each
additional year of maturity. Normally bond is highly interest rate sensitive and long-term bond has higher the interest rate risk compare to short term bond. So, here term premium is increasing every year. So, this yield curve gives a better sense of the market consensus about future economic activity and interest rates. This curve is a normal curve.

Graph:

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