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    Yield Curve and Interest Rates

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    Explain the yield curve and how it reacts to changes in interest rates, and can you explain why long-term (30-year) bonds generally trade at a higher yield than short-term maturities. Apply the forces of inflation, monetary and fiscal policy, trade deficit and foreign influences in your explanation

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    Solution Preview

    A yield curve is a graph that shows the relationship between bond yields and maturities.
    When the rate of inflation is expected to decline, short-term rates are higher than long-term rates and the yield curve is downward sloping (Brigham & Houston, 2007). When the inflation has declined, all rates are lower and the yield curve becomes humped—medium-term rates are higher than either short- or long-term rates. When all rates fall and short-term rates drop below long-term rates, the yield curve is upward sloping.
    Historically, long-term rates are generally above short-term rates because of the maturity premium, so the yield curve usually slopes upward or "normal" yield curve, and a yield curve that slopes downward is called inverted or "abnormal" curve.
    Because maturity risk premium are positive, then if other things were held constant, long-term bonds would always have higher interest rates than short-term bonds.
    Expected inflation has an especially important effect on the yield curve's shape, especially the ...

    Solution Summary

    Yield curves and interest rates are explained. Why long-term bonds generally trade at a higher yield than short-term maturities are determined.

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