Finance Questions

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The response addresses the queries posted in 2011 Words,APA References

Finance

1.

The curve relating to the maturity of debt and interest rates is called the yield curve. The yield curve may assume any shape, but it is generally upward sloping. It means that more the maturity greater the interest risk. In the other debt market, yield curve is used as the benchmark to find out the term structure of the interest rates. Mainly it is used to forecast the changes in economic output and growth.

The three different types of curves are as follows:

1. Normal yield curve: This yield curve depicts that yield is mainly depends on the maturity period. It means that longer maturity bonds have higher yield, due to high risk involved in it as compared to the short term bonds or securities.

2. Flat yield curve: Flat yield curve explains that both the yields i.e. short duration and long duration are quite similar. It is also termed as the economic conversion predictor.

3. Inverted yield curve: An inverted yield curve is results when the short term rates are higher than the long term rates (Van Horne, Wachowicz & Bhaduri, 2008).

2.

The expectation theory supports the yield curve which is upward sloping, since investors always expect the short term rates to increase in the future. This implies that the long term rates will be higher than the short term rates. This theory also depicts that on the successive maturities, expected yield of the same security is determined by investor anticipations of interest rates in the future period of time. Expectation theory does assume that there is more efficiency in the capital markets and there are no transaction costs and investor's sole purpose is to maximize their returns. For example: Investor accepts 9% on bond in the first year and predicting the future rate will be 11%, but the expected current rate will be 10%. The average of the interest rates i.e. first year and following year is (9% + 11%)/2= 10% . thus we conclude that investors will earn the same average expected returns on all maturity combinations.

3.

Liquidity preference theory depicts that higher cost of long term financing induce the investors to hold the bonds for the long duration of time. This theory explains that lenders are risk averse and risk generally increases with the length of lending time because it is more difficult to forecast the more distant future. For example: Investors, who are risk averse, always prefer to make short term investments because to predict the future changes is difficult for the investors.

4.

The market segmentation theory assumes that the debt market is divided into several segments based on the maturity of debt. In each segment, the yield of debt depends on the demand and supply. Investor's preferences of each segment arise because they want to match the maturities of securities to reduce the susceptibility to interest rate changes. This theory also assumes that investors do not shift from one maturity to another in their borrowing-lending activities and therefore, the shifts in yields are caused by changes in the demand and supply of bonds of different maturities. Overall, it implies that investors strongly prefer to invest in assets with maturities matching their liabilities and ...