Saturday, August 29, 2009

the role of expectations in shaping the yield curve

How can a factor as intangible as expectations determine thee shape of the yield curve? Expectations are a potent force in the financial market place because investors act on their expectations. For example, if interest rates are expected to rise in the future, this is disturbing news to investors in long-term bonds. Rising interest rates mean falling prices for bonds and other debt securities. Moreover, the longer the term of a bond, the more sensitive its price is to changes in rates. Faced with the possibility of falling bond prices, many investors will sell their long-term bonds and buy shorter-term securities or hold cash. As result, the prices of long-term bonds will plummet, driving their rates (yields) higher. At the same time, increased investor purchases of short-term securities will send the prices of these securities higher and their yields lower. With rising long-term rates and falling short-term rates, the yield curve will gradually assume an upward slope. the yield curve‘s prophecy of rising interest rates will have come true simply because investors responded to their expectations by making changes in their security portfolios.

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