1. What is the Treasury yield curve and what does it represent?

The yield curve is one way to look at interest rates. It shows the relationship between the rates or yields being offered by bonds of different maturities. It is usually based on U.S. Treasury Bonds. It is mainly used as a benchmark for other debt in the market, such as mortgage rates and bank lending rates. Investors also use the yield curve as a reference point for forecasting interest rates, pricing bonds and creating strategies for boosting total returns. It is also a reliable leading indicator of economic activity.

2. Explain the difference between current yield and yield-to-maturity (YTM).

Current Yield: it is the annual return earned on the price paid for a bond. It is calculated by dividing the bond’s annual coupon interest payment by its purchase price.

Yield-to-maturity: it is the total return an investor will receive if the bond or the security is held until the maturity date. It reflects the total return to the bond holder of holding the bond until maturity which includes which includes all the interest payments from the time of purchase until maturity including interest on interest, it also includes any appreciation or depreciation in the price of the bond. 3. Explain the difference between the coupon rate and the YTM.

Coupon rate: it is the amount of interest paid every year on a bond. It is expressed as a percentage of the face value of the bond. It determines the income that will be earned from a bond.

Yield-to-Maturity: it is the single discount rate that is applied to all future interest and principal payment. It is the internal rate of return that an investor would get on an investment.

4. What factors might have caused the 3-month yield to remain approximately the same over the period 2009 to 2012? (Be specific as to actual events that occurred in this time frame.)

Many factors caused the 3-month yield to stay at its lowest level over the period of 2009 to 2012. An economic slowdown and a signal of recession are major factors. The fed kept it low in order to make it easy for the bank to lend, it was designed to lower the cost of money, stimulate lending and investment, and promote economic growth especially .after a housing crisis that prevented people from taking a loan or refinance.

5. Look at the shape of the curve across the four years. In some years, it steepened, and in others, it flattened.

a. In what year(s) did the curve steepen? Why did the curve steepen over this time period? (Be specific as to events during this time frame)

2010, 2011 and 2012 the yield curve was mostly steepen due to the historical low level of short term interest rate. This low rate was in response to the credit crisis and Great Recession, designed to lower the cost of money, stimulate lending and investment, and promote economic growth.

b. In what year(s) did the yield curve flatten? Why did the curve flatten over this time period? (be specific as to events during this time frame)

c. If the expectations theory of the yield curve holds (see the handout), what does a steep yield curve predict about future interest rates?

A steep curve means that the economy is heading upward and future rates will rise.

d. If the expectations theory of the yield curve holds (see the handout), what does a flat yield curve predict about future interest rates?

A flat yield curve is a sign that the market expectation is that interest rates will remain constant for the foreseeable future. This generally occurs when an economy slows down and often is the first indication of the beginning of a recession.

6. in late 2008, (not on the graph) investors purchased 1-month (4 week) Treasury securities with a coupon rate of 0%. At the same time, the YTM on existing 3-month Treasury securities was briefly negative (meaning that you would pay something greater than par value for the bond, and when it matured you would receive par value: in other words, you were guaranteed to lose money if you purchased this bond!). What economic forces at the time caused/allowed this to happen?

Market volatility and signal of recession in that period after the subprime mortgage crisis and the collapse of many financial institutions that caused the stock market to collapse. Investors were willing lose some money or make no money at all by buying short term treasury security to preserve their cash.

7. in early November, 2010, the Federal Reserve Board announced an initiative to buy back $600 billion in long-term Treasury bonds over an eight month period, to be completed by the end of the third quarter, 2011.

a. What is the reason given by the Fed for doing this?

It was aiming to stimulate the economy by lowering interest rate and injecting more cash into the financial institution to start lending again. That, in turn, is intended to encourage spending by businesses and consumers, which would create jobs.

b. What was the initial impact of this news on the stock and bond markets?

The stock market was fluctuating all day as the Fed as the Fed announced its plan of purchasing more treasuries but ended up a little bit on the positive side. I think the investors were waiting for something more from the Fed to boost the economy, also the market did not react too positive on the news as it seems that investors were aware of such announcement from the fed for the last couple of month as the market has been going up during that period, so most of the announcement seemed to be priced in. in terms of the Bond market, 10 year US treasuries fell after the announcement, pushing the yield up to 2.6% from 2.59% the prior day.

c. What are some of the longer-term risks of such a policy?

1. If the Fed is successful in boosting the inflation rate and energizing the US economy, it seems likely that interest rates will rise over time as a consequence, thus producing losses in the Fed’s longer term Treasury purchases.

2. If the Fed is too aggressive in its asset purchases, confidence in the dollar may be further weakened, and if so Americans have to pay more for imported goods. And for raw materials that are priced in dollars on the world markets, such as oil, grains and cotton, the dollar price has to rise to stay equal with what those goods are worth in other currencies.
d. In hindsight, do you think this was a good move by the Fed? Why or why not?

I think it was a good move from the Fed in terms of injecting money into the system and let bank start to lend or refinance again to the consumers and businesses. But at some pint the Fed would need to withdraw all the money back to avoid a surge in inflation down the road.

8. At their meeting in August of 2011, the Fed pledged to keep short-term interest rates low for the next two years.

a. How did the stock market initially respond?

U.S. stocks jumped the most in more than two years, rebounding from the worst drop since 2008, and 10-year Treasury yields touched a record low as the Federal Reserve vowed to keep interest rates near zero through mid-2013. The Standard & Poor’s 500 Index jumped 4.7 percent to 1,172.53 at 4 p.m. in New York, its biggest gain since March 2009.

b. What do you think the long-term consequences of such an announcement might be on inflation?

Well I believe that if short term interest rates stay low for a long period of time, there will be more money in an economy; people tend to spend more which it will drive the cost of goods and services higher which in turn cause high inflation. In contrast, to fight the inflation, rates need to go up so it will be more expensive to borrow and then it will be less money ion the economy.