Assume that the 'expectations theory' fully explains the Treasury Bond Yield Curve.

The 10-year zero-coupon bond maturing in 2032 has a yield-to-maturity (YTM) of 4%. 

 

Assume that instead of simply buying the 10 year, you decide you will:

buy a 5-year bond today, then, when that bond matures in 2027,  then, you will buy a new 5-year bond that starts in 2027 and will mature in 2032.

 

Scenario A - Upward sloping yield curve.

1. if today's 5 year bond has a YTM of 2%, what would the second bond's YTM need to be for you to get a terminal value that would match simply buying the 10 year bond today? 

 

Scenario B - Downward sloping yield curve

1. if today's 5 year bond has a YTM of 6%, what would the second bond's YTM need to be for you to get a terminal value that would match simply buying the 10 year bond today? 

 

Bond investors love bad news and dropping interest rates are usually a sign of economic weakness or even recessions.

Which scenario indicates the bond market foresees a bad economy (A or B)?

Answer rating: 100% (QA)

In the context of the expectations theory a downward sloping yield curve Scenario B suggests the bon... View the full answer