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Hi tutor,
Hope you could help me on this question from Becker mock exam:
The company is considering an issue of new debt and has analyzed the term structure of interest rates to assist in the decision.
Which of the following would best explain an inverted yield curve?
A. Investors preferred habitat is in long dated loan notes
B. Inflation is expected to rise in the future
C. Investors have a preference for liquidity
D. The central bank has lowered short term interest rates on a temporary basis to stimulate the economyI left the question unanswered because A, C and D all explained an upward sloping yield curve. I wasn’t sure about option B however (could this be the expectations theory? To my knowledge it is the expectations in future interest rates that cause changes in interest rates but I’ve read somewhere before that the theory states that there is an equilibrium between relative inflation rates and relative interest rates)
Anyway, the answer wrote option A, with the explanation of “this can occur where there is a high demand for long term loan notes, pushing up their market values and hence bringing down their yields”
Shouldn’t a higher demand push interest rates up and therefore the market value down to restore equilibrium between demand and supply? I am so confused!
It is not actually a terribly good question from Becker 🙂
However, if investors prefer them then there will be a bigger demand, and if more people are wanting to buy them then this will push up the market value.
And a higher market value will mean they accept a lower interest rate.(With regard to B, higher inflation will end up meaning an expectation of higher interest rates and therefore an upward sloping curve)
Although I hope the above does answer your question OK, here is a general tip for the real exam. If you are uncertain of one or two of the choices then first eliminate those that you know are not correct. Usually you should be able to eliminate 2 if not 3 of them. If you are still left with 2, and you still cannot decide which is right then guess! You have a 50% chance of getting it right and you must not leave any questions unanswered. Just getting one guess right makes a huge difference if you would otherwise have failed on 49 🙂
I will follow your advice on answering the MCQ questions, thanks for it 🙂
I am quite lost now (though I do understand what you have written), because in paper December 2013 Q4 part d, the answer on market segmentation theory wrote that higher demand will push interest rates up first. Now I’m guessing there is no fixed answer for market segmentation theory. Hopefully the exam questions wouldn’t be as vague as becker’s!
The examiner is referring to demand by the borrower!
If the borrower wants more than lenders are prepared to lend, then they will have to increase the interest rate.
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