Risk management Essay Example | Topics and Well Written Essays - 2000 words

Risk management - Essay Example This report will focus on the different types of yield curves and how changes in the slope of yield curve impacts the future prospects of the economy. Further, it will also take into consideration the effectiveness of monetary policy responses in the time of financial crisis and how those responses have affected the shape of the yield curve. Table of Contents Executive Summary 2 Table of Contents 3 Introduction 4 Task 1: To Examine the Types of Yield Curve 4 Task 2: Impact of Yield Curve on Future Economic Prospect 6 Task 3: Effectiveness of Monetary Policy 9 Task 4: Implication for Investor and Policy makers 10 Conclusion 10 Appendices 11 Reference 13 Introduction A yield curve is referred to the graphical representation of the relationship among the yield on a group of securities for different maturities. It explains how interest rates differ with the term to maturity (Burton, Burton and Nesiba, 2010, p.115). The yield curve has too much information about the economic conditions an d the future interest rates. In U.S. the benchmark interest rate last recorded was at 0.25%. Federal Reserve reports the interest rates in U.S. Historically, from 1971 to 2013, the interest rate of U.S. averaged 6.17 % and recorded a high of 20% in March 1980 and a low of 0.25% in December 2008. Interest rate changes depend not only on what Federal Reserve does today or next year but also on perception of the people about the goals and reliability of the monetary authority. In U.S. the monetary policy is determined by the Federal Reserve. The goals and the associated expectations depends on the arrangement of the monetary policy (Haubrich, 2004, p.1). The yield curve is used by the investors to understand the future prospects of economic activities. Task 1: To Examine the Types of Yield Curve The structure of interest rates can be characterized by a graph which shows the relationship between the yields to maturity as a function of term to maturity. Such a graph is termed as yield cu rve. There are four different types of yield curve for U.S. Treasury securities such as normal yield curve or upward sloping yield curve, inverted yield curve or downward sloping yield curve, flat yield curve and humped yield curve. There are two theories which are used to explain the shapes of yield curves. The pure expectation theory reflects the current expectation of the future rates of the market and the market segmentation theory signifies that the shape of yield curve is established by demand for and supply of securities within each maturity sector. In normal yield curve long term rates are high in position than short term rates. The securities with longest maturity provide the highest returns and the shortest maturity securities provide lowest returns. Generally it is upward sloping. The normal yield curve signifies the normal conditions of the capital markets. It presents the borrowers with the risk-return trade-off (Droms and Wright, 2010, pp.144-145). It entails that the investors of the U.S. expect growth in the economy in the future and for this growth to lead to higher interest rates and higher inflation. They don’t purchase longer term securities without receiving a higher interest r