Finance and Accounting Risk Management - Essay Example

? Finance and Accounting Risk Management Executive Summary The United s (U.S Treasury securities yield curve is one of the most intimately watched data of the global economy. Yield curve graph gives a rapid way to evaluate and compare the yields that are offered by the different types of fixed income securities and also to find out the expectations of the investor for market conditions in the future. The yield curve of U.S. Treasury securities is regarded as a market benchmark because it is frequently used as a vital reference point by fixed income investors in order to evaluate the market conditions. The slope of yield curve predicts the future economic activity and that’s why it is used by the investor as a forecasting tool in order to understand the movement in future economic activities. 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 and 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 curve. 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 rate than those proposed by shorter term securities. It normally occurs when central bank of the U.S. such as Federal Reserve are easing monetary policy thus increasing the availability of credit and the supply of money in the economy. A normal yield curve indicates the investors anticipate the economy to expand. A downward sloping yield curve occurs for U.S Treasury securities when the long term yields are lower than the short term yields. It implies that the U.S. investors anticipate the economy to decline in the future and this lower growth may result in the lower interest rates and lower inflation for all maturities. It signifies that the U.S. Federal Reserve is tightening monetary policy thereby restricting the money supply and also making credit less available. It is downward sloping and historically been an indication of an economic recession. A flat yield curve occurs when there is negligible difference between the long and short term interest rates. Whereas, a humped yield curve signifies a hope of higher rates in the middle of the maturity period covered. It reflects the uncertainty of the investor about definite economic policies. It also indicates a move of yield curve from inverted to normal or vice versa (Saha, N.D. pp.212-213). The structure of interest rates of Australia over a period from December 2009 to December 2011 is described as: as on 31st December 2009 it was a normal yield curve which means that it is upward sloping, as on 31st March 2010 also it was a normal yield curve, as on 30th June 2010 it was first an intended yield curve because it is sloping slightly downward but afterwards it takes a position of normal yield curve, as on 30th September 2010 it was neither upward, nor intended yield curve and as on 6th January 2011 it was also a upward sloping normal yield curve (See Appendix A). And as on September 2011 also it was a normal yield curve (See Appendix B). Therefore the movement of the yield curve represents the growth in the U.S. economy and also resulting in higher interest rates. As compare to this the yield curve of U.K. is initially representing a flat yield curve and then the normal yield curve and the curve is also higher than the U.S. yield curve, thus representing the higher growth in the U.K. economy and therefore resulting in more higher interest rates (See Appendix C). Task 2: Impact of Yield Curve on Future Economic Prospect The slope of yield curve is an important indicator of future economic performance of a country. When the investors expects growth in the economy without any severe inflationary pressure then the yield curve takes the form of normal yield curve and it slopes upward. Hence, the investors who have done their investment in long term securities expects a higher return than those who have done their investment in short term securities. Thus, the investor prefers liquidity through the upward sloping yield curve. An upward sloping yield curve leads to the higher inflation and higher interest rates. A deviation of the normal curve is termed as a steep curve. It happens when the higher term bond yields are much higher than the yields of short term securities. It indicates that the economy is picking up the pace as monetary policy stimulates the economy (Jones, 2009, p.333). This signifies that the expectation of the market is a quicker recovery of the economy. Massive shift of short term into long term bonds result in the steepening of the yield curve as investors expects higher yields for long term securities. A downward sloping yield curve takes place when it is expected by the investor that the economy will decline in the future and this lower growth may result in the lower interest rates and lower inflation for all maturities. It indicates that the long term investors will look for lower yields than short term investors because they anticipate that the economy will get worse in the future. Therefore, they seek to lock in higher rates at present before they fall in the near future. A downward sloping yield curves takes place during recession time when the long term rates are lower than the short term rates. An example of downward sloping yield curve was in 2004-05 when foreign investors wanted to buy U.S. Treasury securities due to the reason that they were backed by the U.S. government. Thus, such a continuous demand for such long term products permits the issuer to propose them at lower yields. This situation takes place opposite to the laws of demand and supply, thereby enabling the issuer of the bond to find buyers without the payment of higher rates because these buyers were concerned with an approaching economic slowdown. Generally, a downward sloping yield curve symbolizes an economic irregularity because it does not take into consideration the risk premium as maturity grows longer (Laopodis, 2012). When the economy shifts from a recession to an expansion, a flat yield curve occurs because the interest rates begin to rise and therefore resulting in a positive slope of the yield curve which slopes upward. A flat yield curve also indicates that the economic activity is slowing down (Jones, 2009, p.333). A flat curve signifies that the long and short term yields are converging. As the long and short term investors hardly receive the same return on securities, so it does not happen very often. And at last, a humped yield curve also takes place which indicates that long and short term yields are alike and lesser than intermediate term yields. It also indicates a move of yield curve from inverted to normal or vice versa. It signifies the starting of the recession due to the reason that before becoming inverted it flattens first (Laopodis, 2012). Therefore as a whole, the factors which affect the shape of yield curves are the inflation rates, interest rates, central bank policy, liquidity desires and demand/supply conditions. The yield curve of U.S. is initially flat in shape which indicates the slower economic growth but afterwards it was an upward sloping curve i.e. a normal sloping curve. It happens because the interest rates begin to rise and therefore resulting in a positive slope of the yield curve when the economy shifts from a recession to an expansion. Therefore, it indicates the good economic growth. The yield curve of U.K was also initially flat in shape but afterwards it took the form of a positive slope curve which also indicates the good economic growth. But the slope of the U.K. yield curve is higher than the slope of U.S. yield curve thereby signifying the better economic growth of U.K. in comparison to the U.S. economic growth (See Appendix C). Task 3: Effectiveness of Monetary Policy The main function of the U.S. Federal Reserve System is to carry out monetary policy. It is charged by the congress to use monetary policy in order to encourage efficiently the goals of stable prices, maximum employment, and reasonable long term interest rates. The federal funds rate is influenced by the Federal Reserve by modifying the amount of existing funds in the federal funds market (Office, 2010, p.6). The financial stress had resulted in a global economic slowdown which involves the expansion of monetary supply and the lowering of interest rates. Due to the hit of the financial crisis, investors of U.S. fled debt instruments and stocks for the virtual safety of cash frequently held in the form of other government securities and the U.S. treasury securities. It resulted in the increased demand for dollars and therefore decreased the interest rates of U.S. which is needed to attract investors and hence caused inflows of liquid capital in U.S. (Nanto, 2009, p.34). The Federal Reserve played an important role during financial distress. They increased the amount of reserves through making loans by its discount window. It is a facility that constructs collateralized loans to depository institutions and to banks. The other method of Central bank to adjust reserves is to alter its reserve requirements which identify the reserves amount that is hold by the depository institutions at the Federal Reserve Banks. Recently, it was also granted the power to pay interest on bank reserves thereby giving it a new tool in order to influence the level of interest rates in broader financial market (Office, 2010, p.6). Task 4: Implication for Investor and Policy makers In common the yield curve is significant to both the policymakers and the investors. U.S. Treasury yield curve is used by the investors in order to price and decide the future payments on all instruments and recognize those securities that are more attractive to buy and sell. In addition to this, they also create current trading opportunities and future strategies on shifts in the structure of the general interest rates and its shape. Policymakers identifies the huge amount of information that the bond prices carry and thus scrutinize them closely in order to judge the current state of the economy i.e. about the output and the inflation expectations. For example, the contraction of monetary policy should be attended by higher rates and therefore a higher yield curves (Laopodis, 2012). Conclusion The yield curve of U.S. Treasury securities is regarded as a market benchmark because it is frequently used as a vital reference point by fixed income investors in order to evaluate the market conditions. This report examines the different types of yield curves that indicate the structure of interest from December 2009 to 2011. It focuses on how the changes in the slope of yield curve have an impact on the future prospects of the U.S. economy as well as the economy of United Kingdom. It also takes into consideration the effectiveness of monetary policy during the time of financial stress, and at last it focuses on the policy implications for investors and policy makers. Appendices Appendix A Appendix B Appendix C Reference Burton, M. Burton, and Nesiba, R., 2010. An Introduction to Financial Markets and Institutions. New York: M. E. Sharpe. Droms, W.G. and Wright, J.O., 2010. Finance and Accounting for Nonfinancial Managers. 6th Edn. New York: Basic books. Haubrich, J.G., 2004. Interest Rates, Yield Curves, and the Monetary Regime. Cleveland: Federal Reserve Bank of Cleveland. Jones, C.P., 2009. Investments: Analysis and Management. 11th Edn. New Jersey: John Wiley & Sons. Laopodis, N.K., 2012. Understanding Investments: Theories and Strategies: Significance of the Yield Curve. United Kingdom: Routledge. Nanto, D.K., 2009. The Global Financial Crisis: Analysis and Policy Implications. United States: DIANE Publishing. Office, C.B., 2010. The Budgetary Impact and Subsidy Cost of the Federal Reserve’s actions During the Financial Crisis. United States: Congress of the United States, Congressional Budget Office. Saha, S.S., N.D. Indian Financial System and Market. New Delhi: Tata McGraw-Hill Education. Read More