Generally speaking, an upward-sloping yield curve can be expected when: A) the supply of long-term funds falls short of demand and investors begin to show a preference for more liquid/less risky short-term securities. B) the supply of long-term funds falls short of demand. C) inflationary expectations are beginning to subside. D) inflationary expectations are beginning to subside and investors begin to show a preference for more liquid/less risky short-term securities. The correct answer was A) the supply of long-term funds falls short of demand and investors begin to show a preference for more liquid/less risky short-term securities. When demand for loanable funds outstrips supply, interest rates can be expected to rise in that (long-term) segment of the market; also, more preference for short-term securities can be expected to drive up long-term rates as the liquidity premium rises. Thus, both circumstances in the answer can be expected to put upward pressure on the long end of the yield curve. Query: I don’t understand how the yield will be high if the demand outstrips supply. Logically, if the demand of a product is higher than the supply, then product price will increase. Basic Economics. So, if the demand for long term bonds is higher than supply, then prices of long term bonds will go up. That means yield must come down, right?? Say, for a 8% 20 Year 100$ bond, if its price goes up to 110$, then the required yield must have come down to say 6.5%. If the demand further increases, it will touch 120 $ and the yield must be say 5% then. How will more demand lead to more yield which is the explanation given? I thought more supply and less demand for long term bonds will increase the yields. Am I missing something very basic?
Think about it from the perspective of the borrower rather than the investor. When banks demand more than depositors are willing to supply, they will need to put upward pressure on rates. The second half of the question addresses what you said correctly. More investor demand on the front end of the curve will steepen the curve out.
think of price in a different way…its not the price of bond here…its the price of capital which is yield that goes up link b/w price and yield of bond is separate donot mix the price of bond and price of capital