Can someone explain the reasoning behind the yield curve being flat when inflation is correctly anticipated?

Guys, can someone ans this. It is from CFA exam 2

I am stikll waiting on this incase someone can ans this

the inflation is correctly anticipated --> we can predict similar short-term rates --> the same yield --> flat curve

But wont u expect higher yields since the inflation is increasing

Smeet, I think you may be reading into the wording incorrectly and assuming that inflation is expected to increase. I think the question may mean the “inflation rate”. The rate can also be zero, no change or negative. I think you are confused because you assume inflation is increasing.

Smeet, I know which question your talking about. I have the same question as you. I think the questions read: if inflation is expected to be stable, what is the shape of the yield curve? The answer was a flat yield cuve. I thought this was incorrect. If inflation is stable, doesn’t that mean that the yield curve should be upword sloping to compensate for the inflation?

smeet Wrote: ------------------------------------------------------- > Can someone explain the reasoning behind the yield > curve being flat when inflation is correctly > anticipated? This isn’t true. I suppose that if you buy into a pure expectations yield curve, if inflation is correctly anticipated then the future spot rates will equal the forward rates.

moto376 Wrote: ------------------------------------------------------- > Smeet, I know which question your talking about. I > have the same question as you. > > I think the questions read: if inflation is > expected to be stable, what is the shape of the > yield curve? The answer was a flat yield cuve. > This is a very idealized kind of question but the idea is that if inflation is stable and everyone knows it the forward rate for 6 months, say, in a year should be the same as the current 6 month rate. > > I thought this was incorrect. If inflation is > stable, doesn’t that mean that the yield curve > should be upword sloping to compensate for the > inflation? Not to compensate for inflation but to compensate for uncertainty which they took away in some really artificial way.

wierd question…i was thinking upward sloping as well

JoeyDVivre Wrote: ------------------------------------------------------- > smeet Wrote: > -------------------------------------------------- > ----- > > Can someone explain the reasoning behind the > yield > > curve being flat when inflation is correctly > > anticipated? > > This isn’t true. I suppose that if you buy into a > pure expectations yield curve, if inflation is > correctly anticipated then the future spot rates > will equal the forward rates. Hi Joey, I am bit confused with the spot rate and the forward rate concept. Is the spot rate todays rate and anything in the future the forward rate? In case we need to calculate the yield of a bond of maturity 5 yrs, two years from today ( similar to a question someone had posted erlier) , it is the 5 yerar forward rate 2 yrs from now or is it the 2 yr spot rate?

smeet Wrote: ------------------------------------------------------- > JoeyDVivre Wrote: > -------------------------------------------------- > ----- > > smeet Wrote: > > > -------------------------------------------------- > > > ----- > > > Can someone explain the reasoning behind the > > yield > > > curve being flat when inflation is correctly > > > anticipated? > > > > This isn’t true. I suppose that if you buy into > a > > pure expectations yield curve, if inflation is > > correctly anticipated then the future spot > rates > > will equal the forward rates. > > > Hi Joey, > > I am bit confused with the spot rate and the > forward rate concept. Is the spot rate todays rate > and anything in the future the forward rate? > > In case we need to calculate the yield of a bond > of maturity 5 yrs, two years from today ( similar > to a question someone had posted erlier) , it is > the 5 yerar forward rate 2 yrs from now or is it > the 2 yr spot rate? Well you kind of need both. The five year forward rate two years from now is what you use to value the bond. You will need to get that by bootstrapping using the 7 yr spot rate and the 2-yr spot rate.

Since nominal interest rates = real + inflation, if inflation is stable and this is anticipated, real rates shouldn’t change assuming there are no shocks, and inflation is not changing so nominal interest rates will be expected to stay the same, hence flat yield curve. Is this correct?

yickwong Wrote: ------------------------------------------------------- > Since nominal interest rates = real + inflation, > if inflation is stable and this is anticipated, > real rates shouldn’t change assuming there are no > shocks, and inflation is not changing so nominal > interest rates will be expected to stay the same, > hence flat yield curve. Is this correct? Your explanation looks rt. If we consider this in an economics background, can we say the foll. We expect the inflation to stay constant. AS a result the supply curve will move accordingly i.e wages will be renegotiated, and real interest rate still remains the same. Since real and inflation do not change, nominal does not change either and yield curve is flat

I don’t think this is a great question. If inflation is correctly anticipated but everyone expects that interest rates will fall because the economy is in recession (expectations theory), the yield curve will be downward sloping. Alternatively, if inflation is correctly anticipated but investors demand a large premium for the inconvenience of longer maturities (liquidity preference theory), the yield curve will be upward sloping. I believe that the shape of the yield curve is a function of more than simply the accuracy of expectations with respect to inflation.

This is a question from CFA sample exam