Inverted Yield Curve Essay Example | Topics and Well Written Essays - 1500 words

Inverted Yield Curve - Essay Example The value of a bond is dependent on its required return. â€Å"Whenever the required return on bonds differs from the bond’s coupon interest rate, the bond’s value will differ from its par value. The required return is likely to differ from coupon interest rate because either (1) economic conditions have changed; causing a shift in the basic cost of long-term funds, or (2) the firm’s risk has changed. Increases in the basic cost of long-term funds or in risk will raise the required return; decreases in the cost of funds or in risk will lower the required return† (Lawrence J. Gitman). This is the basic principle of interest rates and bond valuation. The above principle shows that the bond valuation is dependent mostly on economic conditions and the firm’s risk taking ability. So when reasons for lower interest on long-term bonds as compared to short-term bonds are analyzed, it reflects the character of economic conditions. In this way, the bond interest rates work as the barometer of the economic conditions. Normally long term investments are made in the avenues that show steady performances over a period of time and provide the reasonable rate of return. It is seen that whenever stock market underperforms, investors withdraw money from stocks and usually invest in long-term bonds. This raises the demand for bonds and as a result of demand and supply interactions, the requirement of funds through debts instruments decreases; and the result decreases in the interest rates of bonds.