Impact of Interest Rate Volatility on Yield Curve

Hard Term Structure Dynamics Interest Rate Volatility

In a recent analysis of the fixed income market, several economists discussed the implications of fluctuating interest rate volatility on the term structure of interest rates.

One economist posited that the shape of the yield curve is significantly influenced by changes in interest rate volatility. He argued that an increase in volatility tends to shift the yield curve upward, creating a steeper slope, while a decrease in volatility may lead to a flatter yield curve.

Another economist defined interest rate volatility as the degree to which interest rates can change over a given period. He noted that persistent high volatility in interest rates can lead to greater uncertainty in price movements of fixed income securities.

Based on these discussions, which of the following statements accurately reflects the impact of interest rate volatility on the term structure?

High interest rate volatility generally leads to an upward shift in the yield curve due to increased uncertainty about future interest rates.

Low interest rate volatility will cause the yield curve to steepen, reflecting higher expected inflation rates.

Changes in interest rate volatility have little to no effect on the shape of the yield curve under normal market conditions.

Hint

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