Q1. With reference to the Indian economy, consider the following statements regarding ‘Bond Yields’:
- An increase in the fiscal deficit target of the Union Government generally leads to a rise in G-Sec yields.
- The ‘Open Market Operations’ (OMO) sales by the RBI are intended to soften bond yields during periods of liquidity crunch.
- Foreign Portfolio Investors (FPIs) selling Indian debt instruments leads to a decrease in bond prices and an increase in yields.
Which of the statements given above are correct?
(a) 1 and 2 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2, and 3
Answer: (c)
Explanation:
- Statement 1 is correct; higher borrowing increases the supply of bonds, lowering prices and raising yields. Statement 2 is incorrect; OMO sales absorbs liquidity and increase yields; OMO purchases soften yields. Statement 3 is correct; selling pressure drops prices and pushes yields up.
Q2. Given below are two statements, one labeled as Assertion (A) and the other as Reason (R):
- Assertion (A): In an inflationary environment, long-term bonds are riskier for an investor than short-term bonds.
- Reason (R): The ‘Duration’ of a bond, which measures price sensitivity to interest rate changes, is higher for bonds with longer maturities.
Select the correct answer using the code below:
(a) Both A and R are true, and R is the correct explanation of A.
(b) Both A and R are true, but R is not the correct explanation of A.
(c) A is true, but R is false.
(d) A is false, but R is true.
Answer: (a)
Explanation:
- Inflation leads to higher interest rates. Because long-term bonds have higher duration, their market price crashes much more significantly than short-term bonds for every 1% rise in rates.
Q3. If the ‘Federal Reserve’ of the United States aggressively hikes its benchmark interest rates, what is the most likely ‘Contagion Effect’ on the Indian Bond Market?
(a) Yields on Indian G-Secs will fall as capital flows from the US to emerging markets.
(b) The RBI will be forced to buy bonds to prevent yields from rising, leading to a decrease in the money supply.
(c) There will be upward pressure on Indian bond yields due to the narrowing of the ‘Spread’ between US and Indian debt.
(d) Indian bond prices will appreciate as domestic investors hedge against currency depreciation.
Answer: (c)
Explanation:
- When US rates rise, the “spread” (difference) between Indian and US yields narrows. To prevent capital flight, Indian yields must rise to remain attractive to global investors.
Q4. Match the following Economic Phenomena with their Impact on Bond Markets:
| Phenomenon | Primary Impact |
| 1. Quantitative Easing | A. Steepening of the Yield Curve |
| 2. Stagflation | B. Inversion of the Yield Curve |
| 3. ‘Operation Twist’ | C. Downward pressure on Long-term yields |
| 4. Tight Monetary Policy | D. Rise in nominal yields despite low growth |
Which of the following is the correct matching set?
(a) 1-C, 2-D, 3-C, 4-B
(b) 1-A, 2-B, 3-D, 4-C
(c) 1-C, 2-A, 3-B, 4-D
(d) 1-B, 2-C, 3-A, 4-B
Answer: (a)
Explanation:
- Quantitative easing (1) adds liquidity, lowering yields (C). Stagflation (2) involves inflation, which forces yields up (D). Operation Twist (3) specifically targets buying long-term bonds to lower their yields (C). Tight policy (4) can lead to an inverted curve (B) if short-term rates are pushed above long-term expectations.
Q5. Regarding the relationship between Inflation and Bond Prices, consider the following:
- Inflation-Indexed Bonds (IIBs) protect the coupon rate but not the principal amount from inflation.
- If expected inflation is higher than the nominal yield, the ‘Real Yield’ becomes negative.
- The ‘Fisher Effect’ suggests that nominal interest rates adjust one-for-one with changes in expected inflation.
Which of the statements given above is/are correct?
(a) 1 only
(b) 2 and 3 only
(c) 3 only
(d) 1, 2, and 3
Answer: (b)
Explanation:
- Statement 1 is incorrect; IIBs primarily adjust the principal to protect against inflation. Statements 2 and 3 are standard economic tenets (Fisher Equation: $Nominal = Real + Inflation$).
