• Federal funds rate: The interest rate at which banks lend reserves to each other overnight; the primary tool of Federal Reserve monetary policy.
• FOMC (Federal Open Market Committee): The Fed committee that sets monetary policy, including the federal funds rate.
• Yield curve: Graph of bond yields across maturities; shape signals economic and rate expectations.
• Normal yield curve: Upward-sloping; longer maturities yield more; typical in healthy growth environments.
• Inverted yield curve: Short-term rates exceed long-term rates; historically preceded recessions.
• Real interest rate: Nominal interest rate minus inflation rate; represents the actual purchasing power return.
• Duration: Measure of a bond's sensitivity to interest rate changes; used to manage rate risk in portfolios.
• Fisher Effect: The relationship between nominal rates, real rates, and inflation: Nominal Rate ≈ Real Rate + Inflation Rate.

Quiz Questions:

Q1. An investment adviser manages a bond portfolio for a client. The adviser believes the Fed will raise rates significantly over the next 12 months. Which strategy should the adviser most likely recommend?

A) Extend duration by purchasing 30-year Treasury bonds B) Shorten duration by moving to shorter-maturity instruments C) Purchase high-yield bonds, which are less interest-rate sensitive D) Invest entirely in TIPS regardless of the client's objectives

Answer: B — Rising interest rates cause bond prices to fall, with longer-duration bonds falling more. To protect the portfolio, the adviser should shorten duration — moving to shorter-maturity bonds that are less price-sensitive to rate changes. High-yield bonds (C) are less rate-sensitive due to their high credit spread but carry significant default risk.

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Q2. The yield on 2-year Treasury notes is currently 5.2%, while the yield on 10-year Treasury bonds is 4.7%. This yield curve shape is best described as:

A) Normal (upward-sloping) B) Flat C) Inverted D) Humped

Answer: C — When short-term yields exceed long-term yields, the yield curve is inverted. Historically, an inverted yield curve has been one of the most reliable predictors of economic recession, typically with a lag of 6-18 months.

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