Ch.4 MB

facts about yield curves

1. generally slopes upwards 2. slope of yield curve does change 3. often parallel shift in a yield curve

Complete the following table by calculating the ex post and ex ante real interest rates. Nominal interest rate9.5% Actual inflation rate8.2% Expected inflation rate9.4% Ex post real interest rate -------% Ex ante real interest rate -------%

1.3, .1

Suppose Dina is in the 25% tax bracket. She considers purchasing two bonds, a corporate bond, which pays a before-tax interest rate of 11.5%, and a muni bond, which pays a 5% interest rate. Corporate Bond before tax ------ after tax -----

11.5, 8.63

Suppose Dina is in the 25% tax bracket. She considers purchasing two bonds, a corporate bond, which pays a before-tax interest rate of 11.5%, and a muni bond, which pays a 5% interest rate. Muni Bond before tax ------ after tax -----

5, 5

Suppose the nominal interest rate is 7.5% and the inflation rate is 1.5%, and then the real interest rate is -------

6%

Consider a bond with a before-tax coupon rate of 9% Marginal Tax Rate 28% After-Tax Rate of Return ------???

6.48

Consider a bond with a before-tax coupon rate of 9% Marginal Tax Rate 27% After-Tax Rate of Return ------???

6.57

Consider a bond with a before-tax coupon rate of 9% Marginal Tax Rate 23% After-Tax Rate of Return ------???

6.93

Which of the following represents the default risk premium (DRP)? a) DRPi,t=IRmarket,i,t−IRrisk-free,tDRPi,t=IRmarket,i,t−IRrisk-free,t b) DRPi,t=IRmarket,i,t×IRrisk-free,tDRPi,t=IRmarket,i,t×IRrisk-free,t c) DRPi,t=IRmarket,i,tDRPi,t=IRmarket,i,t d) DRPi,t=IRmarket,i,t−IRrisk-free,tIRrisk- free,tDRPi,t=IRmarket,i,t−IRrisk-free,tIRrisk-free,t

A

Steep curve bad news and good news (pure)

Bad: higher inflation in future Good: faster economic growth

Steep curve bad news and good news (segmented)

Bad: mortgage interest rates increase Good: expansionary monetary policy

Steep curve bad news and good news (term)

Bad: savers worry about the future Good: savers currently have better use for their money

The real realized rate of return is

Ex post

Suppose that in May 2016, Goldman & Sons Corporation issues a bond that pays 5.5%. At the same time, the US Treasury, when it issues debt, pays an interest rate of 4% Based on the formula for the default risk premium,-------------------- must pay a DRP of -----% because the rate on ------------ is considered the risk-free rate.

Goldman & Sons Corporation, 1.5%, US Treasury securities

how to calculate default risk premium

It is very difficult to do. you have to predict the future

steep yield curve (pure)

Short term interest rates will be significantly higher in the future

Strategy A: Buy a one-year bond that pays 8% and in one year buy another one-year bond. Strategy B: Buy a two-year bond that pays 7% this year and 7% next year. If the one-year bond that Dina can purchase in one year pays 6%, Dina will choose ----------- Strategy A Strategy B

Strategy A

real realized rate of return

The rate of return earned after controlling for inflation

what is the risk free interest rate similar too?

US treasury bonds

Which of the following explain why financial instruments, such as bonds or loans, carry a default risk? a) A natural disaster b) A firm that issued bonds expanded too quickly and its revenue rose above the expected level c) A household that took out a mortgage loan improved its financial status beyond what the loan officer expected d)Economic recession

a , d

reason for default 1

a firm expands too quickly

flat yield curve (segmented)

a lot is going on at the same time in the markets

Which of the following are properties of yield curves? Check all that apply. a) The slope of a yield curve can and does change. b) Yield curves are subject to frequent parallel shifts. c) Generally, a yield curve slopes upward. d) Generally, a yield curve slopes downward.

a, b, c

which of the following are likely consequences of rising inflation? Check all that apply. a) Savers wanting to save less and borrowers wanting to borrow more b) A redistribution of wealth in favor of the wealthy c) An improved price-signaling mechanism d) A misallocation of resources

a, b, d

Ex post real ir

actual inflation rate

real interest means it is

adjusted for inflation

ibefore tax=

aftertax/(1-z)

Which of the following is consistent with the pure expectations theory of the yield curve? Check all that apply. a) An inverted yield curve suggests that the market thinks short-term interest rates in the future will be lower than they are today. b) Long-term interest rates are based on expectations of what short-term interest rates will be in the future. c) A flat yield curve suggests that the market thinks interest rates in the future will be the same as they are today. d) An upward-sloping yield curve implies that the market thinks short-term interest rates are going to be higher in the future than they currently are.

all

why do wealthy people get richer with inflation

assest/ investments move with interest better than wages

Strategy A: Buy a one-year bond that pays 8% and in one year buy another one-year bond. Strategy B: Buy a two-year bond that pays 7% this year and 7% next year. Which of the following describes conditions under which Dina would be indifferent between Strategy A and Strategy B? a) The rate on the two-year bond is 9%. b) The rate on the one-year bond purchased in one year is 6%. c) The rate on the one-year bond purchased in one year is 9%. d) The rate on the two-year bond is 6%.

b

reason for default 2

borrowers living beyond their means

steep yield curve (term)

borrowers require higher term premium in order to hold long term bonds

Suppose the before-tax yield on the corporate bond is 6.67%. Which of the following is true? a) Dina will prefer the corporate bond over the muni bond. b) Dina will prefer the muni bond over the corporate bond. c) Dina will be indifferent between the corporate bond and the muni bond.

c

Which of the following accurately describes a principal argument of the term premium theory of the yield curve? a) Short-term and long-term bonds are traded in segmented markets. b) Shorter-term bonds have higher yields than longer-term bonds to incentivize investors to purchase shorter-term bonds, which are generally less desirable than longer-term bonds. c) Longer-term bonds have higher yields than shorter-term bonds to incentivize investors to purchase longer-term bonds, which are generally less desirable than shorter-term bonds. d) Long-term interest rates are based on the expectations of what short-term interest rates will be in the future.

c

Which of the following is true about municipal (muni) bonds? a) Generally, investors are indifferent between corporate bonds and muni bonds. b) The interest paid on muni bonds is subject a higher than average federal income tax. c) The interest paid on muni bonds is not subject to federal income tax. d)The interest paid on muni bonds is subject a lower than average federal income tax.

c

How do different models explain a steep yield curve? Check all that apply. a) The economy is headed for a slowdown or a recession. b) Long-term yield fell, while short-term yields increased; thus these markets are different. c) It could be good news (savers have uses for funds) or bad news (savers are worried about the future). d) It could be good news (faster growth) or bad news (higher inflation). e) It could be good news (lower interest rates strengthen real estate market) or it could be bad news (central banks have cut interest rates because they are worried about an impending economic slowdown and there are too many homes being built and sold).

c, d, e

inflation (definition)

continuous increase in the general level of prices

Steep yield curve (segmented)

could result from things happening in the different markets

1. One-year bonds issued by Golden Power, a producer of solar batteries based in Canada, that pay a nominal interest rate of 7.5%2. 2.One-year bonds issued by Sun Waters, a producer of solar water heaters based in Australia, that pay a nominal interest rate of 9.8% A thorough study has shown that the economic situation and prospects in Canada and Australia are very similar. Nevertheless, Lucia decides to invest in Golden Power. Ceteris paribus, which of the following best explains Lucia's choice? A) Canada has more renewable resources than Australia. b) Unemployment rates in Canada are lower than in Australia. c) Real interest rate in Canada is lower than in Australia. d) Inflation in Australia is more than 2.3% higher than in Canada. e) Inflation in Canada is more than 2.3% higher than in Australia.

d

Which of the following is a key argument for the segmented market theory? a) Shorter-term bonds have higher yields than longer-term bonds to incentivize investors to purchase shorter-term bonds, which are generally less desirable than longer-term bonds. b) Short-term interest rates are based on the expectations of what long-term interest rates will be in the future. c) Short-term and long-term bonds are usually traded in the same market. d) The short-term, medium-term, and long-term bond markets are all different markets, characterized by market players who have different objectives in participating in these market.

d

Adjust the following graph to show the effect of a decrease in sales of Zambetti & Sons Corporation on the market for US Treasury securities

demand shift up

Adjust the following graph to show the effect of a decrease in sales of Zambetti & Sons Corporation on the market for corporate bonds

demand shifts down

why does the curve go up for term premium

entice people to buy long-term bonds

DRP

excess between risk free and interest

Ex ante real ir

expected inflation rate

Muni bonds - not subject to

federal income tax

(term) long-term=

higher yield

iaftertax =

ibefore tax(1-z)

fact of pure expectation theory over expected rate

if we know 1 year bond and 2 year bond rate today, we can solve the expected rate

flat yield curve (pure)

interest rates today will be the same in the future

what does this say about interest rates in the future (inverted yield curve)

interest rates will be lower in the future

bond prices and interest have an

inverse relationship

(term) short term =

liquid

Inverted yield curve shows

long-term interest rates are lower than short-term

z=

marginal tax rate

Segmented market theory

markets are completely different

from the perspective of the segmented theory what does an inverted yield curve mean

monetary policy is pushing up on short-term interest rates

default risk premium

more risk = more money lender is going to demand

reason for default 4

natural disaster

Real interest rates =

nominal interest rate - inflation rate

why are bond ratings dangerous

not an accurate measure of default risk

consumers who depend on wages and salaries for consumption see

real income fall and must consume less

reason for default 3

recession

interest =

risk free interest + DRP

flat yield curve (term)

savers are indifferent about short term and long term bonds

pure expectation theory

series of bonds should give you same interest rate as one long term bond

term premium theory

short-term bonds are better than long term bonds

problem with segmented theory

some relation show is coincidence

Default risk

the risk that a borrower will not pay interest or principal back

True or False: As the marginal tax rate increases, the after-tax rate of return decreases

true

Which of the following yield curves is consistent with the main argument of the term premium theory?

upward slope

Which of the following graphs shows a steep yield curve

upward sloping

fact of pure expectation theory over slope

upward sloping curve tells us interest rates will go up in future