FIN 320: Chapter Six (Interest Rates)

Rating and Default Risk Premium

AAA = 0.60% AA = 0.80% A = 1.05% BBB = 1.45%

Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?

An AAA-rated bond has less default risk than a BB-rated bond.

A company's financial health improves.

Decrease, Less Expensive

There is an increase in the perceived marketability of a company's bonds, so the liquidity premium decreases.

Decrease, Less Expensive

A company uses debt to buy another company. Such an event is called a leveraged buyout.

Increase, More Expensive

XYZ Co.'s credit rating was downgraded from AA to BBB.

Increase, More Expensive

Determine which of these fundamental factors is affecting the cost of money in the scenario described:

Inflation

Over the past several years, Germany, Japan, and Switzerland have had lower interest rates than the United States due to lower values of this premium.

Inflation Premium (IP)

During recessions, short-term interest rates decline more sharply than long-term interest rates.

True

The graph's yield curve represents ___ yield curve.

a humped

If the inflation rate was 3.00% and the nominal interest rate was 4.60% over the last year, what was the real rate of interest over the last year? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. Round intermediate calculations to four decimal places.

1.60%

Tahoe Hydroponics issues ten-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average.

10.35%

Recall that on a one-year Treasury security the yield is 4.6900% and 5.6280% on a two-year Treasury security. Suppose the one-year security does not have a maturity risk premium, but the two-year security does and it is 0.25%. What is the market's estimate of the one-year Treasury rate one year from now?

6.0705%

Suppose the yield on a two-year Treasury security is 5.83%, and the yield on a five-year Treasury security is 6.20%. Assuming that the pure expectations theory is correct, what is the market's estimate of the three-year Treasury rate two years from now?

6.45%

The yield on a one-year Treasury security is 4.6900%, and the two-year Treasury security has a 5.6280% yield. Assuming that the pure expectations theory is correct, what is the market's estimate of the one-year Treasury rate one year from now?

6.5744%

This is the difference between the interest rate on a US Treasury bond and a corporate bond of the same profile—that is, the same maturity and marketability.

Default Risk Premium (DRP)

All else equal, the yield on new bonds issued by a leveraged firm will be less than the yield on the new bonds issued by an unleveraged firm.

False

When the economy is weakening, the Fed is likely to increase short-term interest rates.

False

Suppose the Federal Reserve (the Fed) decides to tighten credit by contracting the money supply. Use the following graph by moving the black X to show what happens to the equilibrium level of borrowing and the new equilibrium interest rate.

If the Fed contracts the money supply, less capital is available to be invested. As a result, firms are competing for fewer funds to invest in their production opportunities. The supply of capital decreases, and the supply curve shifts to the left. The new equilibrium shows that $3 billion of capital will be available and borrowed at an interest rate of 12.0%.

Based on an upward-sloping normal yield curve as shown, which of the following statements is correct?

If the pure expectations theory is correct, future short-term rates are expected to be higher than current short-term rates.

Based on the yield curve shown, which of the following statements is true?

Interest rates on medium-term maturities are higher than rates on long-term and short-term maturities.

This premium is added when a security lacks marketability, because it cannot be bought and sold quickly without losing value.

Liquidity (or Marketability) Premium (LP)

This is the premium that reflects the risk associated with changes in interest rates for a long-term security.

Maturity Risk Premium (MRP)

Given the indicated maturities listed in the following table, assume the following yields for US Treasury securities:

Maturity(Years) | Yield (%) 1 = 3.6 5 = 5.5 10 = 5.5 20 = 4.2 30 = 4.0

Suppose that a firm is facing an upward-sloping yield curve and needs to borrow money to invest in production. Does this mean that the firm should consider borrowing only at short-term rates?

No, the firm needs to take the volatility of short-term rates into account.

It is calculated by adding the inflation premium to r*.

Nominal Risk-Free Rate (rRF)

This is the rate for a short-term riskless security when inflation is expected to be zero.

Real Risk-Free Rate of Interest (r*)

Which tend to be more volatile, short- or long-term interest rates?

Short-term interest rates

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 6% per year for each of the next three years and 5% thereafter.

The maturity risk premium (MRP) is determined from the formula: 0.1(t - 1)%, where t is the security's maturity. The liquidity premium (LP) on all Tahoe Hydroponics's bonds is 0.55%.

If inflation is expected to decrease in the future and the real rate is expected to remain steady, then the Treasury yield curve is downward sloping. (Assume MRP = 0.)

True

The Federal Reserve Board has a significant influence over the level of economic activity, inflation, interest rates in the United States.

True

The pure expectations theory assumes that investors do not consider long-term bonds to be riskier than short-term bonds.

True

The yield curve for an AA-rated corporate bond is expected to be above the US Treasury bond yield curve.

True

When the Fed increases the money supply, short-term interest rates tend to decline.

True

Yield curves of highly liquid assets will be lower than yield curves of relatively illiquid assets.

True

Suppose the real risk-free rate and inflation rate are expected to remain at their current levels throughout the foreseeable future. Consider all factors that affect the yield curve. Then identify which of the following shapes that the US Treasury yield curve can take.

Upward-sloping yield curve