chapter 6 study questions

What is the definition of Maturity Risk Premium?

A premium that reflects interest rate risk

Define, explain and give an example of Pure Expectations Theory:

A theory that states that the shape of the yield curve depends on investors' expectations about future interest rates. For example, the yield to maturity on a five-year bond is the average of the current and expected future short-term rate for the next five years.

Determine the real interest rate of a bond with a current interest rate of 8%, and an inflation rate of 3.4%. Real rate = 8-3.4

Formula: Real Rate = Current Interest Rate - Current Inflation Rate 4.7%

If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 8.5%, the maturity risk premium on all 10-year bonds is 1.3%, and corporate bonds have a 0.4% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond? T Bond 6.2% Corp Bond 8.5% LP Corp bond only 0.4% MRP for all 10 year bonds 1.3%

Formula: rcorp - rT-bond - LP = 8.5% - 6.2% - 0.4% = 1.90%

Define, Explain and give an example of Federal Deficits.

If the government spends more than it takes in taxes, they are running a deficit. The higher the federal deficit, the higher the interest rates will get. As a simple example, if a government takes in $10 billion in revenue in a particular year, and its expenditures for the same year are $12 billion, it is running a deficit of $2 billion.

Define, explain, and give examples of which fluctuate more long-term or short-term interest rates

Long term bonds are most sensitive to interest rate changes. The reason lies in the fixed-income nature of bonds: when an investor purchases a corporate bond, for instance, they are actually purchasing a portion of a company's debt. This debt is issued with specific details regarding periodic coupon payments, the principal amount of the debt, and the time period until the bond's maturity. short-term bonds are both excellent savings vehicles. Both are liquid, easily accessible, and relatively safe securities. However, these investments can involve fees, may lose value, and might decrease a person's purchasing power. Although money market funds and short-term bonds have many similarities, they also differ in several ways.

The pure expectations theory contends that the shape of the yield curve depends on investors' expectations about future interest rates.

TRUE

U.S. firms also invest and raise capital throughout the world besides just in the U.S.

TRUE

Define, explain, and give examples of term structure of interest rates

Term structure of interest rates is described as the relationship between long and short term rates. The term structure of interest rates is important to corporate treasures deciding whether to borrow by issuing long or short term debt and to investors who are deciding whether to buy long or short term bonds. An example is The U.S. Treasury Yield Curve.

Define, explain, and give examples of the fundamental factors affecting the cost of money.

The cost of money is the opportunity cost of holding money in hand instead of investing it. The fundamental factors affecting the cost of money is production opportunities, time preferences for consumption, risk, and inflation. Production opportunities are the investment opportunism in heavy cash flow assets. Time preferences for consumption risk is the preferences of consumers for current consumption as opposed for saving for future consumption. Risk is the chance that an investment will provide low or negative return. Inflation is the amount by which prices increase over time.

Define, explain, and give examples of the assumptions of pure expectations.

The expectations theory attempts to predict what short-term interest rates will be in the future based on current long-term interest rates. This theory also explains why longer-term bonds pay higher interest than short-term bonds this is because the longer you hold a long-term bond the more risk you will experiences as the future could be unpredictable. For example, investors that bought a 30-year Russian bond in 2000 will now face default in their bonds 22 years later and might never see their bonds to maturity.

Define, explain, and give examples of the three different basic types of interest rate yield curves.

The first type of yield curve is a normal yield curve. The definition of a normal yield curve is a yield curve of interest rates that is upward sloping. A good way to explain this phenomenon is when short-term interest rates drop below long-term interest rates. This can occur when inflation is expected in the future to go up. This is the normal situation. The curve of a 3% 1-year bond, 4% 3-year bond, 5% 5-year bond, and 7% 10-year bond is an example of a normal yield curve. The second type of yield curve is an abnormal or inverted yield curve. An inverted yield curve is a yield curve of interest rates that slopes downward. An easy way to explain this phenomenon is when short-term interest rates drop below long-term interest rates. This can occur when inflation is expected to go down in the future. An example of an abnormal yield curve is the curve of a 7% 1-year bond, 6% 3-year bond, 5% 5-year bond, and 3% 10-year bond. The third type of yield curve is a humped yield curve. The definition of a humped yield curve is an interest rate yield curve where the interest rates of intermediate maturities are higher than those on short term and long term maturities. This means that short-term rates are low and long-term rates are low at the same time. This can happen when inflation is currently low (causing lower short-term rates) and is expected to go lower in the future (causing lower long-term rates). However, intermediate rates stay higher than these two because inflation may be expected to go higher in the intermediate-term. The curve of 3% a 1-year bond, 5% 3-year bond, 5% 5-year bond, and 4% 10-year bond is an example of a humped yield curve.

5-year Treasury bonds yield 4.0%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5-year T-bonds is 0.4%. There is no liquidity premium on these bonds. What is the real risk-free rate, r*?

Treasury bonds yield - The inflation premium (IP) - The maturity risk premium (MRP) = 4.0% - 1.9% - 0.4% = 1.70%

An analyst evaluating securities has obtained the following information. The real rate of interest is 3% and is expected to remain constant for the next 4 years. Inflation is expected to be 5% next year, 5.5% the following year, and 6% the third year. The maturity risk premium is estimated to be 0.2 * (t - 1)%, where t = number of years to maturity. The liquidity premium on relevant 4-year securities is 0.50%, and the default risk premium on relevant 4-year securities is 0.75% What is the yield on a 1-year T-bill?

rt1 = r* +IP1 +MRP1rt1 = 3% + 5% + 0.2(1-1)% rt1 = 8%

Which of the following sets of interest rates would be a normal yield curve if drawn out?

3% 1-year bond, 4% 3-year bond, 5% 5-year bond, 7% 10-year bond

Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from now and then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. What should the interest rate be today?

6% + 7% + 8 % = 7% The interest rate today on a 3-year bond should be approximately 7%.

Define, explain, and give examples of a foreign trade deficit and how that can influence interest rate levels.

A foreign trade deficit is when a country imports more goods than they do with exports. This means that a country is buying more goods than they are selling to others around the world. Due to the excess of imports, a country would need to be financed which means that they need to borrow money from countries that have surpluses in exports since they are not making enough money for all that they are buying. An example of a foreign trade deficit would be if a country is going through some sort of crisis that has led them to be unable to produce goods that they can export and instead they are buying from other countries which leads to having more imports than exports. This affects interest rates because if a country has a trade deficit, they would likely need to borrow more money from other countries and interest rates depend on other countries. Therefore, if interest rates are increasing in other countries, then that means it would increase in the home country as well for both the debtor and creditor countries.

Define, Explain and give an example of yield curve.

A graph that shows the relationship between bond yields and maturities. For example, assume a two-year bond offers a yield of 1%, a five-year bond offers a yield of 1.8%, a 10-year bond offers a yield of 2.5%, a 15-year bond offers a yield of 3.0%, and a 20-year bond offers a yield of 3.5%. When these points are connected on a graph, they exhibit a shape of a normal yield curve.

Which of the following would be most likely to lead to a higher level of interest rates in the economy?

Corporations step up their expansion plans and thus increase their demand for capital.

You want to a buy a car. You have $10,000 currently, but decide to invest in a Treasury Bond, ROR=1%. The inflation rate is 3%.

Explain: simple just calculated the 3 percent of 10, 000 which is 300 and add it to 10,000 which gives you $10,300 Formula: FV of TB=10,000(1.01) FV of similar car=10,000(1.03) FV of TB=10,100 FV of similar car= $10,300

Companies raise capital in two main forms: assets and equity.

FALSE

Inflation is the chance that an investment will provide a low or negative return

FALSE

The pure expectation theory states that the shape of the yield curve depends on investor's experiences with past interest rates.

FALSE

The price paid for the rental of borrowed funds (usually expressed as a percentage of the rental of $100 per year) is commonly referred to as the

INTEREST RATE

What factor(s) affect the level of interest rates?

Production opportunities Risk Expected inflation

Sally's Cookie Company is a large corporation and issued 3-year bonds that will later be traded on an active secondary market. What is the quoted rate of interest on the 3-year bond given the following? Quoted interest rate (r) = r* + IP + DRP + LP + MRP.The real risk-free rate is 2% (r*). The inflation premium (IP) is 3%. The default risk premium (DRP) is 1%, and the liquidity premium (LP) is 1.5%. Finally, the maturity risk premium (MRP) is 2%.

Quoted interest rate (r) = r* + IP + DRP + LP + MRP r = 2% + 3% + 1% + 1.5% + 2% = 9.5%

What is the quoted rate on a risk-free security composed of(rRF)?

Real risk-free interest rate(r*) + Inflation Premium (IP)

Suppose that the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%. What rate of return would you expect on a 1-year treasury security, assuming the pure expectations theory is valid?

Risk free rate is 3.50% and Inflation is 2.20% 3.50% + 2.20% = 5.70% = Yield on 1-year T-bond

You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.8%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums: Inflation premium=3.25% Liquidity premium=0.6% Maturity risk premium=1.85% Default risk premium=2.15% Based on this data, what is the real risk-free rate of return?

T-bills= rRF=r*+Inflation Premium 5.8%=r*+3.25% r*=5.8%-3.25% *2.55%

An upward-sloping yield curve is often call a "normal" yield curve, while a downward-sloping yield curve is called "abnormal."

TRUE

During periods when inflation is increasing, interest rates tend to increase, while interest rates to fall when inflation is declining?

TRUE

Inflation is the amount by which prices increase over time

TRUE

The four factors that affect the cost of money are production opportunities, time preferences for consumption, risk, and inflation

TRUE

The four most fundamental factors affecting the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation

TRUE

Define, explain, and give examples of what the four factors affecting the cost of money are

The four factors affecting the cost of money are (1) production opportunities, (2) time preference for consumption, (3) risk, and (4) inflation. Production opportunities are the investment opportunities in productive (cash generating) assets. Time preference is the preference of consumers for current consumption as opposed to saving for future consumption. Risk is the chance that an investment will provide a low or negative return. Inflation is the amount by which prices increase over time.

Time preferences for consumption is:

The preferences of consumers for current consumption as opposed to saving for future consumption

Define and explain the term structures of interest rates. Give an example for the conditions as to when the yield curve is "abnormal".

The term structure of interest rates describes the relationship between long- and short-term rates. The term structure is important to corporate treasurers deciding whether to borrow by issuing long- or short-term debt and to investors who are deciding whether to buy long- or short-term bonds. An abnormal yield curve is upward sloping. This usually happens when the interest rates are high, but inflation is expected to decline. Thus, short term interest rates are higher than long term interest rates.

What is the term structure of interest rates used for?

To show the relationship between bond yields and maturities

5-year Treasury bonds yield 4.0%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5-year T-bonds is 0.4%. There is no liquidity premium on these bonds. What is the real risk-free rate, r*?

Treasury bond yield= Real risk free rate+Inflation premium + Maturity risk premium 4.0% = rea risk free rate + 1.9% + 0.4% 1.9+0.4=2.3 4.0-2.3= 1.7%

What is the real risk-free rate of interest?

interest rate that is on a riskless security if there was no inflation to be expected, and is considered to be the rate of interest on short-term treasury securities if there was no inflation

Ryan is currently working on a project. For his project he needs to find the interest rate on a short-term, default-free U.S. Treasury bill given that the real risk-free rate is 1.8% and inflation is expected to be 1.3% during the next year. Given that information, what is the interest rate on the U.S. Treasury Bill?

rT-bill = rRF = r* + IP rRF = Risk-Free Rate r* = Real Risk-Free Rate IP = Inflation Premium r* = 1.8% IP = 1.3% rT-bill = 1.8% + 1.3% rT-bill = 3.1%

An analyst evaluating securities has obtained the following information. The real rate of interest is 6% and is expected to remain constant for the next 3 years. Inflation is expected to be 8% next year, 9% the following year, and 9.5% the third year. The maturity risk premium is estimated to be 0.1 x (t-1)%, where t = number of years to maturity. What is the yield on a 1-year T-bill?

rT1 = r + IP1 + MRP1 r = 6% IP = 8% rT1 = 6% + 8% + 0.1(1-1)% rT1 = 12%