Exam 6: Interest Rates

If the demand curve for funds increased but the supply curve remained constant,we would expect to see the total amount of funds supplied and demanded increase and interest rates in general also increase.

Suppose the U.S.Treasury issued $50 billion of short-term securities and sold them to the public.Other things held constant,what would be the most likely effect on short-term securities' prices and interest rates?

If investors expect the rate of inflation to increase sharply in the future,then we should not be surprised to see an upward sloping yield curve.

Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS)is 1.80%.Suppose further that the MRP on a 10-year T-bond is 0.90%,that no MRP is required on a TIPS,and that no liquidity premium is required on any T-bond.Given this information,what is the expected rate of inflation over the next 10 years? Disregard cross-product terms,i.e. ,if averaging is required,use the arithmetic average.

Which of the following factors would be most likely to lead to an increase in nominal interest rates?

Inflation is expected to increase steadily over the next 10 years,there is a positive maturity risk premium on both Treasury and corporate bonds,and the real risk-free rate of interest is expected to remain constant.Which of the following statements is CORRECT?

If the pure expectations theory holds,which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Assuming the pure expectations theory is correct,which of the following statements is CORRECT?

Interest rates are important in finance, and it is important for all students to understand the basics of how they are determined. However, the chapter really has two aspects that become clear when we try to write test questions and problems for the chapter. First, the material on the fundamental determinants of interest rates - the real risk-free rate plus a set of premiums - is logical and intuitive, and easy in a testing sense. However, the second set of material, that dealing with the yield curve and the relationship between 1-year rates and longer-term rates, is more mathematical and less intuitive, and test questions dealing with it tend to be more difficult, especially for students who are not good at math. As a result, problems on the chapter tend to be either relatively easy or relatively difficult, with the difficult ones being as much exercises in algebra as in finance. In the test bank for prior editions, we tended to use primarily difficult problems that addressed the problem of forecasting forward rates based on yield curve data. In this edition, we leaned more toward easy problems that address intuitive aspects of interest rate theory. We should note one issue that can be confusing if it is not handled carefully - the use of arithmetic versus geometric averages when bringing inflation into interest rate determination in yield curve related problems. It is easy to explain why a 2-year rate is an average of two 1-year rates, and it is logical to use a compounding process that is essentially a geometric average that includes the effects of cross-product terms. It is also easy to explain that average inflation rates should be calculated as geometric averages. However, when we combine inflation with interest rates, rather than using the formulation rRF = [(1 + r*)(1 + IP)] – 1, almost everyone, from Federal Reserve officials down to textbook authors, uses the approximation rRF = r* + IP. Understandably, this can confuse students when they start working problems. In both the text and test bank problems we make it clear to students which procedure to use. Quite a few of the problems are based on this basic equation: r = r* + IP + MRP + DRP + LP. We tell our students to keep this equation in mind, and that they will have to do some transposing of terms to solve some of the problems. The other key equation used in the problems is the one for finding the 1-year forward rate, given the current 1-year and 2-year rates: (1 + 2-year rate)2 = (1 + 1-year rate)(1 + X), which converts to X = (1 + 2yr)2/(1 + 1yr) – 1, where X is the 1-year forward rate. This equation, which is used in a number of problems, assumes that the pure expectations theory is correct and thus the maturity risk premium is zero. -Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.65%.Also,corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds,and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%.What is the default risk premium on corporate bonds?

Which of the following statements is CORRECT?

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.Which of the following statements is CORRECT?

Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 2.00% per year.What is the real risk-free rate of return,r*? The cross-product term should be considered ,i.e. ,if averaging is required,use the geometric average.(Round your final answer to 2 decimal places. )

Interest rates are important in finance, and it is important for all students to understand the basics of how they are determined. However, the chapter really has two aspects that become clear when we try to write test questions and problems for the chapter. First, the material on the fundamental determinants of interest rates - the real risk-free rate plus a set of premiums - is logical and intuitive, and easy in a testing sense. However, the second set of material, that dealing with the yield curve and the relationship between 1-year rates and longer-term rates, is more mathematical and less intuitive, and test questions dealing with it tend to be more difficult, especially for students who are not good at math. As a result, problems on the chapter tend to be either relatively easy or relatively difficult, with the difficult ones being as much exercises in algebra as in finance. In the test bank for prior editions, we tended to use primarily difficult problems that addressed the problem of forecasting forward rates based on yield curve data. In this edition, we leaned more toward easy problems that address intuitive aspects of interest rate theory. We should note one issue that can be confusing if it is not handled carefully - the use of arithmetic versus geometric averages when bringing inflation into interest rate determination in yield curve related problems. It is easy to explain why a 2-year rate is an average of two 1-year rates, and it is logical to use a compounding process that is essentially a geometric average that includes the effects of cross-product terms. It is also easy to explain that average inflation rates should be calculated as geometric averages. However, when we combine inflation with interest rates, rather than using the formulation rRF = [(1 + r*)(1 + IP)] – 1, almost everyone, from Federal Reserve officials down to textbook authors, uses the approximation rRF = r* + IP. Understandably, this can confuse students when they start working problems. In both the text and test bank problems we make it clear to students which procedure to use. Quite a few of the problems are based on this basic equation: r = r* + IP + MRP + DRP + LP. We tell our students to keep this equation in mind, and that they will have to do some transposing of terms to solve some of the problems. The other key equation used in the problems is the one for finding the 1-year forward rate, given the current 1-year and 2-year rates: (1 + 2-year rate)2 = (1 + 1-year rate)(1 + X), which converts to X = (1 + 2yr)2/(1 + 1yr) – 1, where X is the 1-year forward rate. This equation, which is used in a number of problems, assumes that the pure expectations theory is correct and thus the maturity risk premium is zero. -Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 6.00% per year.What is the real risk-free rate of return,r*? Disregard any cross-product terms,i.e. ,if averaging is required,use the arithmetic average.

Which of the following statements is CORRECT?

In the foreseeable future,the real risk-free rate of interest,r*,is expected to remain at 3%,inflation is expected to steadily increase,and the maturity risk premium is expected to be 0.1(t - 1)%,where t is the number of years until the bond matures.Given this information,which of the following statements is CORRECT?

Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.80%.Assume that the pure expectations theory is NOT valid,and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond.What is the yield on a 1-year T-bond expected to be one year from now? Round the intermediate calculations to 4 decimal places and final answer to 2 decimal places.

One of the four most fundamental factors that affect the cost of money as discussed in the text is the time preference for consumption.The higher the time preference,the lower the cost of money,other things held constant.

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

Since yield curves are based on a real risk-free rate plus the expected rate of inflation,at any given time there can be only one yield curve,and it applies to both corporate and Treasury securities.