Exam 6: Interest Rates

If the pure expectations theory is correct (that is,the maturity risk premium is zero),which of the following is CORRECT?

Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 4.10%.What rate of return would you expect on a 1-year Treasury security,assuming the pure expectations theory is valid? Include cross-product terms,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 the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 4.80%.What rate of return would you expect on a 1-year Treasury security,assuming the pure expectations theory is valid? Disregard cross-product terms,i.e. ,if averaging is required,use the arithmetic average.

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 the real risk-free rate is 3.00%,the average expected future inflation rate is 5.90%,and a maturity risk premium of 0.10% per year to maturity applies,i.e. ,MRP = 0.10%(t),where t is the number of years to maturity.What rate of return would you expect on a 1-year Treasury security,assuming the pure expectations theory is NOT valid? Disregard cross-product terms,i.e. ,if averaging is required,use the arithmetic average.

The Federal Reserve tends to take actions to increase interest rates when the economy is very strong and to decrease rates when the economy is weak.

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 the real risk-free rate is 2.50% and the future rate of inflation is expected to be constant at 7.00%.What rate of return would you expect on a 5-year Treasury security,assuming the pure expectations theory is valid? Disregard cross-product terms,i.e. ,if averaging is required,use the arithmetic average.

If investors expect a zero rate of inflation,then the nominal rate of return on a very short-term U.S.Treasury bond should be equal to the real risk-free rate,r*.

One of the four most fundamental factors that affect the cost of money as discussed in the text is the availability of production opportunities and their expected rates of return.If production opportunities are relatively good,then interest rates will tend to be relatively high,other things held constant.

Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.90%.Assuming the pure expectations theory is correct,what is the market's forecast for 1-year rates 1 year from now? Round the intermediate calculations to 4 decimal places and final answer to 2 decimal places.

Niendorf Corporation's 5-year bonds yield 7.75%,and 5-year T-bonds yield 4.80%.The real risk-free rate is r* = 2.75%,the inflation premium for 5-year bonds is IP = 1.65%,the default risk premium for Niendorf's bonds is DRP = 1.20% versus zero for T-bonds,and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) $\times$ 0)1%,where t = number of years to maturity.What is the liquidity premium (LP)on Niendorf's bonds?

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

Assume that the current corporate bond yield curve is upward sloping,or normal.Under this condition,we could be sure that

Because the maturity risk premium is normally positive,the yield curve is normally upward sloping.

If the Treasury yield curve is downward sloping,how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Because the maturity risk premium is normally positive,the yield curve must have an upward slope.If you measure the yield curve and find a downward slope,you must have done something wrong.

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. -The real risk-free rate is 3.55%,inflation is expected to be 3.60% this year,and the maturity risk premium is zero.Taking account of the cross-product term,i.e. ,not ignoring it,what is the equilibrium rate of return on a 1-year Treasury bond? (Round your final answer to 3 decimal places. )

One of the four most fundamental factors that affect the cost of money as discussed in the text is the expected rate of inflation.If inflation is expected to be relatively high,then interest rates will tend to be relatively low,other things held constant.

Assume that the current corporate bond yield curve is upward sloping.Under this condition,then we could be sure that