Which fluctuate more, long-term or short-term interest rates? Why?
Suppose the population of Area Y is relatively young while that of Area O is relatively old, but
everything else about the two areas is equal.
a.Would interest rates likely be the same or different in the two areas? Explain.
b.Would a trend toward nationwide branching by banks and savings and loans, and the devel-
opment of nationwide diversified financial corporations, affect your answer to part a?
Suppose a new and much more liberal Congress and administration were elected, and their first
order of business was to take away the independence of the Federal Reserve System, and to
force the Fed to greatly expand the money supply. What effect would this have
a.On the level and slope of the yield curve immediately after the announcement?
b.On the level and slope of the yield curve that would exist two or three years in the future?
It is a fact that the federal government (1) encouraged the development of the savings and loan
industry; (2) virtually forced the industry to make long-term, fixed-interest-rate mortgages; and
(3) forced the savings and loans to obtain most of their capital as deposits that were withdraw-
able on demand.
a.Would the savings and loans have higher profits in a world with a “normal” or an inverted
yield curve?
b.Would the savings and loan industry be better off if the individual institutions sold their
mortgages to federal agencies and then collected servicing fees or if the institutions held the
mortgages that they originated?
Self-Test Problem (Solution Appears in Appendix A)
Assume that it is now January 1. The rate of inflation is expected to be 4 percent throughout the
year. However, increased government deficits and renewed vigor in the economy are then ex-
pected to push inflation rates higher. Investors expect the inflation rate to be 5 percent in Year
2, 6 percent in Year 3, and 7 percent in Year 4. The real risk-free rate, r*, is expected to remain
at 2 percent over the next 5 years. Assume that no maturity risk premiums are required on
bonds with 5 years or less to maturity. The current interest rate on 5-year T-bonds is 8 percent.
a.What is the average expected inflation rate over the next 4 years?
b.What should be the prevailing interest rate on 4-year T-bonds?
c.What is the implied expected inflation rate in Year 5, given that Treasury bonds which ma-
ture at the end of that year yield 8 percent?
Problems
The real risk-free rate of interest is 3 percent. Inflation is expected to be 2 percent this year and
4 percent during the next 2 years. Assume that the maturity risk premium is zero. What is the
yield on 2-year Treasury securities? What is the yield on 3-year Treasury securities?
A Treasury bond that matures in 10 years has a yield of 6 percent. A 10-year corporate bond has
a yield of 8 percent. Assume that the liquidity premium on the corporate bond is 0.5 percent.
What is the default risk premium on the corporate bond?
One-year Treasury securities yield 5 percent. The market anticipates that 1 year from now, 1-
year Treasury securities will yield 6 percent. If the pure expectations hypothesis is correct, what
should be the yield today for 2-year Treasury securities?
The real risk-free rate is 3 percent, and inflation is expected to be 3 percent for the next 2 years.
A 2-year Treasury security yields 6.2 percent. What is the maturity risk premium for the 2-year
security?
Interest rates on 1-year Treasury securities are currently 5.6 percent, while 2-year Treasury se-
curities are yielding 6 percent. If the pure expectations theory is correct, what does the market
believe will be the yield on 1-year securities 1 year from now?
1–5
EXPECTED RATE OF INTEREST
1–4
MATURITY RISK PREMIUM
1–3
EXPECTED RATE OF INTEREST
1–2
DEFAULT RISK PREMIUM
1–1
EXPECTED RATE OF INTEREST
ST–1
INFLATION RATES
1–8
1–7
1–6
1–5
50 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment
48 An Overview of Corporate Finance and the Financial Environment
