CP

(National Geographic (Little) Kids) #1
Interest rates on 4-year Treasury securities are currently 7 percent, while interest rates on 6-
year Treasury securities are currently 7.5 percent. If the pure expectations theory is correct,
what does the market believe that 2-year securities will be yielding 4 years from now?
The real risk-free rate is 3 percent. Inflation is expected to be 3 percent this year, 4 percent
next year, and then 3.5 percent thereafter. The maturity risk premium is estimated to be
0.0005(t1),wheretnumberofyearstomaturity.Whatisthenominalinterestrateon
a7-yearTreasurysecurity?
Suppose the annual yield on a 2-year Treasury security is 4.5 percent, while that on a 1-year se-
curity is 3 percent. r* is 1 percent, and the maturity risk premium is zero.
a.Using the expectations theory, forecast the interest rate on a 1-year security during the sec-
ond year. (Hint: Under the expectations theory, the yield on a 2-year security is equal to the
average yield on 1-year securities in Years 1 and 2.)
b.What is the expected inflation rate in Year 1? Year 2?
Assume that the real risk-free rate is 2 percent and that the maturity risk premium is zero. If the
nominal rate of interest on 1-year bonds is 5 percent and that on comparable-risk 2-year bonds
is 7 percent, what is the 1-year interest rate that is expected for Year 2? What inflation rate is ex-
pected during Year 2? Comment on why the average interest rate during the 2-year period dif-
fers from the 1-year interest rate expected for Year 2.
Assume that the real risk-free rate, r*, is 3 percent and that inflation is expected to be 8 percent
in Year 1, 5 percent in Year 2, and 4 percent thereafter. Assume also that all Treasury securities
are highly liquid and free of default risk. If 2-year and 5-year Treasury notes both yield 10 per-
cent, what is the difference in the maturity risk premiums (MRPs) on the two notes; that is,
what is MRP 5 minus MRP 2?
Due to a recession, the inflation rate expected for the coming year is only 3 percent. How-
ever, the inflation rate in Year 2 and thereafter is expected to be constant at some level above
3 percent. Assume that the real risk-free rate is r*2% for all maturities and that the ex-
pectations theory fully explains the yield curve, so there are no maturity premiums. If 3-year
Treasury notesyield2percentagepointsmorethan1-yearnotes,whatinflationrateisexpected
after Year 1?
Suppose you and most other investors expect the inflation rate to be 7 percent next year, to fall
to 5 percent during the following year, and then to remain at a rate of 3 percent thereafter. As-
sume that the real risk-free rate, r*, will remain at 2 percent and that maturity risk premiums on
Treasury securities rise from zero on very short-term securities (those that mature in a few days)
to a level of 0.2 percentage point for 1-year securities. Furthermore, maturity risk premiums
increase 0.2 percentage point for each year to maturity, up to a limit of 1.0 percentage point on
5-year or longer-term T-notes and T-bonds.
a.Calculate the interest rate on 1-, 2-, 3-, 4-, 5-, 10-, and 20-year Treasury securities, and plot
the yield curve.
b.Now suppose Exxon Mobil, an AAA-rated company, had bonds with the same maturities as
the Treasury bonds. As an approximation, plot an Exxon Mobil yield curve on the same
graph with the Treasury bond yield curve. (Hint: Think about the default risk premium on
Exxon Mobil’s long-term versus its short-term bonds.)
c.Now plot the approximate yield curve of Long Island Lighting Company, a risky nuclear
utility.

Spreadsheet Problem

a.Start with the partial model in the file Ch 01 P13 Build a Model.xlsfrom the textbook’s web
site. Suppose you are considering two possible investment opportunities: a 12-year Treasury
bond and a 7-year, A-rated corporate bond. The current real risk-free rate is 4 percent, and in-
flation is expected to be 2 percent for the next two years, 3 percent for the following four years,
and 4 percent thereafter. The maturity risk premium is estimated by this formula: MRP 0.1%

1–13
BUILD A MODEL:
ANALYZING INTEREST RATES

1–12
YIELD CURVES

1–11
INTEREST RATES

1–10
MATURITY RISK PREMIUM

1–9
EXPECTED RATE OF INTEREST


1–8
EXPECTED RATE OF INTEREST


1–7
EXPECTED RATE OF INTEREST


1–6
EXPECTED RATE OF INTEREST


Spreadsheet Problem 51

An Overview of Corporate Finance and the Financial Environment 49
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