188 Part 3 Financial Assets
INFLATION AND INTEREST RATES The real risk-free rate of interest, r*, is 3%; and it is
expected to remain constant over time. Inflation is expected to be 2% per year for the next
3 years and 4% per year for the next 5 years. The maturity risk premium is equal to
0.1 (t! 1)%, where t " the bond’s maturity. The default risk premium for a BBB-rated
bond is 1.3%.
a. What is the average expected inflation rate over the next 4 years?
b. What is the yield on a 4-year Treasury bond?
c. What is the yield on a 4-year BBB-rated corporate bond with a liquidity premium of
0.5%?
d. What is the yield on an 8-year Treasury bond?
e. What is the yield on an 8-year BBB-rated corporate bond with a liquidity premium of
0.5%?
f. If the yield on a 9-year Treasury bond is 7.3%, what does that imply about expected
inflation in 9 years?
PURE EXPECTATIONS THEORY The yield on 1-year Treasury securities is 6%, 2-year secu-
rities yield 6.2%, and 3-year securities yield 6.3%. There is no maturity risk premium.
Using expectations theory, forecast the yields on the following securities:
a. A 1-year security, 1 year from now
b. A 1-year security, 2 years from now
c. A 2-year security, 1 year from nowSuppose interest rates on residential mortgages of equal risk are 5.5% in California and
7.0% in New York. Could this differential persist? What forces might tend to equalize
rates? Would differentials in borrowing costs for businesses of equal risk located in
California and New York be more or less likely to exist than differentials in residential
mortgage rates? Would differentials in the cost of money for New York and California
firms be more likely to exist if the firms being compared were very large or if they were
very small? What are the implications of all of this with respect to nationwide branching?
Which fluctuate more—long-term or short-term interest rates? Why?
Suppose you believe that the economy is just entering a recession. Your firm must raise
capital immediately, and debt will be used. Should you borrow on a long-term or a short-
term basis? Why?
Suppose the population of Area Y is relatively young and the population of Area O is rela-
tively old but everything else about the two areas is the same.
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 the development of na-
tionwide diversified financial corporations affect your answer to part a? Explain.
Suppose a new process was developed that could be used to make oil out of seawater. The
equipment required is quite expensive; but it would, in time, lead to low prices for gaso-
line, electricity, and other types of energy. What effect would this have on interest rates?
Suppose a new and more liberal Congress and administration are elected. Their first order
of business is to take away the independence of the Federal Reserve System and to force
the Fed to greatly expand the money supply. What effect will 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 mort-
gages, and (3) forced the savings and loans to obtain most of their capital as deposits that
were withdrawable on demand.