Chapter 7: Interest Rates Problems

Book Title: Essentials of Financial Management

Printed By: KEVIN ABEJON ALQUEZA ([email protected])
© 2013, 2010 Cengage Learning Asia, Cengage Learning

Chapter Review
Problems

Easy Problems 1–7

Intermediate Problems 8–16

Challenging Problems 17–19

7-1. YIELD CURVES The following yields on U.S. Treasury securities were taken
from a recent financial publication:

Term Rate

6 months 5.1%

1 year 5.5

2 years 5.6

3 years 5.7

4 years 5.8

5 years 6.0

10 years 6.1

20 years 6.5

30 years 6.3

a. Plot a yield curve based on these data.

b. What type of yield curve is shown?

c. What information does this graph tell you?

d. Based on this yield curve, if you needed to borrow money for longer than
1 year, would it make sense for you to borrow short term and renew the
loan or borrow long term? Explain.
7-2. REAL RISK-FREE RATE You read in The Wall Street Journal that 30-day T-bills
are currently yielding 5.5%. Your brother-in-law, a broker at Safe and Sound
Securities, has given you the following estimates of current interest rate
premiums:

Inflation premium = 3.25%

Liquidity premium = 0.6%

Maturity risk premium = 1.8%

Default risk premium = 2.15%

On the basis of these data, what is the real risk-free rate of return?

7-3. EXPECTED INTEREST RATE The real risk-free rate is 3%. Inflation is
expected to be 2% this year and 4% 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?

7-4. DEFAULT RISK PREMIUM A Treasury bond that matures in 10 years has a
yield of 6%. A 10-year corporate bond has a yield of 8%. Assume that the
liquidity premium on the corporate bond is 0.5%. What is the default risk
premium on the corporate bond?

7-5. MATURITY RISK PREMIUM The real risk-free rate is 3%, and inflation is
expected to be 3% for the next 2 years. A 2-year Treasury security yields 6.2%.
What is the maturity risk premium for the 2-year security?

7-6. INFLATION CROSS-PRODUCT An analyst is evaluating securities in a

developing nation where the inflation rate is very high. As a result, the analyst
has been warned not to ignore the cross-product between the real rate and
inflation. If the real risk-free rate is 5% and inflation is expected to be 16%
each of the next 4 years, what is the yield on a 4-year security with no maturity,
default, or liquidity risk? (Hint: Refer to “The Links between Expected Inflation
and Interest Rates: A Closer Look”.)

7-7. EXPECTATIONS THEORY One-year Treasury securities yield 5%. The market
anticipates that 1 year from now, 1-year Treasury securities will yield 6%. If the
pure expectations theory is correct, what is the yield today for 2-year Treasury
securities?

7-8. EXPECTATIONS THEORY Interest rates on 4-year Treasury securities are

currently 7%, while 6-year Treasury securities yield 7.5%. If the pure
 expectations theory is correct, what does the market believe that 2-year
securities will be yielding 4 years from now?

7-9. EXPECTED INTEREST RATE The real risk-free rate is 3%. Inflation is
expected to be 3% this year, 4% next year, and 3.5% thereafter. The maturity
risk premium is estimated to be , where t = number of years to
maturity. What is the yield on a 7-year Treasury note?

7-10. INFLATION Due to a recession, expected inflation this year is only 3%.
However, the inflation rate in Year 2 and thereafter is expected to be constant
at some level above 3%. Assume that the expectations theory holds and the
real risk-free rate (r*) is 2%. If the yield on 3-year Treasury bonds equals the 1-
year yield plus 2%, what inflation rate is expected after Year 1?

7-11. DEFAULT RISK PREMIUM A company’s 5-year bonds are yielding 7.75% per
year. Treasury bonds with the same maturity are yielding 5.2% per year, and
the real risk-free rate (r*) is 2.3%. The average inflation premium is 2.5%; and
the maturity risk premium is estimated to be , where t = number
of years to maturity. If the liquidity premium is 1%, what is the default risk
premium on the corporate bonds?

7-12. MATURITY RISK PREMIUM An investor in Treasury securities expects

inflation to be 2.5% in Year 1, 3.2% in Year 2, and 3.6% each year thereafter.
Assume that the real risk-free rate is 2.75% and that this rate will remain
constant. Three-year Treasury securities yield 6.25%, while 5-year Treasury
securities yield 6.80%. What is the difference in the maturity risk premiums
(MRPs) on the two securities; that is, what is ?

7-13. DEFAULT RISK PREMIUM The real risk-free rate, r*, is 2.5%. Inflation is
expected to average 2.8% a year for the next 4 years, after which time inflation
is expected to average 3.75% a year. Assume that there is no maturity risk
premium. An 8-year corporate bond has a yield of 8.3%, which includes a
liquidity premium of 0.75%. What is its default risk premium?

7-14. EXPECTATIONS THEORY AND INFLATION Suppose 2-year Treasury bonds

yield 4.5%, while 1-year bonds yield 3%. r* is 1%, and the maturity risk premium
is zero.

a. Using the expectations theory, what is the yield on a 1-year bond 1 year
from now?

b. What is the expected inflation rate in Year 1? Year 2?

7-15. EXPECTATIONS THEORY Assume that the real risk-free rate is 2% and that
the maturity risk premium is zero. If a 1-year Treasury bond yield is 5% and a
2-year Treasury bond yields 7%, what is the 1-year interest rate that is
expected for Year 2? What inflation rate is expected during Year 2? Comment
on why the average interest rate during the 2-year period differs from the 1-
year interest rate expected for Year 2.

7-16. INFLATION CROSS-PRODUCT An analyst is evaluating securities in a

developing nation where the inflation rate is very high. As a result, the analyst
has been warned not to ignore the cross-product between the real rate and
inflation. A 6-year security with no maturity, default, or liquidity risk has a yield
of 20.84%. If the real risk-free rate is 6%, what average rate of inflation is
expected in this country over the next 6 years? (Hint: Refer to “The Links
between Expected Inflation and Interest Rates: A Closer Look”.)

7-17. INTEREST RATE PREMIUMS A 5-year Treasury bond has a 5.2% yield. A 10-
year Treasury bond yields 6.4%, and a 10-year corporate bond yields 8.4%. The
market expects that inflation will average 2.5% over the next 10 years
( ) . Assume that there is no maturity risk premium
and that the annual real risk-free rate, r*, will remain constant over the next 10
years. (Hint: Remember that the default risk premium and the liquidity
premium are zero for Treasury securities: .) A 5-year corporate
bond has the same default risk premium and liquidity premium as the 10-year
corporate bond described. What is the yield on this 5-year corporate bond?

7-18. YIELD CURVES Suppose the inflation rate is expected to be 7% next year,
5% the following year, and 3% thereafter. Assume that the real risk-free rate, r*,
will remain at 2% and that maturity risk premiums on Treasury securities rise
from zero on very short-term bonds (those that mature in a few days) to 0.2%
for 1-year securities. Furthermore, maturity risk premiums increase 0.2% for
each year to maturity, up to a limit of 1.0% on 5-year or longer-term 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. Suppose a AAA-rated company (which is the highest bond rating a firm

can have) had bonds with the same maturities as the Treasury bonds.
Estimate and plot what you believe a AAA-rated company’s yield curve
would look like on the same graph with the Treasury bond yield curve.
(Hint: Think about the default risk premium on its long-term versus its
short-term bonds.)
 c. On the same graph, plot the approximate yield curve of a much riskier
lower-rated company with a much higher risk of defaulting on its bonds.

7-19. INFLATION AND INTEREST RATES In late 1980, the U.S. Commerce
Department released new data showing inflation was 15%. At the time, the
prime rate of interest was 21%, a record high. However, many investors
expected the new Reagan administration to be more effective in controlling
inflation than the Carter administration had been. Moreover, many observers
believed that the extremely high interest rates and generally tight credit, which
resulted from the Federal Reserve System’s attempts to curb the inflation rate,
would lead to a recession, which, in turn, would lead to a decline in inflation
and interest rates. Assume that, at the beginning of 1981, the expected
inflation rate for 1981 was 13%; for 1982, 9%; for 1983, 7%; and for 1984 and
thereafter, 6%.

a. What was the average expected inflation rate over the 5-year period
1981–1985? (Use the arithmetic average.)

b. Over the 5-year period, what average nominal interest rate would be
expected to produce a 2% real risk-free return on 5-year Treasury
securities? Assume .

c. Assuming a real risk-free rate of 2% and a maturity risk premium that

equals , where t is the number of years to maturity, estimate
the interest rate in January 1981 on bonds that mature in 1, 2, 5, 10, and
20 years. Draw a yield curve based on these data.

d. Describe the general economic conditions that could lead to an upward-

sloping yield curve.

e. If investors in early 1981 expected the inflation rate for every future year
to be 10% (that is, ), what would the yield
curve have looked like? Consider all the factors that are likely to affect
the curve. Does your answer here make you question the yield curve you
drew in Part c?

Chapter 7: Interest Rates Problems

Book Title: Essentials of Financial Management
Printed By: KEVIN ABEJON ALQUEZA ([email protected])
© 2013, 2010 Cengage Learning Asia, Cengage Learning

© 2019 Cengage Learning Inc. All rights reserved. No part of this work may by reproduced or used in any form or by any means -
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