A B C D E F G H I

1 06problem 9/15/2021 1:34 2/1/2021

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3 Chapter 6. Solution to End-of-Chapter Comprehensive/Spreadsheet Problem
4 Problem 6-20
5
6 a. What effect would each of the following events likely have on the level of nominal interest rates?
7 (1) Households dramatically increase their savings rate.
8 This action will increase the supply of money; therefore, interest rates will decline.
9 (2) Corporations increase their demand for funds following an increase in investment opportunities.
10 This action will cause interest rates to increase.
11 (3) The government runs a larger-than-expected budget deficit.
12 The larger the federal deficit, other things held constant, the higher the level of interest rates.
13 (4) There is an increase in expected inflation.
14 This expectation will cause interest rates to increase.
15
16 b. Suppose you are considering two possible investment opportunities, a 12-year Treasury bond and a 7-year,
17 A-rated corporate bond. The current real risk-free rate is 4%, and inflation is expected to be 2% for the
18 next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is estimated by
19 this formula: MRP = 0.02 ( t – 1) %. The liquidity premium (LP) for the corporate bond is estimated to be
20 0.3%. You may determine the default risk premium (DRP), given the company’s bond rating, from the
21 following table. Remember to subtract the bond's LP from the corporate spread given in the
22 table to arrive at the bond's DRP. What yield would you predict for each of these two investments?
23
24 12-year Treasury Bond
25 Real risk-free rate (r*): 4.000%
26 Maturity: 12
27 Expected inflation: for the next 2 years = 2%
28 Expected inflation: for the next 4 years = 3%
29 Expected inflation: for the next 6 years = 4%
30 12
31 Inflation premium: =((G27*D27)+(G28*D28)+(G29*D29))/D30 3.333%
32
33 Maturity risk premium: = 0.02*(C26-1)% = 0.220%
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35 12-year Treasury yield = r* + IP12 + MRP12 = 7.553%
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37 7-year Corporate Bond
38 Rating : A
39 Real risk-free rate (r*): 4.000%
40 Maturity: 7
41 Expected inflation: for the next 2 years = 2%
42 Expected inflation: for the next 4 years = 3%
43 Expected inflation: for the next 1 years = 4% DRP + LP
44 7 from text table:
45 Inflation premium: =((G41*D41)+(G42*D42)+(G43*D43))/D44 2.857% Rating DRP + LP
46 AAA 0.10%
47 Maturity risk premium: = 0.02*(C40-1)% = 0.120% AA 0.46%
48 Liquidity premium: Given in problem 0.300% A 0.84%
49 Default risk premium: =IF(B38=H46,I46-G48,IF(B38=H47,I47-G48,I48-G48)) 0.540%
50 (see screen to right for an alternative way to find the
51 default risk premium.)
52 7-year Corporate yield = r* + IP7 + MRP7 + LP + DRP = 7.817%
53
54 Yield Spread = Corporate – Treasury = 0.264%
55 Reconciliation: Default premium 0.540%
56 Liquidity premium 0.300%
57 Inflation premium -0.476%
58 Maturity premium -0.100%
59 0.264%
60
61 c. Given the following Treasury bond yield information, construct a graph of the
62 yield curve.
63 Maturity
64 Periods Years Yield
65 1 year 1.00 5.37%
66 2 years 2.00 5.47%
67 3 years 3.00 5.65%
68 4 years 4.00 5.71%
69 5 years 5.00 5.64%
70 10 years 10.00 5.75%
71 20 years 20.00 6.33%
72 30 years 30.00 5.94%
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74 Now we can use a scatter chart to construct a yield curve.
75
76 Yield Curve
77 Interest Rate
78 7%
79 6%
80 5%
81 4%
82 3%
83 2%
1%
84
0%
85
0 5 10 15 20 25 30
86
Years to Maturity
87
88
89 d. Based on the information about the corporate bond provided in part b, calculate yields and then
90 construct a new yield curve graph that shows both the Treasury and the corporate bonds.
91
92 The real risk-free rate would be the same for the corporate and treasury bonds. Similarly, without
93 information to the contrary, we would assume that the maturity and inflation premiums would be the same for
94 bonds with the same maturities. However, the corporate bond would have a liquidity premium and a default
95 premium. If we assume that these premiums are constant across maturities, then we can use the LP and DRP
96 as determined above and add them to the T-bond yields to find the corporate yields. This procedure
97 was used in the table below.
98
99 Years Treasury A-Corporate Spread LP DRP
100 1 5.37% 6.21% 0.84% 0.30% 0.54%
101 2 5.47% 6.31% 0.84% 0.30% 0.54%
102 3 5.65% 6.49% 0.84% 0.30% 0.54%
103 4 5.71% 6.55% 0.84% 0.30% 0.54%
104 5 5.64% 6.48% 0.84% 0.30% 0.54%
105 10 5.75% 6.59% 0.84% 0.30% 0.54%
106 20 6.33% 7.17% 0.84% 0.30% 0.54%
107 30 5.94% 6.78% 0.84% 0.30% 0.54%
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109 Now we can graph the data in the first 3 columns of the above table to get the Treasury and A-rated Corporate
110 yield curves:
111
112
113
Treasury and A-Rated Corporate Yield Curves
114 Interest Rate
115 8%
116 7% A Corporate
117 6%
118 Treasury
5%
119
120 4%
121 3%
122 2%
123 1%
124
0%
125 0 5 10 15 20 25 30
126
Years to Maturity
127
128
129 Note that if we constructed yield curves for corporate bonds with other ratings, the higher the rating, the
130 lower the curves would be. Note too that the DRP for different ratings can change over time as investors' (1)
131 risk aversion and (2) perceptions of risk change, and this can lead to different yield spreads and curve
132 positions. Expectations for inflation can also change, and this will lead to upward or downward shifts in all
133 the yield curves.
134
135 e. Which part of the yield curve (the left side or right side) is likely to be the most volatile over time?
136 Short-term rates are more volatile than longer-term rates; therefore, the left side of the yield curve
137 would be most volatile over time.
138
139 f. Using the Treasury yield information in part c, calculate the following rates using geometric averages:
140
141 (1) The 1-year rate, 1 year from now r
1 1

142 (2) The 5-year rate, 5 years from now r

5 5

143 (3) The 10-year rate, 10 years from now r

10 10

144 (4) The 10-year rate, 20 years from now r

20 10

145
146 Maturity Maturity Yield
147 in years
148 1 year 1 5.37%
149 2 years 2 5.47%
150 3 years 3 5.65%
151 4 years 4 5.71%
152 5 years 5 5.64%
153 10 years 10 5.75%
154 20 years 20 6.33%
155 30 years 30 5.94%
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157 (1) The 1-year rate, 1 year from now
158 (1 + r2)2 = (1 + r1) × (1+ 1r1)
159 1.1124 = 1.0537 × (1+ 1r1)
160 5.57% = r
1 1

161
162 (2) The 5-year rate, 5 years from now
163 (1 + r10)10 = (1 + r5)5 × (1 + 5r5)5
164 1.7491 = 1.3157 × (1 + 5r5)5
165 1.3294 = (1 + 5r5)5
166 5.86% = r
5 5

167
168 (3) The 10-year rate, 10 years from now
169 (1 + r20)20 = (1+ r10)10 × (1+ 10r10)10
170 3.4128 = 1.7491 × (1+ 10r10)10
171 1.9512 = (1+ 10r10)10
172 6.91% = r
10 10

173
174 (4) The 10-year rate, 20 years from now
175 (1+ r30)30 = (1+ r20)20 × (1 + 20r10)10
176 5.6468 = 3.4128 × (1 + 20r10)10
177 1.6546 = (1 + 20r10)10
178 5.16% = r
20 10