FIN 4313 Chapter Notes - Chapter 6: Yield Curve, United States Treasury Security, Credit Risk

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erinlouse51

6 Nov 2018

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Term-to-maturity on the horizontal axis and interest rate percent on the vertical axis. The expectation theory: expectation theory- holds that the shape of the yield curve is determined by the i(cid:374)(cid:448)esto(cid:396)s" e(cid:454)pe(cid:272)tatio(cid:374)s of futu(cid:396)e i(cid:374)te(cid:396)est (cid:396)ate (cid:373)o(cid:448)e(cid:373)e(cid:374)ts a(cid:374)d that (cid:272)ha(cid:374)ges i(cid:374) these expectations change the shape of the yield curve. Assumes that investors are profit maximizers and that there is no risk difference between holding a long-term security and holding a series of short-term securities that are rolled over to their investment horizon (risk neutral) Investors are indifferent about purchasing long-term or short-term securities. R = the observed (spot or actual) market interest rate. Using the term structure formula to calculate implied forward rates: (cid:1858)(cid:1856) (cid:1857)= [(cid:4666)1+(cid:4667)/(cid:4666)1+ (cid:2869)(cid:4667) (cid:2869)] 1. Market-segmentation and preferred-habitat theories: market-segmentation theory- maintains that market participants have strong preferences for securities of a particular maturity and that they buy and sell securities consistent with these maturity preferences.

Related Questions

Maria Juarez is a professional tennis player, and your firm manages her money. She has asked you to give her information about what determines the level of various interest rate. Your boss has prepared some questions for you to consider.

a) What are the four most fundamental factors that affect the cost of money, or the general level of interest rate, in the economy?

b) What is the real risk-free rate of interst (r*)and the nominal risk-free rate (r RF)? How are these two rates measured?

c) Define the term inflation premium(IP), default risk premium (DRP), liquidity premium (LP),and the maturity risk premium(MRP). Which of premium is included in determining the interst rate on (1)Short term U.S Treasury securities, (2)Long term U.S Treasury securities, (3)short term corporate securities, (4) long term coporate securities? Explain how the premiums would vary over time and among the different securities listed.

d) What is the term structure of interest rate? What is the yield curve?

e)Suppose most investors expect the inflation rate to be 5% next year, 6% the following year, and 8% thereafter. The real risk free rate is 3%. The maturity risk primium is zero for bonds that mature in 1 year or less and 0.1% for 2 years bonds; then the MRP increases by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest on 1-,10-, and 20-year treasury bonds? Draw a yield curve with these data. What factor can explain why this constructed yield curve is upward-sloping?

f) At any give time, how would the yield curve facing a AAA rated company compare with the yield curve for U.S Treasury securities? At any given time, How would the yield curve facing a BB rated company compare with the yield curve for U.S treasury securities? Draw a graph to illustrat your answer.

g) What is the pure expectations theory? What does the pure expectation theory imply about the term structure of interest rate?

Please select the correct answer and give an explanation why it is the best answer.

1. Holding large amounts of bank capital helps prevent bank failures because

a. It means that the bank has a higher income

b. It makes loans easier to sell

c. It can be used to absorb the losses resulting from bad loans

d. It makes it easier to call in loans

2. The spread between the interest rates on bonds with default-free bonds is called

a. Bond margin

b. Junk margin

c. Default premium

d. Risk premium

3. When yield curves are steeply upward sloping.

a. Short-term interest rates are above long-term interest rates

b. Medium-term interest rates are above both short-term and long-term interest rates.

c. Long-term interest rates are above short-term interest rates

d. Short-term interest rates are about the same as long-term interest rates

Nominal Interest Rates and Yield Curves: A recent study of inflationary expectations has revealed that the concensus among economic forecasters yields the following average annual rates of inflation expected over the periods noted. (Note: Assume that the risk that future interetst rate movements will affect the longer maturities more than the shorter maturities is 0; that is, assume that there is no maturity risk)

Period	Avg Annual Rate of Inflation
3 Months	5%
2 Years	6%
5 Years	8%
10 Years	8.5%
20 Years	9%

A) If the real rate of interest is currently 2.5%, find the nominal rate of interest on each of the following U.S. Treasury issues: 20-year bond, 3-month bill, 2-year note, and 5 year bond

B) If the real rate of interest suddenly dropped to 2% without any change in inflationary expectations, what effect, if any, would it have on your answers in part a? Explain

C) Using your findings in part a, draw a yield curve for U.S. Treasury securities.

D) What would a follower of the liquidity preference theory say about the preferences of lenders and borrowers tend to affect the shape of the yield curve drawn in part C? Illustrate that effect by placing on your graph a dotted line that approximates the yield curve without the effect of liquidity preference

E) What would a follower of the market segmentation theory say about the supply and demand for long term loans versus the supply and demand for short term loans given the yield curve constructed for part C of this problem?

Thanks for the help! :)

FIN 4313 Chapter Notes - Chapter 6: Yield Curve, United States Treasury Security, Credit Risk

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