Question

1. What is interest rate? Explain the 4 factors that determine the level of interest rates.

2. Explain what effect each of the following events would likely to have on the level of interest rates: a. Households dramatically reduce their current consumptions.
   b. Corporations increase their demand for funds following increased investment opportunities.
   c. Inflation is expected to decrease.

3. Definitions. Complete the following statements:

   1. Risk premium that indicates the ease of a bond to be converted to cash on short notice at a

      “reasonable” price is ______________________________.

   2. ____________________________ is added to the real risk-free rate to protect investors against

      loss of purchasing power for goods.

   3. The risk that a borrower will not pay the interest or principal on a loan is

      _________________________________.

   4. ____________________________is added to longer term securities to compensate investors for

      risk of holding long-term debt securities.

   5. The relationship between bond yield and maturities is called the _____________________, while

      the resulting plotted curve is the _________________ curve.

4. Suppose the inflation rate is expected to be 2%/year next year, 1%/year in the following 3 years, and 0.5%/year thereafter. Assume that the real risk-free interest rate will remain at 1.5%. Maturity risk premium on a debt security is determined by 0.05% (t – 1) where t is the number of years to maturity of the debt security. a) Calculate the interest rate on 1, 5, and 10 year Treasury securities. b)The following table provides quoted interest rates on various bonds with similar maturity. Using the data reported on the table, compute the default risk premium of A corporate bond by taking the difference between the quoted interest rate on A corporate bond and the quoted interest rate on the US Treasury.

   	Interest rate
   U.S. Treasury bond	2.53%
   AAA corporate	2.75%
   AA corporate	2.89%
   A corporate	3.06%

   C) Assume liquidity premium stays at 0.7% for the A corporate bond, regardless of its years to maturity. Along with default risk premium (found in part b) and information about expected inflation and maturity risk premium, calculate the interest rate on 1, 5, and 10 year A bond. D) Plot the yield curve of A bond together with the yield curve of Treasury securities. E) Describe the yield curve for U.S. Treasury securities. F) How does the yield curve of the A rated bond compare with the yield curve for U.S. Treasury securities? G) How does the yield curve of a C rated bond compare with the yield curves for U.S. Treasury and A corporate bond? Explain.

5. When the economy was experiencing high inflation in early 1980s, what di the Fed do to help slow down the high inflation? Explain how the Fed’s action would affect short-term rates and long-term rates of Treasury securities, and thus a possible yield curve resulting from it. What would be the likely impact of the Fed’s actions on the yield curves of U.S. Treasury and corporate bonds?

Answer 1

1). Simply put, interest rate is the cost at which one borrows money. Conversely, it is the price which one seeks for having lent money. Interest rates are primarily affected by supply and demand of money, inflation and government policies.As demand for credit increases, interest rates rise whereas when supply of credit increases, interest rates fall. Similarly, when inflation rises (purchasing power decreases), interest rates rise as lenders require higher interest rates. Governments influence interest rates through the monetary policy. When governments borrow from the market, interest rates go up.

2a). As household consumption falls dramatically, it means that demand is falling which will lead to a decrease in interest rates.

b). Corporations increase their demand for funds following increased investment opportunities. - This will lead to an increase in interest rates as demand for credit is increasing.

c). Inflation is expected to decrease - This would lead to a fall in interest rates as purchasing power increases.

3a).

Risk premium that indicates the ease of a bond to be converted to cash on short notice at a “reasonable” price is liquidity premium.

b). Inflation premium is added to the real risk-free rate to protect investors against loss of purchasing power for goods.

c). The risk that a borrower will not pay the interest or principal on a loan is default risk.

d). Maturity risk premium is added to longer term securities to compensate investors for risk of holding long-term debt securities.

e). The relationship between bond yield and maturities is called the term structure of interest rates while the resulting plotted curve is the yield curve.