![CFIN (with Online, 1 term (6 months) Printed Access Card) (New, Engaging Titles from 4LTR Press)](https://www.bartleby.com/isbn_cover_images/9781305661653/9781305661653_largeCoverImage.gif)
Concept explainers
The graph which shows the relationship between yields and maturities on a particular date is known as the yield curve, and this relationship is simply called the term structure of securities. The yield curve could be upward sloping where the long-term yields are higher than the short-term yields and is also known as normal yield curve. However, if the long-term yields are lower than the short-term yields then the slope with be downward sloping and is referred to as inverted or abnormal yield curve.
Interest rate consists of risk-free rate, real risk-free rate and inflation premium, and a risk premium such as liquidity risk (LP), default risk (DRP) and maturity risk (MRP). Since, real risk-free rate generally remains constant, it is the changes in the expectation of risk premium and inflation which affects the interest rate of the security. Hence, inflation expectation is the most significant reason for changes in yield and determination of yield curve.
Interest rate or yield on treasuries can be determined using the below equation, where default risk premium DRP and liquidity premium (LP) is zero, as treasuries are considered as liquid and default free investment. Maturity risk premium (MRP) is there as they have differing maturity securities issued.
Expectation theory states that the shape of the yield curve depends on the expectation of future inflation rate and hence an increasing inflation rate will result in an upward sloping curve whereas a decreasing rate would result in downward sloping curve.
Inflation is expected to be 1.5% in Year 1 and Year 2 and would settle for a rate greater than 1.5% thereafter. Yield in year 1 and 2 will remain the same and on 3-year bond will be 0.5% more than yield in Year 1 and 2. The bond is risk free and has a real risk-free rate of 2%.
![Check Mark](/static/check-mark.png)
Want to see the full answer?
Check out a sample textbook solution![Blurred answer](/static/blurred-answer.jpg)
Chapter 5 Solutions
CFIN (with Online, 1 term (6 months) Printed Access Card) (New, Engaging Titles from 4LTR Press)
- Assume that the real risk-free rate is 2% and that the maturityrisk premium is zero. If a 1-year Treasury bond yield is 5% and a 2-year Treasury bondyields 7%, what is the 1-year interest rate that is expected for Year 2? Calculate this yieldusing a geometric average. What inflation rate is expected during Year 2? Comment onwhy the average interest rate during the 2-year period differs from the 1-year interestrate expected for Year 2.arrow_forwardThe rate of inflation for the next 12 months (Year 1) is expected to be 1.4 percent; it is expected to be 1.8 percent the following year (Year 2); and it is expected to be 2.0 percent every year after Year 2. Assume the real risk-free, r*, is 3 percent for all maturities. What should be the yield to maturity on risk-free bonds that mature in (a) one year, (b) five years, and (c) 10 years.arrow_forwardAssume that the real risk-free rate is 1% and that the maturity risk premium is zero. If a 1-year Treasury bond yield is 6% and a 2-year Treasury bond yields 7%, what is the 1-year interest rate that is expected for Year 2? Calculate this yield using a geometric average. Do not round intermediate calculations. Round your answer to two decimal places. What inflation rate is expected during Year 2? Do not round intermediate calculations. Round your answer to two decimal places.arrow_forward
- The real risk-free rate of interest, r*, is 4 percent, and it is expected to remain constant over time. Inflation is expected to be 2 percent per year for the next three years, after which time inflation is expected to remain at a constant rate of 5 percent per year. The maturity risk premium is equal to 0.1(t - 1)%, where t = the bond’s maturity. What is the yield on a 10-year Treasury bond?arrow_forwardSuppose the yield on a two-year-old Treasury bond is 5 percent and the yield on a one-year Treasury bond is a 4 percent. If the maturity risk premium (MRP) on these bonds is zero (0), what is the expected one-year interest rate during the second year (Year 2)?arrow_forwardIf the real rate of interest is 2%, inflation is expected to be 3% during the coming year, and the default risk premium, illiquidity risk premium, and maturity risk premium for the Bonds-R-Us Corporation are all 1% each, what would be the yield (stated rate) on a Bonds-R-Us bond?arrow_forward
- Suppose that the current one-year rate (one-year spot rate) and expected one-year government bonds over years 2, 3 and 4 are as follows: 1R1 = 4.80%, E(2r1) = 5.45%, E(3r1) = 5.95%, E(4r1) = 6.10% Assume that there are no liquidity premiums. To the nearest basis point, what is the current rate for the four-year-maturity government bond? 5.57% 5.62% 5.83% 6.10%arrow_forwardSuppose that the current one-year rate (one-year spot rate) and expected one-year government bonds over years 2, 3 and 4 are as follows: 1R₁ = 4.80%, E(2r₁) = 5.45%, E(3r₁) = 5.95%, E(41) = 6.10% Assume that there are no liquidity premiums. To the nearest basis point, what is the current rate for the four-year-maturity government bond? A. 5.57% B. 5.62% C. 5.83% D. 6.10%arrow_forwardSuppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 1.80%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T-bond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.arrow_forward
- The outstanding bonds of Winter Tires Inc. provide a real rate of return of 3.2 percent. If the current rate of inflation is 2.1 percent, what is the actual nominal rate of return on these bonds?arrow_forwardTreasury securities that mature in 6 years currently have an interest rate of 7.75 percent. Inflation is expected to be 5 percent in each of the next three years and 6 percent each year thereafter. The maturity risk premium is estimated to be 0.10% × (t – 1), where t is equal to the maturity of the bond (i.e., the maturity risk premium of a one-year bond is zero). The real risk-free rate is assumed to be constant over time. What is the real risk-free rate of interest? Group of answer choices 3.00% 1.75% 1.00% 2.50%arrow_forwardThe real risk-free rate of interest, k* is 3 percent. Inflation is expected to be 4 percent this year, 5 percent next year, and 3 percent per year thereafter. The maturity risk premium equals 0.1% (t - 1), where t equals the bond's maturity. That is a 5-year bond has a maturity risk premium of 0.4 percent. A 5-year corporate bond yields 8 percent. What is the yield on a 10-year corporate bond that has the same default risk and liquidity premium as the 5 -year corporate bond?arrow_forward
- Essentials Of InvestmentsFinanceISBN:9781260013924Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.Publisher:Mcgraw-hill Education,
- Foundations Of FinanceFinanceISBN:9780134897264Author:KEOWN, Arthur J., Martin, John D., PETTY, J. WilliamPublisher:Pearson,Fundamentals of Financial Management (MindTap Cou...FinanceISBN:9781337395250Author:Eugene F. Brigham, Joel F. HoustonPublisher:Cengage LearningCorporate Finance (The Mcgraw-hill/Irwin Series i...FinanceISBN:9780077861759Author:Stephen A. Ross Franco Modigliani Professor of Financial Economics Professor, Randolph W Westerfield Robert R. Dockson Deans Chair in Bus. Admin., Jeffrey Jaffe, Bradford D Jordan ProfessorPublisher:McGraw-Hill Education
![Text book image](https://compass-isbn-assets.s3.amazonaws.com/isbn_cover_images/9781260013924/9781260013924_smallCoverImage.jpg)
![Text book image](https://www.bartleby.com/isbn_cover_images/9781260013962/9781260013962_smallCoverImage.gif)
![Text book image](https://www.bartleby.com/isbn_cover_images/9781337909730/9781337909730_smallCoverImage.gif)
![Text book image](https://www.bartleby.com/isbn_cover_images/9780134897264/9780134897264_smallCoverImage.gif)
![Text book image](https://www.bartleby.com/isbn_cover_images/9781337395250/9781337395250_smallCoverImage.gif)
![Text book image](https://www.bartleby.com/isbn_cover_images/9780077861759/9780077861759_smallCoverImage.gif)