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INTEREST RATE DETERMINATION 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 rates. 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 rates, in the economy? b. What is the real risk-free rate of interest (r″) and the nominal risk-free rate (r RF )? How are these two rates measured? c. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP) . Which of these premiums is included in determining the interest rate on (1) short-term U.S. Treasury securities, (2) long-term U.S. Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed. d. What is the term structure of interest rates? What is a 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 premium is zero for bonds that mature in 1 year or less and 0.1% for 2-year bonds; then the MRP increases by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest rate on 1-, 10-, and 20-year Treasury bonds? Draw a yield curve with these data. What factors can explain why this constructed yield curve is upward sloping? f. At any given 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 illustrate your answer. g. What is the pure expectations theory? What does the pure expectations theory imply about the term structure of interest rates? h. Suppose you observe the following term structure for Treasury securities: Maturity Yield 1 year 6.0% 2 years 6.2 3 years 6.4 4 years 6.5 5 years 6.5 Assume that the pure expectations theory of the term structure is correct. (This implies that you can use the yield curve provided to “back out” the market’s expectations about future interest rates.) What does the market expect will be the interest rate on 1-year securities 1 year from now? What does the market expect will be the interest rate on 3-year securities 2 years from now? Calculate these yields using geometric averages. i. Describe how macroeconomic factors affect the level of interest rates. How do these factors explain why interest rates have been lower in recent years?

BuyFind

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781337395250
BuyFind

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781337395250

Solutions

Chapter
Section
Chapter 6, Problem 21IC
Textbook Problem

INTEREST RATE DETERMINATION 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 rates.

Your boss has prepared some questions for you to consider.

  1. a. What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?
  2. b. What is the real risk-free rate of interest (r″) and the nominal risk-free rate (rRF)? How are these two rates measured?
  3. c. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included in determining the interest rate on (1) short-term U.S. Treasury securities, (2) long-term U.S. Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed.
  4. d. What is the term structure of interest rates? What is a yield curve?
  5. 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 premium is zero for bonds that mature in 1 year or less and 0.1% for 2-year bonds; then the MRP increases by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest rate on 1-, 10-, and 20-year Treasury bonds? Draw a yield curve with these data. What factors can explain why this constructed yield curve is upward sloping?
  6. f. At any given 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 illustrate your answer.
  7. g. What is the pure expectations theory? What does the pure expectations theory imply about the term structure of interest rates?
  8. h. Suppose you observe the following term structure for Treasury securities:
Maturity Yield
1 year 6.0%
2 years 6.2
3 years 6.4
4 years 6.5
5 years 6.5

Assume that the pure expectations theory of the term structure is correct. (This implies that you can use the yield curve provided to “back out” the market’s expectations about future interest rates.) What does the market expect will be the interest rate on 1-year securities 1 year from now? What does the market expect will be the interest rate on 3-year securities 2 years from now? Calculate these yields using geometric averages.

  1. i. Describe how macroeconomic factors affect the level of interest rates. How do these factors explain why interest rates have been lower in recent years?

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Chapter 6 Solutions

Fundamentals of Financial Management (MindTap Course List)
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Ch. 6 - Suppose interest rates on residential mortgages of...Ch. 6 - Which fluctuate morelong-term or short-term...Ch. 6 - Suppose you believe that the economy is just...Ch. 6 - Suppose the population of Area Y is relatively...Ch. 6 - Suppose a new process was developed that could be...Ch. 6 - Suppose a new and more liberal Congress and...Ch. 6 - It is a fact that the federal government (1)...Ch. 6 - Suppose interest rates on Treasury bonds rose from...Ch. 6 - What does it mean when it is said that the United...Ch. 6 - Suppose you have noticed that the slope of the...Ch. 6 - YIELD CURVES Assume that yields on U.S. Treasury...Ch. 6 - REAL RISK-FREE RATE You read in The Wall Street...Ch. 6 - EXPECTED INTEREST RATE The real risk-free rate is...Ch. 6 - DEFAULT RISK PREMIUM A Treasury bond that matures...Ch. 6 - MATURITY RISK PREMIUM The real risk-free rate is...Ch. 6 - INFLATION CROSS-PRODUCT An analyst is evaluating...Ch. 6 - EXPECTATIONS THEORY One-year Treasury securities...Ch. 6 - EXPECTATIONS THEORY Interest rates on 4-year...Ch. 6 - EXPECTED INTEREST RATE The real risk-free rate is...Ch. 6 - INFLATION Due to a recession, expected inflation...Ch. 6 - DEFAULT RISK PREMIUM A companys 5-year bonds are...Ch. 6 - MATURITY RISK PREMIUM An investor in Treasury...Ch. 6 - DEFAULT RISK PREMIUM The real risk-free rate, r,...Ch. 6 - EXPECTATIONS THEORY AND INFLATION Suppose 2-year...Ch. 6 - EXPECTATIONS THEORY Assume that the real risk-free...Ch. 6 - INFLATION CROSS-PRODUCT An analyst is evaluating...Ch. 6 - INTEREST RATE PREMIUMS A 5-year Treasury bond has...Ch. 6 - YIELD CURVES Suppose the inflation rate is...Ch. 6 - INFLATION AND INTEREST RATES In late 1980, the...Ch. 6 - INTEREST RATE DETERMINATION AND YIELD CURVES a....Ch. 6 - INTEREST RATE DETERMINATION Maria Juarez is a...

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