In an effort to better understand how her investments are affected by market factors, Michelle Delatorre, the professional tennis player introduced in the Integrative Problem in Chapter, has posed some questions about yields and interest rates that she wants answered. Your boss at Balik and Kiefer has asked you to answer the following questions for Ms. Delatorre.

a. What is the difference between the dollar return and the percentage return, or yield, on an investment? Show how each return is computed.

b. Ms. Delatorre mentioned that she purchased a stock one year ago for $250 per share and that the stock has a current market value equal to $240. She knows she received a dividend payment equal to $25 per share, but she doesn’t know what rate of return she earned on her investment. Help Ms. Delatorre by showing her how to compute the rate of return on her investment.

c. What do you call the price that a borrower must pay for debt capital? What is the price of equity capital? What are the four fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?

d. What is the real risk-free rate of interest (r*) and the nominal risk-free rate (rRF)? How are these two rates measured?

e. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included when 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.

f. What is the term structure of interest rates? What is a yield curve? At any given time, how would the yield curve facing a given company such as IBM or Microsoft compare with the yield curve for U.S. Treasury securities? Draw a graph to illustrate your answer.

g. Several theories have been advanced to explain the shape of the yield curve. The three major ones are the market segmentation theory, the liquidity preference theory, and the expectations theory. Briefly describe each of these theories. Do economists regard one as being “true”?

h. Suppose most investors expect the rate of inflation to be 1 percent next year, 3 percent the following year, and 4 percent thereafter. The real risk-free rate is 3 percent. The maturity risk premium is 0 percent for bonds that mature in one year or less and 0.1 percent for two-year bonds; the MRP increases by 0.1 percent per year thereafter for 20 years and then becomes stable. What is the interest rate on one-year, 10-year, and 20-year Treasury bonds? Draw a yield curve with these data. Is your yield curve consistent with the three term structure theories?