216 Part 3 Financial Assets INTEGRATED C/ MORTON HANDLEY&COMPANY 6-21 INTEREST RATE DETERMINATION Maria Juare 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 some questions for you to consider Your boss has a. What are the four most fundamental factors that affect the cost of money, or the general level of interest rate b What is the real risk-free rate of interest () and the nominal risk-free rate (a) How are these two raes in the economy measured? risk c. Define the terms anflation pre (P), default risk promium (DRP, liquidity premium (LP), and mtunithy of these premiums is included in determining the interest rate on (1) short-term premium (MRP). Which Treasury securities, (2) long-term US. Treasury securities, (3) short-term corporate securities, and (4) long erms corporate secunities? 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. pose most investors expect the inflation rate to be ys net year, 6% the following year, and thereafter. The real risk-free rate is 3% The maturity risk premium is zero for bonds that mature in 1 year or and 0.1% for 2-year bonds; then the MRP increases by 01% per year thereafter for 20 years, after which it stable. What is the interest rate on 1-, 10, and 20-year Trwasury bonds? Draw a yield curve with these data. What factors can explain why this constructed yield curve is upward sloping? t At any given time, how would the yield curve facing a AAA-rated company compare with the yield curve & What is the pure expectations theory? What does the pure expectations theory imply about the term h Suppose you observe the following term structure for Treasury securities for U.S. Treasury securities? At any given time, how would the yield curve facing a BB-rated company compane with the yield curve for U.S. Treasury securities? Draw a graph to illustrate your answer structure of interest rates? Maturity Yield 1 year 2 years62 3 years64 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 securitios 1 year from now? What dos the market expect will be the interest rate on 3-year securities 2 years from now? Calculate these yields using geometric average Describe how macroeconomic factors affect the level of interest rales. internest rates have been lower in recent years? How do these factors explain why