a. What effect would each of the following events likely have on the level of nominal interest rates? 1. Households dramatically decrease their savings rate. This action will decrease the supply of money; therefore, interest rates will increase 2. Corporations decrease their demand for funds following a decrease in investment opportunities. This action will cause interest rates to decrease 3. The government runs a larger-than-expected budget deficit. The larger the federal deficit, other things held constant, the higher the level of interest rates. 4. There is a decrease in expected inflation. This expectation will cause interest rates to decrease b. Suppose you are considering two possible investment opportunities: a 12-year Treasury bond and a 7-year, AA-rated corporate bond. The current real risk-free rate is 5%, and inflation is expected to be 2% for the next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP = 0.03(t-1) %. The liquidity premium (LP) for the corporate bond is estimated to be 0.2%. You may determine the default risk premium (DRP), given the company's bond rating, from the following table. Remember to subtract the bond's LP from the corporate spread given in the table to arrive at the bond's DRP. Corporate Bond Yield Spread = DRP + LP Rate U.S. Treasury 0.83% AAA corporate 1.03 0.20% AA corporate 1.35 0.52 A corporate 1.69 0.86 What yield would you predict for each of these two investments? Round your answers to three decimal places. 1 X % 12-year Treasury yield: % 7-year Corporate yield: c. Given the following Treasury bond yield information, construct a graph of the yield curve. Maturity Yield 5.42% 1 year 2 years 5.47 3 years 5.66 4 years 5.72 5 years 5.65 10 years 5.77 20 years 6.35 30 years 5.98 Choose the correct graph. The correct graph is graph C B. A. 8% 7%- 6%- 5%- Yield Curve Kate 8% 7%- 6%- 5%- Yield Curve A. C. Interest Rate Interest Rate 8% 7%- 6% 5%- 4% 3%- 2%- 1%- 0% + 8%- 7%- 6%- 5%- 4% 3%- 2%- 1%- 0% + 10 Yield Curve 15 Years to Maturity Yield Curve 20 25 30 20 B. D. Interest Rate Interest Rate 8%- 7%- 6%- 5%- 4% 3%- 2%- 1%- 0% + 8%- 7%- 6%- 5%- 4%- 3%- 2%- 1%- 0%- 10 Yield Curve 15 Years to Maturity Yield Curve 20 20 25 30 d. Based on the information about the corporate bond provided in part b, calculate yields and then construct a new yield curve graph that shows both the Treasury and the corporate bonds. Round your answers to two decimal places. Years Treasury yield AA-corporate yield 1 5.42% % 7.57 % 2 5.47% % 3 5.66% 4 5.72% % % 5 5.65% 10 5.77% % 20 6.35% 30 5.98% Choose the correct graph. The correct graph is graph B B. A. Treasury and Corporate Yield Curves 8%- 7%- 6%- 5%- 4%- 3%- 2%- 1%- 0% + 10 15 20 Years to Maturity Interest Rate % % Treasury and Corporate Yield Curves 10 15 20 Years to Maturity 25 30 Interest Rate 8% 7%- 6% 5%- 4%- 3%- 2% 1% 0% + 25 30 Treasury and Corporate Yield Curves Treasury and Corporate Yield Curves 8% 8% 7% 7%- 6%- 6% 5% 5% 4% 4%- 3%- 3% 2%- 2%- 1%- 1% 0% + 0%+ 10 20 25 10 15 20 15 Years to Maturity Treasury bond Years to Maturity Treasury bond Corporate bond e. Which part of the yield curve (the left side or right side) is likely to be most volatile over time? Short-term rates are more volatile than longer-term rates; therefore, the left side of the yield curve would be most volatile over time. f. Using the Treasury yield information in part c, calculate the following rates using geometric averages (round your answers to three decimal places): 1. The 1-year rate, 1 year from now % 2. The 5-year rate, 5 years from now % 3. The 10-year rate, 10 years from now % 4. The 10-year rate, 20 years from now % C. 30 D. Interest Rate 25 Corporate bond 30 a. What effect would each of the following events likely have on the level of nominal interest rates? 1. Households dramatically decrease their savings rate. This action will decrease the supply of money; therefore, interest rates will increase 2. Corporations decrease their demand for funds following a decrease in investment opportunities. This action will cause interest rates to decrease 3. The government runs a larger-than-expected budget deficit. The larger the federal deficit, other things held constant, the higher the level of interest rates. 4. There is a decrease in expected inflation. This expectation will cause interest rates to decrease b. Suppose you are considering two possible investment opportunities: a 12-year Treasury bond and a 7-year, AA-rated corporate bond. The current real risk-free rate is 5%, and inflation is expected to be 2% for the next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP = 0.03(t-1) %. The liquidity premium (LP) for the corporate bond is estimated to be 0.2%. You may determine the default risk premium (DRP), given the company's bond rating, from the following table. Remember to subtract the bond's LP from the corporate spread given in the table to arrive at the bond's DRP. Corporate Bond Yield Spread = DRP + LP Rate U.S. Treasury 0.83% AAA corporate 1.03 0.20% AA corporate 1.35 0.52 A corporate 1.69 0.86 What yield would you predict for each of these two investments? Round your answers to three decimal places. 1 X % 12-year Treasury yield: % 7-year Corporate yield: c. Given the following Treasury bond yield information, construct a graph of the yield curve. Maturity Yield 5.42% 1 year 2 years 5.47 3 years 5.66 4 years 5.72 5 years 5.65 10 years 5.77 20 years 6.35 30 years 5.98 Choose the correct graph. The correct graph is graph C B. A. 8% 7%- 6%- 5%- Yield Curve Kate 8% 7%- 6%- 5%- Yield Curve A. C. Interest Rate Interest Rate 8% 7%- 6% 5%- 4% 3%- 2%- 1%- 0% + 8%- 7%- 6%- 5%- 4% 3%- 2%- 1%- 0% + 10 Yield Curve 15 Years to Maturity Yield Curve 20 25 30 20 B. D. Interest Rate Interest Rate 8%- 7%- 6%- 5%- 4% 3%- 2%- 1%- 0% + 8%- 7%- 6%- 5%- 4%- 3%- 2%- 1%- 0%- 10 Yield Curve 15 Years to Maturity Yield Curve 20 20 25 30 d. Based on the information about the corporate bond provided in part b, calculate yields and then construct a new yield curve graph that shows both the Treasury and the corporate bonds. Round your answers to two decimal places. Years Treasury yield AA-corporate yield 1 5.42% % 7.57 % 2 5.47% % 3 5.66% 4 5.72% % % 5 5.65% 10 5.77% % 20 6.35% 30 5.98% Choose the correct graph. The correct graph is graph B B. A. Treasury and Corporate Yield Curves 8%- 7%- 6%- 5%- 4%- 3%- 2%- 1%- 0% + 10 15 20 Years to Maturity Interest Rate % % Treasury and Corporate Yield Curves 10 15 20 Years to Maturity 25 30 Interest Rate 8% 7%- 6% 5%- 4%- 3%- 2% 1% 0% + 25 30 Treasury and Corporate Yield Curves Treasury and Corporate Yield Curves 8% 8% 7% 7%- 6%- 6% 5% 5% 4% 4%- 3%- 3% 2%- 2%- 1%- 1% 0% + 0%+ 10 20 25 10 15 20 15 Years to Maturity Treasury bond Years to Maturity Treasury bond Corporate bond e. Which part of the yield curve (the left side or right side) is likely to be most volatile over time? Short-term rates are more volatile than longer-term rates; therefore, the left side of the yield curve would be most volatile over time. f. Using the Treasury yield information in part c, calculate the following rates using geometric averages (round your answers to three decimal places): 1. The 1-year rate, 1 year from now % 2. The 5-year rate, 5 years from now % 3. The 10-year rate, 10 years from now % 4. The 10-year rate, 20 years from now % C. 30 D. Interest Rate 25 Corporate bond 30