e 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 the supply of money, therefore, Interest rates will e 2. Corporations increase their demand for funds following an increase in investment opportunities This action will cause interest rates to 3. The government runs a larger than expected budget deficit. The larger the federal deficit, other things held constant, the the level of interest rates. 4. There is a decrease in expected inflation This expectation will cause interest rates to 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 3%, 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 - 0.01(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. 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 3%, 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 = 0.01(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 U.S. Treasury 0.83% AAA corporate 0.20% AA corporate 1.43 0.60 A corporate What yield would you predict for each of these two investments? Round your answers to three decimal places 12-year Treasury yield: Rate 1.03 1.81 0.98 % 7-year Corporate yield: c. Given the following Treasury bond yield information, construct a graph of the yield curve. Maturity Yield 1 year 5.32% 2 years 5.37 3 years 5.58 4 years 5.64 5 years 5.56 10 years 5.68 20 years 6.30 30 years 5.89 Choose the correct graph The correct graph is e A Yield Curve B Yield Curve 8% 896 7% 7% 6% 6% 5% *** 5% Interest Rate 4% Interest Rate 4% 53% 3% 29 29 09 % 0% 10 30 15 20 Years to Maturity 10 15 20 Years to Maturity 30 7% 7% 6% 6% 5% Interest Rate Interest Rate 394 3% 2% 29 IN . IN % 0% 10 15 20 Years to Maturity 25 10 15 20 Years to Mohanty 25 30 2 96 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. AA-corporate Years Treasury yield yield 1 5.32% 5.37% 5.58% 5.64% 5.5696 5.68% 6.30% 5.89% 3 % 4 946 5 96 10 20 30 The correct graph is A Treasury and Corporate Yield Curves B. 854 Trenvury and Corporate Yield Curves % A 7% 7% 6% 6% 5 5% E4% 5% Interest Rate Interest Rate 4% 3% 3% 2% 246 1% 1% 0% 0% 5 25 30 30 10 15 20 Years to Maturity Treasury bond 20 Years to Maturity Treasury bond Corporate bond Corporate bond c. D. Treasury and Corporate Yield Curves Treasury and Corporate Yield Curves 8% 8% 7% 7% 6% 5% Interest Rate 15% % 84% 4% Interest Rate 3% 3% 2% 2% 19 1% 096 0% 25 30 30 25 30 10 15 20 Years to Maturity Treasury bond 10 15 20 Years to Maturity Treasury bond Corporate 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 B volatile than longer term rates therefore, the side of the yield curve would be most volatile over time 1. Using the Treasury yield information in parte, 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 A
