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Problem 6-1

Yield Curves

TERM

6 months

4.36%

1 year

5.43%

2 years

5.62%

3 years

5.75%

4 years

5.81%

5 years

6%

10 years

6.4%

20 years

6.66%

30 years

a.

RATE

6.71%

Plot a yield curve based on these data.

a)

The correct sketch is

a.

b.

c.

d.

.

A

B

C

D

b.

What type of yield curve is shown?

a. The yield curve is abnormal

b. The yield curve is upward sloping

c. The yield curve is flat

d. The yield curve is downward sloping

e. The yield curve is inverted

c.

What information does this graph tell you?

a. In general, the rate of inflation is expected to increase and the maturity risk

b. In general, the rate of inflation is expected to decrease and the maturity risk

c. In general, the rate of inflation is expected to increase and the maturity risk

d. The shape of the yield curve depends only on the expectations about future

inflation, which is expected to increase

e.

In general, the rate of inflation is expected to decrease and the maturity risk

d.

Based on this yield curve, if you needed to borrow money for longer than one year,

would it make sense for you to borrow short term and renew the loan or borrow long term?

Explain.

I.

II.

III.

IV.

V.

Even though the borrower renews the loan at increasing short-term rates,

those rates are still below the long-term rate, but what makes the higher long-term rate

attractive is the rollover risk that may possibly occur if the short-term rates go even higher

than the long-term rate (and that could be for a long time!).

Generally, it would make sense to borrow short term because each year the

loan is renewed the interest rate would be higher.

Generally, it would make sense to borrow short term because each year the

loan is renewed the interest rate would be lower.

Generally, it would make sense to borrow long term because each year the

loan is renewed the interest rate would be lower.

Differences in yields that may exist between the short term and long term

cannot be explained by the forces of supply and demand in each market.

Problem 6-2

Real Risk-Free Rate

You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.2%. Your

brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of

On the basis of these data, what is the real risk-free rate of return? Round your answer to two

decimal places.

%

Problem 6-3

Expected Interest Rate

The real risk-free rate is 2.5%. Inflation is expected to be 1.5% this year and 4.75% during the

next 2 years. Assume that the maturity risk premium is zero.

What is the yield on 2-year Treasury securities? Round your answer to two decimal

places.

A. %

What is the yield on 3-year Treasury securities? Round your answer to two decimal

places.

B.

%

Problem 6-4

A Treasury bond that matures in 10 years has a yield of 4%. A 10-year corporate bond has a

yield of 8.5%. Assume that the liquidity premium on the corporate bond is 0.4%. What is the

%

Problem 6-5

The real risk-free rate is 3%, and inflation is expected to be 3.5% for the next 2 years. A 2-year

Treasury security yields 9.25%. What is the maturity risk premium for the 2-year security?

%

Problem 6-7

Expectations Theory

One-year Treasury securities yield 3.35%. The market anticipates that 1 year from now, 1-year

Treasury securities will yield 5.4%. If the pure expectations theory is correct, what is the yield

today for 2-year Treasury securities? Calculate the yield using a geometric average. Round

%

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