solutions_ch_05 - CHAPTER 5 HISTORY OF INTEREST RATES RISK...

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CHAPTER 5: HISTORY OF INTEREST RATES & RISK PREMIUMS 1. Your holding period return for the next year on the money market fund depends on what 30 day interest rates will be each month when it is time to roll over maturing securities. The one-year savings deposit will offer a 7.5% holding period return for the year. If you forecast the rate on money market instruments to rise significantly above the current yield of 6%, then the money market fund might result in a higher HPR for the year. While the 20-year Treasury bond is offering a yield to maturity of 9% per year, which is 150 basis points higher than the rate on the one-year savings deposit at the bank, you could wind up with a one-year HPR of much less than 7.5% on the bond if long-term interest rates rise during the year. If Treasury bond yields rise above 9% during the year, then the price of the bond will fall, and the capital loss will wipe out some or all of the 9% return you would have received if bond yields had remained unchanged over the course of the year. 2. a. If businesses decrease their capital spending they are likely to decrease their demand for funds. This will shift the demand curve in Figure 5.1 to the left and reduce the equilibrium real rate of interest. b. Increased household saving will shift the supply of funds curve to the right and cause real interest rates to fall. c. An open market purchase of Treasury securities by the Fed is equivalent to an increase in the supply of funds (a shift of the supply curve to the right). The equilibrium real rate of interest will fall.
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