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06problem 3/22/2010 7:10 12/21/2005 Chapter 6. Solution to End-of-Chapter Comprehensive/Spreadsheet Problem Problem 6-20 a. What effect would each of the following events likely have on the level of nominal interest rates? (1) Households dramatically increase their savings rate. This action will increase the supply of money; therefore, interest rates will decline. (2) Corporations increase their demand for funds following an increase in investment opportunities. This action will cause interest rates to increase. (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 an increase in expected inflation. This expectation will cause interest rates to increase. b. Suppose you are considering two possible investment opportunities, a 12-year Treasury bond and a 7-year, A-rated corporate bond. The current real risk-free rate is 4%, and inflation is expected to be 2% for the next two years, 3% for the following four years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP = 0.1 ( t - 1) %. The liquidity premium for the corporate bond is estimated to be 0.7%. Finally, you may determine the default risk premium, given the company’s bond rating, from the default risk premium table in the text. What yield would you predict for each of these two investments? Treasury Bond Risk-free rate = 4.00% Maturity: 12 Expected inflation: for the next 2 years = 2% Expected inflation: for the next 4 years = 3% Expected inflation: for the next 6 years
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