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CHAPTER 5: HISTORY OF INTEREST RATES AND RISK PREMIUMS 1. For the money market fund, your holding period return for the next year depends on the level of 30-day interest rates each month when the fund rolls over maturing securities. The one-year savings deposit offers a 7.5% holding period return for the year. If you forecast that the rate on money market instruments will increase significantly above the current 6% yield, then the money market fund might result in a higher HPR than the savings deposit. The 20-year Treasury bond offers a yield to maturity of 9% per year, which is 150 basis points higher than the rate on the one-year savings deposit; however, you could earn a one-year HPR much less than 7.5% on the bond if long-term interest rates increase during the year. If Treasury bond yields rise above 9%, then the price of the bond will fall, and the resulting capital loss will wipe out some or all of the 9% return you would have earned if bond yields had remained unchanged over the course of the year. 2. a. If businesses reduce their capital spending, then 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.Open market purchases of U.S. Treasury securities by the Federal Reserve Board 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. 3. a.The “Inflation-Plus” CD is the safer investment because it guarantees the purchasing power of the investment. Using the approximation that the real rate equals the nominal rate minus the inflation rate, the CD provides a real rate of
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This note was uploaded on 03/10/2011 for the course FMIS 3601 taught by Professor Vizanko during the Spring '08 term at University of Minnesota Duluth.

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