HW_4_Solutions_Chapter_5[1]

HW_4_Solutions_Chapter_5[1] - Chapter 5 How Do Risk and...

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Chapter 5 How Do Risk and Term Structure Affect Interest Rates? s Answers to End-of-Chapter Questions 3. During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms. 4. True. When bonds of different maturities are close substitutes, a rise in interest rates for one bond causes the interest rates for others to rise because the expected returns on bonds of different maturities cannot get too far out of line. 5. If yield curves on average were flat, this would suggest that the risk premium on long-term relative to short-term bonds would equal zero and we would be more willing to accept the pure expectations theory. 7. The steep upward-sloping yield curve at shorter maturities suggests that short-term interest rates are expected to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected short-term interest rates in the near future are above the current short-term interest rate. The downward slope for longer maturities indicates that short-term interest rates are eventually expected to fall sharply. With a positive risk premium on long-term bonds, as in the liquidity premium theory, a downward slope of the yield curve occurs only if the average of expected short-term interest rates is declining, which occurs only if short-term interest rates far into the future are falling. Since interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to rise moderately in the near future but fall later on. 8.
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This note was uploaded on 09/07/2011 for the course FIN 353 taught by Professor Cobus during the Spring '08 term at S.F. State.

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HW_4_Solutions_Chapter_5[1] - Chapter 5 How Do Risk and...

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