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# Ch 6 - 10.5 10.0 9.5 9.0 8.5 Percent 8.0 7.5 Actual yield...

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Interest Rate (%) Years to Maturity 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 0 2 4 6 8 10 12 14 16 18 20 Interest Rate (%) 6.5 Years to Maturity (%) Percent Actual yield curve Maturity premium Pure expectations yield curve Years to Maturity risk Solutions to End-of-Chapter Problems 6-1 a.     Term     Rate       6 months 5.1%   1 year 5.5   2 years 5.6   3 years 5.7   4 years 5.8   5 years 6.0 10 years 6.1 20 years 6.5 30 years 6.3 b. The yield curve shown is an upward sloping yield curve. c. This yield curve tells us generally that either inflation is expected to increase or there is an  increasing maturity risk premium. d. Even though the borrower reinvests in 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!).  This exposes you to rollover risk.  If you borrow for 30 years outright you have  locked in a 6.3% interest rate each year. 6-2 T-bill rate = r* + IP       5.5% = r* + 3.25%              r* = 2.25%.

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6-3 r* = 3%; I 1  = 2%; I 2  = 4%; I 3  = 4%; MRP = 0; r T2  = ?; r T3  = ? r = r* + IP + DRP + LP + MRP. Since these are Treasury securities, DRP = LP = 0. r T2 = r* + IP 2 . IP 2 = (2% + 4%)/2 = 3%. r T2 = 3% + 3% = 6%. r T3 = r* + IP 3 . IP 3 = (2% + 4% + 4%)/3 = 3.33%. r T3 = 3% + 3.33% = 6.33%. 6-4 r T10  = 6%; r C10  = 8%; LP = 0.5%; DRP = ? r = r* + IP + DRP + LP + MRP. r T10  = 6% = r* + IP 10  + MRP 10 ; DRP = LP = 0. r C10  = 8% = r* + IP 10  + DRP + 0.5% + MRP 10 . Because both bonds are 10-year bonds the inflation premium and maturity risk premium on both  bonds are equal.  The only difference between them is the liquidity and default risk premiums. r C10  = 8% = r* + IP + MRP + 0.5% + DRP.  But we know from above that r* + IP 10  + MRP 10  = 6%;  therefore,     r C10 = 8% = 6% + 0.5% + DRP 1.5% = DRP. 6-5 r* = 3%; IP 2  = 3%; r T2  = 6.2%; MRP 2  = ?     r T2 = r* + IP 2  + MRP 2  = 6.2%     r T2 = 3% + 3% + MRP 2  = 6.2% MRP 2 = 0.2%. 6-6 r* = 5%; I 1-4  = 16%; MRP = DRP = LP = 0; r 4  = ?
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Ch 6 - 10.5 10.0 9.5 9.0 8.5 Percent 8.0 7.5 Actual yield...

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