Term+Structure+Solution

Term+Structure+Solution - FINA 3104 Practice Problems Fall...

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FINA 3104 Practice Problems Fall 2011 The Term Structure of Interest Rates (Suggested Solution) 1. True or False (a) According to the expectations hypothesis, a rising yield curve implies that interest rates are expected to increase in the future. Solution: True. Under the expectations hypothesis, forward rates equal expected future short rates. A rising yield curve, which indicates increasing forward rates, implies that future interest rates are expected to increase. (b) The term structure of interest rates is the relationship between the coupon rate on a bond and time to maturity of the bond. Solution: False. The term structure of interest rates is the relationship between the yield on a bond and time to maturity of the bond. (c) The liquidity preference theory of the term structure of interest rates states that forward rates do not equal expected future interest rates. Solution: True. In particular, if investors prefer holding short-term bonds, they demand a premium for holding long-term bonds. For example, the one-year forward rates, which effectively lock up investors’ money, will be higher than the expected one-year rates.
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Term+Structure+Solution - FINA 3104 Practice Problems Fall...

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