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**Unformatted text preview: **Chapter 6. Interest Rates 1. If R 1 =5%, E( 1 R 2 )=4%, what is R 2 according to the Expectations Hypothesis? (1+ R 2 )^2 = (1+ R 1 )*(1+E( 1 R 2 )) => (1+ R 2 )^2 = (1.05)*(1.04) => (1+( R 2 ))^2 = 1.092 => R 2 = 4.4988% Approximately, R 2 = ( R 1 +E( 1 R 2 ))/2 = 4.5% 2. If the current one year CD rate is 5% and the best estimate of one year CD which will be available one year from today is 7%, what is the current two year CD rate with 1% liquidity premium? R 1 + E( 1 R 2 ) = 2 * ( R 2- LP) => 5% + 7% = 2 * ( R 2- 1%) => R 2 = 7% 3. David Cone is concerned about the interest rate changes for his fixed income investment. He looked at the treasury yield curve on Wall Street Journal and observed a normal yield curve. Based on this observation, which of the following statements is correct? a. Companies must have more investment opportunities now than they expected to have in the future b. Future short-term interest rates are expected to be higher than current short-term interest rates assuming the pure expectation theory holds. c. Maturity risk premium is positive d. Inflation must be expected to increase in the future e. Expectation theory must be correct b. Assuming that the expectations theory holds, the overall expected returns from short-term rollover and long-term investments are the same. This implies that the long-term rate is an average of current short-term and expected future short-term rates. A normal (rising) yield curve with a long term rate being higher than the current short-term rate is indicative of the fact that future short-term rates are expected to be higher than current short-term rates. 4. The current interest rate on a 2-year Treasury security is 5.5% while the 1-year US Treasury security yields 5%. Assuming that the pure expectations theory holds, what is the markets estimated interest rate on 1-year Treasury security one year from now? R 2 = [ R 1 + E( 1 R 2 )]/2, 5.5% = [5% + E( 1 R 2 )]/2, E( 1 R 2 ) = 6% 5. Assume that interest rates on 20-year Treasury and corporate bonds are as follows: T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18% The differences in these rates were probably caused primarily by: a. Tax effects b. Default risk differences c. Maturity risk differences d. Inflation differences e. Real risk-free rate differences b 6. A bond trader observes the following information: The Treasury yield curve is downward sloping . Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds. Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquidity premium is built into corporate bond yields. On the basis of this information, which of the following statements is most CORRECT?...

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