Case 11: Amber Plank

Term Structure of Interest Rates

Amber Plank is a high school senior who plans to attend college next year and major in Astronomy.
Her first choice is to attend the University of Charleston, which is highly regarded in her intended field.
However, to do so she will have to take out a substantial amount of loans as this is a private
university with high tuition costs. While loan rates today are not high by historical standards, Amber
will be charged the one-year rate that exists at the time she takes out the loans. That is, each year
when she borrows to pay for her tuition, she will be assessed interest at a rate consistent with the
short-term rate that exists in the future.

Amber's second collegiate choice is to attend the University of Florida. The benefit of doing so is that
she will receive a full scholarship and thus will not have to borrow in order to attend this institution.
The drawback is that while this is a fine university, it does not specialize in her major.

Selecting which university to attend is an extremely important decision to make. In order to perform a
complete cost comparison between the two universities, Amber must determine the future one-year
interest rates that are likely to exist. Since they are the rates at which she will have to borrow in the
future, accuracy is extremely important as these interest costs will eventually be used in a cost-benefit
analysis.

Table 1 lists today's rates that exist for U.S. Treasury securities of various maturities.

Table 1
Time to Maturity Yield to Maturity
1 year 7.0%
2 years 7.5%
3 years 8.0%
4 years 8.5%
5 years 8.6%

Questions

1. What are the four most important variables that determine a bond's yield to maturity?
2. Define a Yield Curve.
3. Explain the Expectations Hypothesis and use the theory to try to predict what the one-year
interest rates will be over the next five years.
4. Explain the Liquidity Preference Hypothesis and use the theory to try to predict what the one-
year interest rates will be over the next five years.
5. Explain the Market Segmentation Hypothesis and use the theory to try to predict what the
one-year interest rates will be over the next five years.