TUTORIAL:

1. If a yield curve looks like the one below, what is the market predicting about the
movement of future short-term interest rates? What might the yield curve
indicate about the market’s predictions about the inflation rate in the future?

Interest rate and price have negative relationship.

e.g.: when interest rate is high, market price of investment will be low, because cost of
borrowing is higher, so less people can invest. So less demand, so value of investment falls.
Relationship between interest rate and yield to maturity: positive
When interest rate increases, price falls, so yield rises. When yield is higher than coupon so
bond is cheaper (discount)
Inflation and interest rates relationship: positive.
Because the initial, steep upward slope indicates that the average of expected short-term
interest rates in the near future is above the current short-term interest rate, the steep upward-
sloping yield curve at shorter maturities suggests that short-term interest rates are expected to
rise moderately in the near future.
The decreasing slope for lengthier maturities suggests that short-term interest rates are likely
to decline substantially in the future. With a positive risk premium on long-term bonds, as in
the liquidity premium theory, the yield curve slopes downward only if the average of
predicted short-term interest rates falls, which occurs only if short-term interest rates far into
the future decrease. Because interest rates and projected inflation move in lockstep, the yield
curve indicates that the market expects inflation to grow modestly in the short term but
decline afterwards.
Liquidity premium theory: According to the liquidity premium theory, bond investors favor
highly liquid, short-dated securities that can be sold rapidly over long-dated securities. The
theory also claims that changes in interest rates compensate investors for greater default and
pricing risk. This implies that investors must be paid positive liquidity premium, int, to hold
long term bonds
 • Key Assumption: Bonds of different maturities are substitutes, but are not perfect
substitutes
• Implication: Modifies Pure Expectations Theory with features of Market
Segmentation Theory

The flat yield curve at shorter maturities implies that short-term interest rates are likely to
decline considerably in the near future, but the steep upward slope of the yield curve at longer
maturities shows that interest rates are expected to increase farther into the future. Because
interest rates and projected inflation move in unison, the yield curve indicates that the market
expects inflation to decline somewhat in the short term but rise subsequently.
2. Predict what will happen to interest rates on a corporation’s bonds if the federal
government guarantees today that it will pay creditors if the corporation goes
bankrupt in the future. What will happen to the interest rates on Treasury
securities?
Bond without government guarantee:
Cannot pay the coupon cannot pay face value during the maturity bond becomes default.
Bond with government guarantee:
Government will cover risk
Guaranteed Bonds:
Guarantor makes payment if bond issuer fails to do so to bondholder.

The government guarantee lowers the default risk on business bonds, making them more
appealing in comparison to Treasury securities. Increased demand for corporate bonds and
decreased demand for Treasury securities will result in lower corporate bond interest rates
and higher Treasury bond interest rates.

3. Predict what would happen to the risk premiums on corporate bonds if

brokerage commissions were lowered in the corporate bond market.
A risk premium is the investment return an asset is expected to yield in excess of the risk-
free rate of return.
Lower costs mean corporate bonds are more liquid. This increases the demand for corporate
bonds, result in lower risk premium.
Lower brokerage commissions for corporate bonds would make them more liquid and thus
increase their demand, which would lower their risk premium.
 4. If the income tax exemption on municipal bonds were abolished, what would
happen to the interest rates on these bonds? What effect would it have on
interest rates on US Treasury securities?
Abolishing the tax-exempt feature of municipal bonds would make them less desirable
relative to Treasury bonds.
The resulting decline in the demand for municipal bonds and increase in demand for Treasury
bonds would raise the interest rates on municipal bonds, while the interest rates on Treasury
bonds would fall.
5. The one-year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%,
9%,10.5%, 13%,14.5%, 16%, 17.5%.
(a) Using the pure expectations theory, what will be the interest rates on a 3-year
bond and 6-year bond?
For 3 year bond: (interest rate for years 1, 2 and 3/3)
3+4.5+6/3
= 13.5/3
= 4.5%
For 6 year bond: (Interest rate for the first 6 years/number of years)
(13.5+7.5+9+10.5)/6
= 40.5/6
= 6.75%
(b) Now assume that the investor prefers holding short-term bonds. A liquidity
premium of 10 basis points is required for each year of a bond’s maturity. What
will be the interest rates on a 3-year bond and 6-year bond?
Liquidity premium: 10 basis points = 10/100 = 0.1 so for 3 years 0.1 × 3 = 0.3
3 year bond:
0.1 × 3 = 0.3 basis points
[(3+4.5+6)/3] + 0.3
= 4.5 + 0.3
=4.8%
6 year bond:
0.1 × 6 = 0.6
[(3+4.5+6+7.5+9+10.5))/6] + 0.6
= 6.75 + 0.6
= 7.35%
 6. One-year T-bill rates are 2% currently. If interest rates are expected to go up
after 3 years by 2% every year, what should be the required interest rate on a
10-year bond issued today?
For the first three years interest rate remains at 2%
2+2+2
=6
For the remaining 7 years, interest rate increases by 2% each year.
y4 = 2(1+0.02) = 2.04
y5 = 2(1.02)² = 2.08
y6 = 2(1.02)³ = 2.12
y7 = 2(1.02)⁴ = 2.16
y8 = 2(1.02)⁵ = 2.21
y9 = 2(1.02)⁶ = 2.25
y10 = 2(1.02)⁷ = 2.30
Sum = 15.16
6+15.16
= 21.16/10
= 2.116%
7. At your favourite bond store, Bonds-R-Us, you see the following prices:
A. 1-year $100 zero selling for $90.19
B. 3-year 10% coupon $1000 par bond selling for $1000
C. 2-year 10% coupon $1000 par bond selling for $1000
Assume that the pure expectations theory for the term structure of interest rates holds,
no liquidity or maturity premium exists, and the bonds are equally risky. What is the
implied 1-year rate two years from now?
1 year bond rate today:
Face Value
Price= n
(1+ r)
100
90.19= 1
(1+r )
90.19(1+ r)=100
(1+r) = 100/90.19
(1+r) = 1.10877
r = 1.10877 -1
r = 0.10877
r= 10.87%
Or (face value - selling price)/selling price
100 - 90.19/90.19 = 10.877%
2 year bond rate today:
C oupon P ayment Par V alue
Bond Price=∑ t
+ N
(1+ r) (1+ r)
10% coupon rate × 1000 per value = 100 coupon payment
100 1100
1000=∑ +
(1.10877) (1+r )2

1100
1000=∑ 90.19+ 2
(1+r )
1100
1000−90.19=∑ 2
(1+ r)

909.81(1+r )2 = 1100

(1+r )2 = 1.2090
1+r = 1.0995
R = 0.09954
= 9.95%
3 year bond rate today:
100 100 1100
1000=∑ + +
1 .10877 1.09954 =1.20899 (1+ r)3
2

1100
1000=∑ 90.19+82.714+ 3
(1+ r)
1100
1000=∑ 172.904+ 3
(1+ r )
1100
1000 – 172.904 = 3
(1+r )
827.096(1+r )3 = 1100

(1+r )3 = 1.32995
1+r = 1.09971
R = 0.09972
= 9.97%
1-year rate 2 years from now:
Now - 2021 1 year - 2022 2 year – 2023 3 year - 2024
10.877% 9.95% 9.97%

= [(3 years×3 year rate) - (2 years×2 year rate)]

= (3 × 0.0997) - (2 × 0.0995)
0.2991 – 0.199
= 0.1001
=10.01%
7. If the interest rates on one- to five-year bonds are currently 4%, 5%, 6%, 7%, and 8%,
and the term premiums for one- to five-year bonds are 0%, 0.25%, 0.35%, 0.40%, and
0.50%, predict what the one-year interest rate will be two years from now.
[(1 +i3-k3)3/(1 +i2-k2)2] -1

k = term premiums

I = interest rates

(1+i3−k 3)3
−1
(1+i 2−k 2)2

(1+0.06−0.0035)3
−1
(1+0.05−0.0025)2
1.17926
−1
1.09726
= 0.07473 = 7.47%