DETERMINANTS OF INTEREST RATES

Problems
1. A particular security’s equilibrium rate of return is 8 percent. For all securities, the
inflation risk premium is 1.75 percent and the real risk-free rate is 3.5 percent. The
security’s liquidity risk premium is 0.25 percent and maturity risk premium is 0.85
percent. The security has no special covenants. Calculate the security’s default risk
premium.

2. You are considering an investment in 30-year bonds issued by Moore Corporation. The
bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are
currently earning 3.25 percent. Your broker has determined the following information
about economic activity and Moore Corporation bonds:

Real Risk-Free Rate = 2.25%

Default Risk Premium = 1.15%
Liquidity Risk Premium = 0.50%
Maturity Risk Premium = 1.75%

a. What is the inflation premium? r = r* + IP

b. What is the fair interest rate on Moore Corporation 30-year bonds?

3. Dakota Corporation 15-year bonds have an equilibrium rate of return of 8 percent. For all
securities, the inflation rate is 3.50 percent. The r* is 1.75 percent, security’s liquidity
risk premium is 0.25 percent and maturity risk premium is 0.85 percent. The security has
no special covenants. Calculate the bond’s default risk premium.

4. A two-year Treasury security currently earns 1.94 percent. Over the next two years, the
real risk-free rate is expected to be 1.00 percent per year and the inflation premium is
expected to be 0.50 percent per year. Calculate the maturity risk premium on the two-year
Treasury security.

5. Tom and Sue’s Flowers Inc.’s 15-year bonds are currently yielding a return of 8.25
percent. The expected inflation premium is 2.25 percent annually and the real risk-free
rate is expected to be 3.50 percent annually over the next 15 years. The default risk
premium on Tom and Sue’s Flowers’ bonds is 0.80 percent. The maturity risk premium is
0.75 percent on 5-year securities and increases by 0.04 percent for each additional year to
maturity. Calculate the liquidity risk premium on Tom and Sue’s Flowers Inc.’s 15-year
bonds.

6. Nikki G’s Corporation’s 10-year bonds are currently yielding a return of 6.05 percent.
The expected inflation premium is 1.00 percent annually and the real risk-free rate is
expected to be 2.10 percent annually over the next 10 years. The liquidity risk premium
on Nikki G’s bonds is 0.25 percent. The maturity risk premium is 0.10 percent on 2-year
securities and increases by 0.05 percent for each additional year to maturity. Calculate the
default risk premium on Nikki G’s 10-year bonds.
7. The current one-year Treasury-bill rate is 5.2 percent and the expected one-year rate 12
months from now is 5.8 percent. According to the unbiased expectations theory, what
should be the current rate for a two-year Treasury security?

8. Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bill
rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:

1R1 = 6%, E(2r1) = 7%, E(3r1) = 7.5%, E(4r1) = 7.85%

Using the unbiased expectations theory, calculate the current (long-term) rates for one-,
two-, three-, and four-year-maturity Treasury securities.

9. One-year Treasury bills currently earn 3.45 percent. You expect that one year from now,
one-year Treasury bill rates will increase to 3.65 percent. If the unbiased expectations
theory is correct, what should the current rate be on two-year Treasury securities?

10. Suppose we observe the following rates: 1R1 = 8%, 1R2 = 10%. If the unbiased
expectations theory of the term structure of interest rates holds, what is the one-year
interest rate expected one year from now, E (2r1 )?

11. Suppose we observe the three-year Treasury security rate ( 1R3) to be 12 percent, the
expected one-year rate next year—E (2r1)—to be 8 percent, and the expected one-year
rate the following year— E (3r1)—to be 10 percent. If the unbiased expectations theory of
the term structure of interest rates holds, what is the one-year Treasury security rate?

12. The Wall Street Journal reports that the rate on four-year Treasury securities is 5.60
percent and the rate on five-year Treasury securities is 6.15 percent. According to the
unbiased expectations hypotheses, what does the market expect the one-year Treasury
rate to be four years from today, E (5r1)?

13. Suppose we observe the following rates: 1R1 = 0.10, 1R2 = 0.14, and E (2r1 ) 0.18. If the
liquidity premium theory of the term structure of interest rates holds, what is the liquidity
premium for year 2?

14. Assume the current interest rate on a one-year Treasury bond (1R1) is 4.50 percent, the
current rate on a two-year Treasury bond ( 1R2) is 6.50 percent. If the unbiased
expectations theory of the term structure of interest rates is correct, what is the one-year
interest rate expected on Treasury bills during year 3 (E(3r1) or 3f1)? (LG 2-8)