Introduction To Finance Markets Investments and Financial Management 16th Edition Melicher Solutions Manual

Introduction to Finance Markets
Investments and Financial Management

16th Edition Melicher Solutions Manual
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Chapter Eight | Interest Rates
Chapter 8
Interest Rates
CHAPTER PREVIEW
Lenders charge an “interest rate” on money they “loan” to individuals and businesses. Borrowers
pay an “interest rate” on money “lent” to them for a specified time period. Interest rates are
determined by the supply and demand for loanable funds that exist at a point in time. We describe
the determinants of market or nominal interest rates which include an inflation premium, a default
risk premium, a maturity risk premium, and a lack of liquidity premium. We follow with a
description of the characteristics of U.S. Treasury debt obligations which are considered by most
individuals to be free of default risk. Our attention then turns to coverage of the term or maturity
structure of interest rates and why interest rates generally increase as maturities or lives of debt
instruments lengthen. This is followed by a discussion of past inflation premiums and price
movements. Our last topic in the chapter addresses default risk premiums or the “quality” of
bonds issued by the government and by corporations.
To develop student interest, you may have students prepare a table showing changes in the
term structure of interest rates and default risk premiums over the last several years. Such data can
be found on the FRED database on the Federal Reserve Bank of St. Louis website at
http://www.stlouisfed.org. Discussion time can profitably be devoted to possible reasons for any
changes in each of the series and their interrelationships. Students also may be assigned a report in
which they use the consumer price index to update Figure 8.3. Class discussion can be generated
by asking students to write reports that examine past periods of high inflation.
LEARNING OBJECTIVES
LO 8.1 Describe how interest rates change in response to shifts in the supply and demand for
loanable funds.
LO 8.2 Identify the major components of market interest rates.
LO 8.3 Describe the types of U.S. Treasury marketable securities and indicate who owns them.
LO 8.4 Define the term structure of interest rates and describe the three theories used to explain
the term structure.
LO 8.5 Discuss historical and recent price movements in the United States and describe the
various types of inflation.
LO 8.6 Describe default risk and default risk premiums and discuss how these premiums are
observed and measured.
CHAPTER OUTLINE
I. (8.1) SUPPLY AND DEMAND FOR LOANABLE FUNDS

A. Historical Changes in U.S. Interest Rate Levels
B. Loanable Funds Theory
1. Sources of Loanable Funds
©2017 John Wiley and Sons, Inc. Melicher, Introduction to Finance, 16/e. For Instructor Use Only.
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2. Factors Affecting the Supply of and Demand for Loanable Funds

a. Volume of Savings
b. Expansion of Deposits by Depository Institutions
c. Liquidity Attitudes
3. Effect of Interest Rates on the Quantity of Loanable Funds Being Demanded
4. Actions of the Banking System, the Fed, and the Government
5. International Factors Affecting Interest Rates
II. (8.2) COMPONENTS OF MARKET INTEREST RATES
III. (8.3) DEFAULT RISK-FREE SECURITIES: U.S. TREASURY DEBT INSTRUMENTS

A. Marketable Securities
1. Treasury Bills
2. Treasury Notes
3. Treasury Bonds
B. Dealer System
C. Tax Status of Federal Obligations
D. Ownership of Public Debt Securities
E. Maturity Distribution of Marketable Debt Securities
IV. (8.4) TERM OR MATURITY STRUCTURE OF INTEREST RATES

A. Relationship between Yield Curves and the Economy
B. Term Structure Theories
V. (8.5) INFLATION PREMIUMS AND PRICE MOVEMENTS

A. Historical International Price Movements
1. Ancient Rome
2. The Middle Ages Through Modern Times
B. Inflation in the United States
1. Revolutionary War
2. War of 1812
3. Civil War
4. World War I
5. World War II and the Postwar Period
6. Recent Decades
C. Types of Inflation
1. Price Changes Initiated by a Change in Costs
2. Price Changes Initiated by a Change in the Money Supply
3. Speculation and Administrative Inflation
VI. (8.6) DEFAULT RISK PREMIUMS
VII. SUMMARY
LECTURE NOTES
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I. (8.1) SUPPLY AND DEMAND FOR LOANABLE FUNDS

Loanable funds are the amount of money made available by lenders to borrowers. The
supply and demand for loanable funds will take place as long as both lenders and borrowers
have the expectation of satisfactory returns.
The interest rate is the price of loanable funds in financial markets. The price that
equates the demand for and supply of loanable funds in the financial markets is the
equilibrium interest rate. Figure 8.1 can be used to graphically show how interest rates
are determined in the financial markets. Interest rates may move from an equilibrium level
if an unanticipated change or shock (e.g., higher rate of inflation) occurs that will cause the
demand for, or supply of, loanable funds to change.
The loanable funds theory (referred to as a flow theory) holds that interest rates are a
function of the supply of and demand for loanable funds. Factors affecting the supply of
loanable funds include: volume of savings, expansion of credit by depository institutions,
and liquidity attitudes. Since the Civil War, there have been four periods of rising or
relatively high long-term interest rates and four periods of low or falling interest rates on
long-term loans and investments.
(Use Figure 8.1 and Review Questions 1 through 7 here.)
II. (8.2) COMPONENTS OF MARKET INTEREST RATES

In addition to supply and demand relationships, interest rates (r) are determined by: the real
rate of interest (RR); an inflation premium (IP); a default risk premium (DRP); a maturity
risk premium (MRP); and a liquidity premium (LP). In equation form, we have:
r = RR + IP + DRP + MRP + LP.
The real rate of interest is the interest rate on a risk-free financial debt instrument. The
inflation premium is the average inflation rate expected over the life of the debt instrument.
The default risk premium indicates compensation for the possibility that the borrower will
not pay interest and/or repay principal according to the financial instrument’s contractual
arrangements. The maturity risk premium is the added return expected by lenders or investors
because of interest rate risk (possibility of fluctuations in market values due to market interest
rate changes) on instruments with longer maturities. The liquidity premium is compensation
for those financial debt instruments that cannot be easily converted to cash at prices close to
their estimated fair market values.
(Use Review Question 8 here.)
III. (8.3) DEFAULT RISK-FREE SECURITIES: U.S. TREASURY DEBT INSTRUMENTS

The obligations of the federal government are so vast that they now dominate both short-
term and long-term capital markets. They play an important role in the investment patterns
of most financial institutions. While interest received from federal obligations is subject to
federal taxes, it is not taxable by state and municipal authorities. Because federal
obligations are the highest quality available, all other obligations must provide yields
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scaled above those of the government. Only the yields on municipal obligations are lower
due to their interest exemption from federal taxes rather than their quality. Students may
look up these yield spreads in The Wall Street Journal, in other financial publications, or
by accessing various Federal Reserve Bank Web sites.
The obligations of the federal government are broadly classed as marketable and
nonmarketable. Marketable obligations such as Treasury bills (maturities up to one year),
Treasury notes (maturities from two to 10 years), and Treasury bonds (maturities from 11
to 30 years, with the focus on 30-year maturities today) constitute the bulk of total
obligations. Treasury auctions are held for bills, notes, and bonds, as well as for the sale of
treasury inflation-protected securities and floating rat notes. Nonmarketable obligations
are represented primarily by U.S. savings bonds. The Treasury’s website can be used to
determine the relative magnitude of the various types of obligations.
Outstanding issues of federal obligations are traded actively in the nation’s secondary
bond markets. A select group of dealers, made up of both large commercial banks and
nonbank institutions, dominate this secondary market. The dealers buy and sell securities
for their own account, arrange transactions with both their customers and other dealers, and
also purchase debt directly from the Treasury for resale to investors.
(Use Review Questions 9 through 12 here.)
The very magnitude of the federal debt means that obligations representing that debt
play a role in most investment portfolios. Ownership by individual groups is shown in
Table 8.1. The Fed and government accounts held 41.3% of the U.S. Treasury securities
that were outstanding in September, 2015 (down from 52.1% in September, 2006). Thus,
private investors increased their holdings of Treasury securities from 47.9% in September,
2006 to 58.7% in September, 2015. Foreign and international investors held 33.6% of U.S.
Treasury securities that were outstanding in September, 2015 compared with holdings of
25.1% in September, 2006. Of concern is the increasing dependence on foreign purchases
and holdings of Treasury securities. The public debt increased from $8.5 trillion in
September, 2006 to $18.2 trillion in September, 2015.
(Use Table 8.1 and Review Question 13 here.)
Table 8.2 provides a picture of the maturity distribution of the marketable interest-
bearing public debt held by private investors. Short-term obligations (less than a 1 year
maturity) accounted for 28.1% of the outstanding marketable interest-bearing public debt in
September, 2015, while the 1-5 years maturity class accounted for 42.0%. The average
maturity of marketable issues was 5 years and 1 month in September, 2015. In September,
2008, the average maturity was only 3 years and 10 months. From the end of World War
II, the average maturity of the debt declined dramatically until it reached a low of 2 years
and 5 months in 1975. The average maturity then increased and was an even 6 years in
1989.
(Use Table 8.2 and Review Questions 14 and 15 here.)
IV. (8.4) TERM OR MATURITY STRUCTURE OF INTEREST RATES
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The term structure of interest rates refers to the impact of debt maturities on interest rates.
The term structure is shown graphically in terms of yield curves, which are constructed by
graphing yields on debt securities with comparable default risk against their maturities as
of a specific point in time.
Three theories are used to explain the term structure of interest rates: expectations
theory, liquidity premium theory, and market segmentation theory. The expectations theory
reflects investor expectations about future short-term and long-term inflation rates. If
inflation rates are expected to be the same across all maturities, then the yield over time on
short-term securities is expected to be the same as the current rate on long-term securities.
Under the liquidity premium theory, investors are willing to trade off some yield for the
greater liquidity that is inherent in short-term securities. Thus, the yield curve is expected
to be upward sloping.
The market segmentation theory contends that securities with different maturities are
less than perfect substitutes for each other. Thus, the yield curve is influenced by
institutional pressures.
(Use Figure 8.2, Table 8.3, and Review Questions 16 and 17 here.)
V. (8.5) INFLATION PREMIUMS AND PRICE MOVEMENTS

Wide swings in prices are not a recent phenomenon. Earliest records refer to them, giving
testimony to the importance attached to the subject throughout the ages.
The ancient Roman Period is often cited because of the availability of historical records
of the events that led to wide price swings. The large quantities of gold and other precious
metals brought to Rome as a result of conquests in Egypt gave rise to increasing prices and
interest rates. The use of precious metals as money meant an increase in the money supply
relative to the supply of goods and services—hence, there was inflation. Nero’s
debasements of gold and silver coins were numerous and, as history reveals, irreversible.
During the Middle Ages, debasement of coinage was frequently used as a source of
revenue for princes and kings, particularly in France. Records indicate that debasement
often provided greater revenues for French rulers than any other source.
Spain brought back huge supplies of gold and silver from Mexico and Peru and, as in
Rome, prices increased as the circulating money supply (precious metals) increased. With
its huge stores of precious metals, Spain was able to purchase goods from other countries
that had not been equally affected by price increases. This led to a decline in Spain’s
domestic productivity. Once its precious metals were spent, Spain was left with an
economy ill prepared to compete against other countries that had benefited from
productivity increases.
Inflation was somewhat restrained during World War I, but shortly thereafter (in 1923)
Germany experienced one of the wildest periods of inflation in history. Inflation was again
somewhat restrained during World War II except in certain countries—for example, China
and Hungary, where runaway inflation occurred.
(Use Review Questions 18 and 19 here.)
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Although peacetime swings in price levels are common, the principal movements are
those during or after wars. The Revolutionary War, which brought this nation into existence,
was financed by inflation. Without authority to levy taxes, the Second Continental Congress
issued notes in ever increasing amounts until they were virtually worthless. The phrase “not
worth a continental” became a part of the American language.
The War of 1812 was financed by issuing bonds of small denomination bearing no
interest and having no maturity date. Prices went up and a depression followed. The Civil
War was financed, in part, through the issuance of paper money called “greenbacks.”
Inflation resulted and post-war attempts to retire the greenbacks resulted in depression.
Greenbacks continue to circulate to this day, but they are mainly collectors’ items.
About two-thirds of the total cost of World War I was financed by heavy borrowing,
much of it from the banking system. Prices rose and then dropped following the war.
During World War II, attempts were made to avoid inflationary finance through price
control mechanisms. Nevertheless, huge sums were borrowed from the banking system and
from the sale of savings bonds to individuals. When the controls were lifted after the war,
inflation resulted.
Prices rose during the Korean War; they rose again during the 1955–1957 period of
expansion in economic activity following the 1954 recession. During the buildup of the
Vietnam War, prices increased somewhat, but following that conflict they rose at the
highest rate since World War I. While inflation in the U.S. during the mid-1970s was
intense as a result of the oil crisis in the Middle East, inflationary pressures were even
greater in many other industrial countries.
As the 1970s ended, the general public became cynical about prospects for controlling
inflation—they simply built inflation into their expectations. One result was extremely high
nominal interest rates as investors attempted to protect fixed income investments from
declining purchasing power. Monetary restraint was exercised in 1980, which quickly led
to a depressing effect on the economy. This restraint was then abandoned and monetary
stimulus drove interest rates to new peaks. The Reagan administration reversed the
monetary stimulus and a decline in the economy quickly followed. By the end of 1982,
economic recovery was back in place and the back of inflation had been broken.
Throughout the first decade of the twenty first century, inflation remained at historically
low levels. Low inflation levels have continued through 2015. See Figure 8.3.
(Use Figure 8.3 and Review Questions 20 and 21 here.)
The price level can, at times, increase without changes in the money supply or velocity,
if costs increase faster than productivity. These costs will eventually be passed on to
consumers in the form of higher prices. This type of inflation is referred to as cost-push
inflation. This distinguishes it from inflation due to an increase in the money supply, which
is called demand-pull inflation. In practice, both aspects of inflation are likely to be
operative at the same time. Inflation may also be initiated by especially large changes in
demand in certain industries.
Inflation caused by increased money supply can lead to additional price pressure,
referred to as speculative inflation. When prices have risen for some time, it is generally
accepted that they will keep on rising. This may prove self-fulfilling for a time. Instead of
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higher prices resulting in decreased demand, people may buy more to stock up on goods
before they get even more expensive. This happened in the late 1970s.
Relatively high levels of inflation persisted during the decades of the 1950, 1960s, and
1970s giving rise to belief in a long-run inflationary bias (called administrative inflation) in
the economy. Prices and wages tend to rise during periods of rapid economic expansion.
Wage contracts that have escalator clauses to keep wages in line with prices are very
effective, but at times these contracts result in wage increases greater than productivity
increases. Further, the wage increases are fixed and do not decline during subsequent
economic contractions. In effect, there is a sort of ratchet effect—a level of costs remaining
high prevents prices from declining. The U.S. government typically takes action to relieve
unemployment problems long before the ultimate effect of a prolonged recession can take
effect. Large corporations tend to rely on nonprice competition rather than cut prices.
These and other factors provide the basis for a long-run inflationary bias. However, as
Figure 8.3 shows, inflation levels peaked at the beginning of the 1980s and has continued
at low levels (2% to 3%) in recent years.
(Use Review Questions 22, 23, and 24 here.)
VI. (8.6) DEFAULT RISK PREMIUMS

We focus on the capital markets when discussing long-run inflation expectations and
interest rate differentials between securities. The risk-free rate (as represented by the rate
on long-term Treasury securities) is comprised of a real return component and a long-run
inflation expectations component. Default risk is the probability that the issuer of a security
will fail to make interest or principal payments. The difference between the risk-free rate
and the interest rate on a risky corporate bond is referred to as the default risk premium.
Default risk premiums indicate the degree of investor pessimism or optimism about
economic expectations as of a point in time. Investors require relatively higher premiums to
compensate for default risk when the economy is in a recession or is expected to enter one.
This is because more firms fail or suffer financial distress during periods of recession
compared with periods of economic expansion. Students might be asked to update the
default risk premiums information contained in Table 8.4 in order to facilitate discussion
and enhance their understanding,
(Use Table 8.4 and Review Questions 25 and 26 here.)
REVIEW QUESTIONS AND ANSWERS
1. (LO 8.1) What is the “interest rate,” and how is it determined?

The interest rate is the price of loanable funds in financial markets. The price that equates
the demand for and supply of loanable funds in the financial markets is the equilibrium
interest rate.
Stated differently, the term interest rate is the price that equates the demand for and
supply of loanable funds. An equilibrium interest rate is established when the demand by
borrowers for funds equals the supply of funds by lenders.
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2. (LO 8.1) Describe how interest rates may adjust to an unanticipated increase in inflation.
Interest rates may move from an equilibrium level if an unanticipated change or “shock”
occurs that will cause the demand for, or supply of, loanable funds to change. Graph C in
Figure 8.1 can be used to illustrate the impact of an unanticipated increase in inflation.
Lenders (suppliers) immediately require a higher rate of interest. This is shown by an upward
shift in the supply curve for a given level of demand for loanable funds. This shift causes the
interest rate (r) to increase or rise.
3. (LO 8.1) Identify major periods of rising interest rates in U.S. history, and describe some of
the underlying reasons for these interest rate movements.
The first period of rising interest rates was from 1864 to 1873 and was based on the rapid
economic expansion during the period following the Civil War. The second period, from
1905 to 1920, was based on large-scale prewar expansion and after 1914 on the inflation
associated with World War I. The third period, from 1927 to 1933, was due to the boom from
1927 to 1929 and the unsettled conditions in the securities markets during the early years of
the depression, from 1929 to 1933. The fourth period, from 1946 to 1982, was based on the
rapid expansion in the period following the end of World War II; the Vietnam War; and in
the 1970s to dislocations associated with various wage and price controls, costs associated
with increased ecological concerns, and rapidly rising energy costs. Rates have been in a
general downward trend since early 1982.
4. How did the Fed contribute to the recent historically low interest rates?
To avoid a financial meltdown during the 2007-08 financial crisis and the 2008-09 great
recession, the Fed engaged in a nontraditional monetary policy action called quantitative
easing (QE) three times (2008, 2010, and 2012). These QE actions involved the Fed
purchasing of U.S. Treasury and mortgage-backed debt securities from banks and other
financial institutions resulting in increased liquidity in the financial system.
5. How does the loanable funds theory explain the level of interest rates?
The loanable funds theory holds that interest rates are a function of the supply of and
demand for loanable funds. This is a flow theory, in that it focuses on the relative supply and
demand of loanable funds during a specified period. If the supply of funds increases, holding
demand constant, interest rates will tend to fall. Likewise, an increase in the demand for
loans will tend to drive up interest rates. Figure 8.1 contains graphical relationships involving
the impact of changes in supply and demand from an equilibrium level.
6. What are the main sources of loanable funds? Indicate and briefly discuss the factors that
affect the supply of loanable funds.
The two basic sources are current savings and the creation of new funds through the
expansion of credit by depository institutions. The major determinant in the long run of the
volume of savings, corporate as well as individual, is the level of national income. Also
important is the pattern of income taxes, life cycle stages, and factors that affect indirect
savings in the form of life insurance and pension plans. In addition, interest rate changes
have a lag effect on savings associated with the use of consumer credit.
The availability of short-term credit depends upon commercial bank and other depository
institution lending policies and upon Federal Reserve policies that affect them. The
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availability of long-term credit of different types depends upon the policies of the many
different suppliers of credit.
Liquidity attitudes are also important. Liquidity attitudes are a significant factor, at times,
in determining the available supply of loanable funds, both long-term and short-term, relies
on the attitude of lenders regarding the future. For example, it is possible that liquidity
attitudes may result in the holding of some funds idle that would normally be available for
lending because of uncertainty about the outlook for the economy.
7. Indicate the sources of demand for loanable funds, and discuss the factors that affect the
demand for loanable funds.
The demand for loanable funds comes from all sectors of the economy. Businesses borrow to
finance current operations and to buy plants and equipment. Farmers borrow to meet short-
term and long-term needs. Institutions such as hospitals and schools borrow primarily to
finance new buildings and equipment. Individuals borrow on a long-term basis to finance the
purchase of homes, and on an intermediate- and short-term basis to purchase durable goods
or to tide them over through emergencies. Governmental units borrow to finance public
buildings, to bridge the gap between expenditures and tax receipts, and to meet budget
deficits.
The effect of interest rates on the demand for various types of credit is summarized in the
chapter.
8. What are the factors, in addition to supply-and-demand relationships, that determine market
interest rates?
The market interest rate is the interest rate observed in the marketplace for a debt
instrument. A market, or nominal, interest rate contains at least two components—a real rate
of interest and an inflation premium. The real rate of interest is the interest rate on a risk-
free financial debt instrument when no inflation is expected. It is generally believed that
investors must expect a minimum level of return in order to get them to invest in debt
instruments instead of holding cash. The inflation premium is the additional expected return
to compensate for anticipated inflation over the life of a debt instrument.
Interest rates (r) are determined by the real rate of interest (RR), an inflation premium (IP), a
default risk premium (DRP), a maturity risk premium (MRP), and a liquidity premium (LP)
in addition to supply and demand relationships. The real rate of interest is the interest rate on
a risk-free debt instrument. The default risk premium indicates compensation for the
possibility that the borrower will not pay interest and/or repay principal according to the
contractual arrangements. The maturity risk premium is the added return expected by lenders
or investors because of the possibility of fluctuations in debt values due to market interest
rate changes (i.e., interest rate risk) on instruments with longer maturities. The liquidity
premium is compensation for those financial debt instruments that cannot be easily converted
to cash at “fair” market prices.
9. What are the types of marketable securities issued by the Treasury?
Marketable government securities, as the term implies, are those that may be purchased and
sold through customary market channels. Treasury auctions are held for the initial offering of
bills, notes, and bonds, as well as for the sale of treasury inflation-protected securities and
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floating rate notes. Treasury bills bear the shortest maturities of federal obligations. They are
typically issued for 91 days but also are issued with a maturity of up to one year. Treasury
bills are issued on a discount basis and mature at par. Treasury notes, referred to as
intermediate-term federal debt securities, are issued at specific interest rates with maturities
of two to 10 years. Treasury bonds have an original maturity of 11 to 30 years, with the
current emphasis being on issuing 30-year maturities. These bonds bear interest at stated
rates.
10. Explain the mechanics of issuing Treasury bills, indicating how the price of a new issue is
determined.
Treasury bills are issued on a discount basis and mature at par. Each week the Treasury bills
to be sold are awarded to the dealers and other investors who submit the highest bids. When
the sealed bids are opened, they are arrayed from highest to lowest; that is, those bidders
asking the least discount (offering the highest price) are placed high in the array. The bids are
then accepted in the order of their position in the array until all bills are awarded. Bidders
seeking a high discount (and offering a low price) may fail to receive any bills that particular
week. Investors interested in purchasing small volumes of Treasury bills ($10,000 to
$500,000) may submit their orders on an “average competitive price” basis. The Treasury
deducts these small orders from the total volume of bills to be sold. After the bills are allotted
on the competitive basis described above, the smaller orders are then executed at a discount
equal to the average of the competitive bids accepted for the large orders.
11. Describe the dealer system for marketable U.S. government securities.
The dealer system for marketable U.S. government securities is comprised of a small group
of dealers in government securities with an effective marketing network throughout the
United States. Commercial bank and nonbank dealers buy and sell securities for their own
account and arrange transactions with both their customers and other dealers. New dealers are
added to this select group only when they can demonstrate satisfactory responsibility and
volume of activity. These large-volume dealers are designated by, and report their activity
daily to, the Federal Reserve Bank of New York.
12. What is the tax status of income from federal securities?

The interest on all federal obligations is now subject to ordinary federal income taxes and tax
rates. Income from the obligations of the federal government is exempt from all taxing
authority of state and local governments. Federal bonds, however, are subject to both federal
and state inheritance, estate, or gift taxes.
13. Describe any significant changes in the ownership pattern of federal debt securities in recent
years.
The government made a special effort following World War II to increase the nonbank
ownership of the federal debt, with emphasis on an increase in individual ownership. In
addition to increased individual ownership, nonbank corporations, state and local
governments, and foreign investors have dramatically increased their ownership of the debt.
Ownership of the federal debt is shown in the Economic Report of the President and can
be obtained from the Department of the Treasury at http://www.treasurydirect.gov. The
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ownership of U.S. Treasury securities, by group or category, is shown in Table 8.1 in the
chapter. Private investors, who owned approximately 48 percent of the total outstanding
Treasury securities in 2006, increased their ownership to over 57 percent by 2011 and to
nearly 59 percent by 2015. The percentage of Treasury securities held by U.S. government
accounts (agencies and trust funds) and Federal Reserve Banks dropped from about 52
percent in 2006 down to about 41 percent in 2015. Foreign and international investors
increased their holdings of total public debt from about 25 percent in 2006, to 28 percent in
2008, about 32 percent in 2011, and nearly 34 percent in 2015. This shows the continuing
importance of foreign and international investors in financing the U.S. national debt.
14. What have been the recent developments in the maturity distributions of marketable interest-
bearing federal debt?
The average length of the marketable debt reached a low level of two years and five months
in late 1975. Since that time, progress has been made in raising the average length of
maturities to about five years by selling longer-term securities. Table 8.2 shows the average
maturity for several dates beginning in 2006 when it was four years and nine months. The
average maturity fell to three years and 10 months in 2008 before increasing to an even five
years in 2011 and five years and one month in 2015.
15. Describe the process of advance refunding of the federal debt.

One of the new debt management techniques used to extend the average maturity of the
marketable debt without disturbing the financial markets is advance refunding. This occurs
when the Treasury offers owners of a given issue the opportunity to exchange their holdings
well in advance of the holdings’ regular maturity for new securities of longer maturity.
16. What is the term structure of interest rates and how is it expressed?
The term structure of interest rates indicates the relationship between interest rates or
yields and the maturity of comparable quality debt instruments. This relationship is typically
depicted through the graphic presentation of a yield curve. A properly constructed yield
curve must first reflect securities of similar default risk. Second, the yield curve must
represent a particular point in time, and the interest rates should reflect yields for the
remaining time to maturity. (The process for calculating yields to maturity is shown in
Chapter 9.) Third, the yield curve must show yields on a number of securities with differing
lengths of time to maturity.
17. Identify and describe the three basic theories used to explain the term structure of interest
rates.
Three theories are commonly used to explain the term structure of interest rates.
The expectations theory contends that the shape of a yield curve reflects investor
expectations about future inflation rates. If the yield curve is flat, expectations are that the
current short-term inflation rate will remain essentially unchanged over time. When the yield
curve is downward sloping, investors expect inflation rates to be lower in the future.
The liquidity preference theory holds that investors or debt instrument holders prefer to
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invest short term so that they have greater liquidity and less maturity or interest rate risk.
Lenders also prefer to lend short term because of the risk of higher inflation rates and greater
uncertainty about default risk in the future. Borrowers prefer to borrow long term so that they
have more time to repay loans. The net result is a willingness to accept lower interest rates on
short-term loans as a trade-off for greater liquidity and lower interest rate risk.
The market segmentation theory holds that securities of different maturities are not
perfect substitutes for one another. For example, commercial banks concentrate on holding
short-term government securities in an effort to match the short-term maturities of their
demand and other deposit liabilities. On the other hand, the nature of insurance company and
pension fund liabilities allows these firms to concentrate holdings in long-term securities.
Thus, supply-and-demand factors in each market segment affect the shape of the yield curve.
18. Describe the process by which inflation took place before modern times.
Inflation took place, at times, because the money supply increased when gold or silver hoards
were seized during a war or foreign lands were colonized. The most frequent form of
inflation was the debasement of coins.
19. Discuss the early periods of inflation based on the issue of paper money.
The first outstanding example of this type of inflation was in France, where John Law was
given a charter in 1719 for a bank that could issue paper money. Paper money was also
issued in excessive quantities during the American Revolutionary War and the French
Revolution.
20. What was the basis for inflation during World Wars I and II?
Inflation during World War I was widespread because the money supply was increased to
finance the war, but it was held in check to some degree by government action. The most
spectacular inflation took place in Germany after the war when in 1923 prices soared to
astronomical heights. The money supply was increased to some extent to finance World War
II, but attempts to control inflation met with some success. Runaway inflation occurred,
however, especially in China and Hungary.
21. Discuss the causes of the major periods of inflation in American history.
Revolutionary War: issuance of excessive supplies of paper money and lack of confidence in
the financial stability of the government
War of 1812: issuance of paper currency
Civil War: issuance of paper currency
World Wars I and II: sale of bonds to the banking system
Post-World War II period: increase in the cost of production due to increases in the amounts
paid to the factors of production, which were greater than increases in productivity; also,
increased bank credit
Vietnam War and postwar period: rapid increase in government expenditures financed in
part by deficits; devaluation of the dollar, first by 12 percent and then by 10 percent; poor
crops in many parts of the world and drought in the Midwest in 1974; Arab oil embargo and
increases in the price of crude oil by oil exporting countries
22. Explain the process by which price changes may be initiated by a general change in costs.
8-12
Cost-push inflation occurs when prices are raised to cover rising production costs, such as
wages. The price level can sometimes increase without the original impulse coming from
either the money supply or its velocity. If costs rise faster than productivity increases, as
when wages go up, businesses with some control over prices will try to raise them to cover
the higher costs. Such increases are likely to be effective when the demand for goods is
strong compared to the supply. The need for more funds to meet production and distribution
at higher prices usually causes the money supply and velocity to increase.
23. How can a change in the money supply lead to a change in the price level?
Demand-pull inflation occurs when an excessive demand for goods and services is created
during periods of economic expansion as a result of large increases in the money supply.
Demand-pull inflation traditionally exists during periods of economic expansion when the
demand for goods and services exceeds the available supply of such goods and services.
An increase in the money supply occurs when the Fed purchases government securities
through its open-market operations. If this happens when people and resources are not fully
employed, the volume of trade goes up; prices are only slightly affected at first. As unused
resources are brought into use, however, prices will go up. When resources, such as metals,
become scarce, their prices rise. As any resource begins to be used up, the expectation of
future price rises will itself force prices up, because attempts to buy before such price rises
will increase demand above current needs.
Once resources are fully employed, the full effect of the increased money supply will be
felt on prices. Prices may rise out of proportion for a time as expectations of higher prices
lead to faster spending and so raise the velocity of money. The expansion will continue until
trade and prices are in balance at the new levels of the money supply.
24. What is meant by the speculative type of inflation?
Speculative inflation is caused by the expectation that prices will continue to rise,
resulting in increased buying to avoid even higher future prices. Since prices have risen for
some time, people believe that they will keep on rising. Inflation becomes self-generating for
a time because, instead of higher prices resulting in lower demand, people may buy more to
get goods before their prices go still higher, as happened in the late 1970s. This effect may be
confined to certain areas, as it was to land prices in the 1920s Florida land boom, or to
security prices in the 1928–1929 stock market boom. Such a price rise leads to an increase in
velocity as speculators try to turn over their funds as rapidly as possible, and many others try
to buy ahead of needs before there are further price rises.
25. What is meant by default risk and a default risk premium?

Default risk is the risk that a borrower will not pay interest and/or repay the principal on a
loan or other debt instrument according to the agreed contractual terms. It can be measured
as the difference in interest rates between a long-term Treasury bond and a specified long-
term corporate bond.
The default risk premium is an added market interest rate component that provides higher
expected compensation for taking on default risk. The premium for default risk will increase
as the probability of default increases. Thus, at a point in time, default risk premiums will be
8-13
higher for high yield or junk bonds relative to investment grade bonds.
26. How can a default risk premium change over time?
Default risk premiums change with changes in investor pessimism or optimism about
economic expectations. Since more firms fail or suffer financial distress during recessions,
default risk premiums increase as the expectation of a recession increases. As the economy
recovers, default risk premiums usually become smaller since the likelihood that firms will
suffer financial distress diminishes.
EXERCISES AND ANSWERS
1. Go to the Federal Reserve Web site at http://www.federalreserve.gov, and find interest rates
on U.S. Treasury securities and on corporate bonds with different bond ratings.
a. Prepare a yield curve or term structure of interest rates.
Note: the instructor will need to update the information provided in Table 8.3 and
Figure 8.2.
b. Identify existing default risk premiums between long-term Treasury bonds and corporate
bonds.
Note: the instructor will need to update the information in Table 8.4.
2. As an economist for a major bank you are asked to explain the present substantial increase
in the price level, notwithstanding the fact that neither the money supply nor the velocity of
money has increased. How can this occur?
Inflation may be associated with a change in costs, a change in the money supply,
speculation, and administrative pressures. Actually, inflation has been at relatively low levels
in the U.S. in recent years. Inflation can be associated with an increase in the money supply
or the velocity of money (which are ruled-out here). Inflation could be due to cost-push or
demand-pull cost changes, speculation, or administrative pressures. Costs have not been
rising very rapidly in recent years and little speculation has been taking place. Some
administrative inflation may take place. Administrative inflation is the tendency of prices,
aided by union-corporation contracts, to rise during economic expansion and to resist
declines during recessions.
3. As an advisor to the United States Treasury you have been asked to comment on a proposal
for easing the burden of interest on the national debt. This proposal calls for the elimination
of federal taxes on interest received from Treasury debt obligations. Comment on the
proposal.
Municipal (state and local) debt has interest rates that are lower than the interest rates on
Treasury debt because the interest on municipal debt is exempt from federal taxes. The first
most likely reaction to eliminating federal taxes on interest received from Treasury debt is
that the Federal government would sell debt at lower interest rates which would reflect this
8-14
tax change. However, tax receipts to the government would also decline causing the budget
deficit to increase. This, in turn, would cause the Treasury to issue larger amounts of debt
securities. The result might be no discernible impact on the size of the national debt.
4. As one of several advisors to the secretary of the U.S. Treasury, you have been asked to
submit a memo in connection with the average maturity of the securities of the federal
government. The basic premise is that the average maturity is far too short. As a result,
issues of debt are coming due with great frequency and needing constant reissue. On the
other hand, the economy is presently showing signs of weakness. It is considered unwise to
issue long-term obligations and absorb investment funds that might otherwise be invested in
employment-producing construction and other private sector support. Based on these
conditions, what do you recommend as a course of action to the secretary of the U.S.
Treasury?
The lengthening of the maturity structure of the national debt has been a long-standing
problem for the Treasury. A limited number of options are available. Since the condition in
this problem is that the economy is showing signs of weakness, it would be almost
impossible to lengthen the average maturity significantly at this time. The best possible
approach would be to schedule the sale of obligations with a spread of maturities—that is,
some short, some intermediate, and a small amount of long-term maturities. When the
economy shows renewed strength, the volume of obligations sold on a long-term basis can be
increased. Further, advance refunding of outstanding issues can be utilized at such a time.
5. Assume a condition in which the economy is strong, with relatively high employment. For
one reason or another, the money supply is increasing at a high rate, with little evidence of
money creation slowing down. Assuming the money supply continues to increase, describe
the evolving effect on price levels.
Although the parallel between the money supply growth rate and prices seems to no longer
exist, it is generally acknowledged that there is some relationship. It is assumed that if the
money supply increases faster than the supply of goods, prices must rise in response to the
supply/demand situation. When the money supply increases, we are inclined to spend more
as our cash balances exceed our desired levels. In due time, the increase in spending is
reflected in increasing prices as production levels reach their limits.
6. Assume you are employed as an investment advisor. You are working with a retired
individual who depends on her income from her investments to meet her day-to-day
expenditures. She would like to find a way of increasing the current income from her
investments. A new high yield or junk bond issue has come to your attention. If you sell these
high-yield bonds to a client, you will earn a higher than average fee. You wonder whether
this would be a win-win investment for your retired client, who is seeking higher current
income, and for you, who would benefit in terms of increased fees. What would you do?
High yield or junk bonds are considered to be high risk with potential loss of interest and/or
principal. Preservation of financial capital usually is of primary emphasis to retired
individuals with income usually being secondary. It would be unethical (and possibly
illegal) not to explain the risk associated with investing in junk bonds to the retired
individual. While there is an opportunity for a higher return, there is also substantial risk in
8-15
the form of possible loss of interest and the possibility that the bond principal may not be
repaid at maturity.
PROBLEMS AND ANSWERS
1. Assume investors expect a 2.0 percent real rate of return over the next year. If inflation is
expected to be 0.5 percent, what is the expected nominal interest rate for a one-year U.S.
Treasury security?
r = RR + IP = 2.0% + 0.5% = 2.5%
2. A one-year U.S. Treasury security has a market interest rate of 2.25 percent. If the expected
real rate of interest is 1.50 percent, what is the expected annual inflation rate?
r = RR + IP
IP = r – RR = 2.25% - 1.50% = 0.75%
3. A 20-year U.S. Treasury bond has a 3.50 percent interest rate, while a same maturity
corporate bond has a 5.25 percent interest rate. Real interest rates and inflation rate
expectations would be the same for the two bonds. If a default risk premium of 1.50
percentage points is estimated for the corporate bond, determine the liquidity premium for the
corporate bond.
r = RR + IP + DRP + MRP + LP,

Where the DRP exists for a corporate bond.
RR and IP are the same for both bonds. There is no MRP because both bonds have equal 20-
year maturities.
Thus, LP = r corporate bond – r treasury bond – DRP = 5.25% - 3.50% - 1.50% = 0.25%
4. A 30-year U.S. Treasury bond has a 4.0 percent interest rate. In contrast, a ten-year Treasury
note has an interest rate of 3.7 percent. If inflation is expected to average 1.5 percentage
points over both the next ten years and thirty years, determine the maturity risk premium for
the thirty-year bond over the ten-year note.
r = RR + IP + DRP + MRP + LP
RR and IP are the same for both the bond and the note there is no DRP or LP.
Thus, MRP = r 30-year Treasury – IP) – (r 10-year Treasury – IP) = (4.0% - 1.5%) – (3.7% -
1.5%) = 2.5% - 2.2% = 0.3%
Or, MRP = r 30-year Treasury – r10-year Treasury = 4.0% - 3.7% = 0.3%
5. A thirty-year U.S. Treasury bond has a 4.0 percent interest rate. In contrast, a ten-year
Treasury note has an interest rate of 2.5 percent. A maturity risk premium is estimated to be
0.2 percentage points for the longer maturity bond. Investors expect inflation to average 1.5
percentage points over the next ten years.
8-16
a. Estimate the expected real rate of return on the ten-year U.S. Treasury note.
r = RR + IP + MRP
RR = r – IP – MRP
RR 10-year Treasury = 2.5% -1.5% - 0.0% = 1.0%
b. If the real rate of return is expected to be the same for the thirty-year bond as for the ten-
year note, estimate the average annual inflation rate expected by investors over the life of
the thirty-year bond.
r = RR + IP + MRP
If RR was 1.0% from Part (a) for the 10-year Treasury, then RR is 1.0% also for the 30-
year Treasury.
IP = r 30 year bond- r 10-year note – RR - MRP = 4.0% - 2.5% - 1.0% - 0.2% = 0.3%
6. You are considering an investment in a one-year government debt security with a yield of 5
percent or a highly liquid corporate debt security with a yield of 6.5 percent. The expected
inflation rate for the next year is expected to be 2.5 percent.
a. What would be your real rate earned on either of the two investments?
Government debt rate = real rate + inflation premium

Real rate = 5% - 2.5% = 2.5%
b. What would be the default risk premium on the corporate debt security?
Risky debt rate = government debt rate + default risk premium

Default risk premium = 6.5% - 5% = 1.5%
7. Inflation is expected to be 3 percent over the next year. You desire an annual real rate of
return of 2.5 percent on your investments.
a. What nominal rate of interest would have to be offered on a one-year Treasury security for
you to consider making an investment?
Government debt rate = real rate + inflation premium

Government debt rate = 2.5% + 3% = 5.5%
b. A one-year corporate debt security is being offered at 2 percentage points over the one-
year Treasury security rate that meets your requirement in (a). What would be the market
interest rate on the corporate security?
Corporate debt rate = government debt rate + default risk premium

Corporate debt rate = 5.5% + 2% = 7.5%
8-17
8. Find the nominal interest rate for a debt security given the following information: real rate =
2%, liquidity premium = 2%, default risk premium = 4%, maturity risk premium
= 3%, and the inflation premium = 3%.
Nominal Interest Rate (r) = Real Rate (RR) + Inflation Premium (IP)
r = 2% + 3% = 5%
9. Find the default risk premium for a debt security given the following information: inflation
premium = 3%, maturity risk premium = 2.5%, real rate = 3%, liquidity premium = 0%, and
market interest rate is 10%.
DRP = r – RR – IP – MRP – LP
DRP = 10% – 3% – 3% – 2.5% – 0% = 1.5%
10. Find the default risk premium for a debt security given the following information: inflation
premium – 2.5 percent, maturity risk premium = 2.5 percent, real rate = 3 percent, liquidity
premium = 1.5 percent, and nominal interest rate = 14 percent.
DRP = r – RR – IP – MRP – LP
DRP = 14% – 3% – 2.5% – 2.5% – 1.5% = 4.5%
11. Assume that the interest rate on a one-year Treasury bill is 6 percent and the rate on a two-
year Treasury note is 7 percent.
Basic Relationships:
r = RR + IP
IP = r – RR
a. If the expected real rate of interest is 3 percent, determine the inflation premium on the
Treasury bill.
IP = 6% – 3% = 3%
b. If the maturity risk premium is expected to be zero, determine the inflation premium on
the Treasury note.
IP = 7% – 3% = 4%
c. What is the expected inflation premium for the second year?
Expected inflation premium for Year 2 = 4% – 3% = 1%
12. A Treasury note with a maturity of four years carries a nominal rate of interest of 10 percent.
In contrast, an 8-year Treasury note has a yield of 8 percent.
r = RR + IP
RR = r – IP
8-18
a. If inflation is expected to average 7 percent over the first four years, what is the
expected real rate of interest?
RR = 10% – 7% = 3%
b. If the inflation rate is expected to be 5 percent for the first year, calculate the average
annual rate of inflation for years two through four.
7% × 4 = 28% for 4 years
28% – 5% = 23% for Years 2, 3, and 4
23%/3 = 7.67% average annual rate for Years 2, 3, and 4
c. If the maturity risk premium is expected to be zero between the two Treasury securities,
what will be the average annual inflation rate expected over years five through eight?
IP = r – RR
Treasury note: IP = 10% – 3% = 7%
Treasury bond: IP = 8% – 3% = 5%
7% × 4 = 28% for first 4 years
5% × 8 = 40% for 8 years
(40% – 28%)/4 = 12%/4 = 3% average annual rate for Years 5, 6, 7, and 8
13. The interest rate on a 20-year Treasury bond is 9.25 percent. A comparable maturity Aaa-
rated corporate bond is yielding 10 percent. Another comparable maturity but lower quality
corporate bond has a yield of 14 percent which includes a liquidity premium of 1.5 percent.
Treasury bond rate (TBR) = RR + IP
DRP = r – TBR – MRP – LP
a. Determine the default risk premium on the Aaa-rated bond.
Aaa rated bond: DRP = 10% – 9.25% – 0% – 0% = .75%
b. Determine the default risk premium on the lower quality corporate bond.
Lower quality bond: DRP = 14% – 9.25% – 0% – 1.5% = 3.25%
14. A 30-year corporate bond has a nominal interest rate of 12 percent. This bond is not very
liquid and consequently requires a 2 percent liquidity premium. The bond is of low quality
and thus has a default risk premium of 2.5 percent. The bond has a remaining life of 25 years
resulting in a maturity risk premium of 1.5 percent.
Treasury bond rate (TBR) = RR + IP
r = TBR + DRP + MRP + LP
a. Estimate the market interest rate on a 30-year Treasury bond.
TBR = r – DRP – MRP – LP = 12% – 2.5% – 1.5% – 2% = 6%
b. What would be the inflation premium on the Treasury bond if investors required a real
rate of interest of 2.5 percent?
8-19
IP = TBR – RR = 6% – 2.5% = 3.5%

15. Challenge Problem Following are some selected interest rates.
Maturity or Term Rate Type of Security
1 year 4.0% Corporate loan (high quality)
1 year 5.0% Corporate loan (low quality)
1 year 3.5% Treasury bill
5 years 5.0% Treasury note
5 years 6.5% Corporate bond (high quality)
5 years 8.0% Corporate bond (low quality)
10 years 7.0% Treasury bond
a. Plot a yield curve using interest rates for government default risk-free securities.
The yield curve for government securities would be constructed using the following
securities with interest rates on the vertical axis and time to maturity on the horizontal
axis.
Maturity Rate Government Security

1 year 3.5% Treasury bill
5 years 5.0% Treasury note
b. Plot a yield curve using corporate debt securities with low default risk (high quality) and a
separate yield curve for low quality corporate debt securities.
The yield curves for corporate debt securities would be constructed using the following
securities with interest rates on the vertical axis and time to maturity on the horizontal
axis.
High Quality
1 year 4.0% Corporate loan (high quality)
Low Quality
1 year 5.0% Corporate loan (low quality)
8-20
c. Measure the amount of default risk premiums, assuming constant inflation rate
expectations and no maturity or liquidity risk premiums on any of the debt securities for
both high quality and low quality corporate securities based on information from (a) and
(b). Describe and discuss why differences might exist between high quality and low
quality corporate debt securities.
Corporate Treasury Default Risk

Default Risk Quality Securities - Securities = Premiums
High Quality:
1-year maturities 4.0% 3.5% 0.5%
Low Quality:
Low quality corporate debt requires the offering of higher default risk premiums (relative
to high quality debt) to get investors to invest in riskier corporate debt.
d. Identify the average expected inflation rate at each maturity level in (a) if the real rate is
expected to average 2 percent per year and if there are no maturity risk premiums
expected on Treasury securities.
Inflation
Nominal Rate - Real Rate = Premium
1 year 3.5% Treasury bill 2.0% 1.5%
5 years 5.0% Treasury note 2.0% 3.0%
10 years 7.0% Treasury bond 2.0% 5.0%
20 years 7.5% Treasury bond 2.0% 5.5%
e. Using information from (d), calculate the average annual expected inflation rate over
years 2 through 5. Also calculate the average annual expected inflation rates for years 6
through 10 and for years 11 through 20.
Inflation Total
Nominal Rate - Real Rate = Premium Inflation
1 year 3.5% Treasury bill 2.0% 1.5% 1.5%
5 years 5.0% Treasury note 2.0% 3.0% 15.0%
10 years 7.0% Treasury bond 2.0% 5.0% 50.0%
20 years 7.5% Treasury bond 2.0% 5.5% 110.0%
Average annual expected inflation rates:
8-21
2-5 years: (15.0% -1.5%)/4 = 13.5%/4 = 3.375%

6-10 years: (50% - 15%)/5 = 35%/5 = 7.0%
11-20 years: (110% - 50%)/10 = 60%/10 = 6.0%
f. Based on the information from (e), re-estimate the maturity risk premiums for high quality
and low quality corporate debt securities. Describe what seems to be occurring over time
and between differences in default risks.
Note: It is assumed that default risk premiums are constant across all maturities of high
quality corporate debt, as well as for all maturities of low quality corporate debt (of course
the level of default risk premiums would be higher for low quality debt versus high quality
debt).
Nominal Risk-free Maturity Risk

High Quality Rate Corporate Debt - Rate = Premium
1 year 4.0% Corporate loan 3.5% 0.5%
5 years 6.5% Corporate bond 5.0% 1.5%
Low Quality
Maturity risk premiums are relatively higher, as well as increase more rapidly, for low
quality corporate debt compared to high quality corporate debt. The differences are:
5-year maturities: 3.0% - 1.5% = 1.5%

10-year maturities: 3.5% - 1.5% = 2.0%
20-year maturities: 4.5% - 2.0% = 2.5%
This assumes that the default risk premium spread between high and low corporate debt remains
constant across maturities. Otherwise, the differences being observed in terms of maturity risk
premiums may actually reflect differences in default risk premium spreads.
SUGGESTED QUIZ
1. Define or discuss briefly:

a. Real rate of interest
b. Liquidity premium
c. Treasury bills
d. Treasury bonds
8-22
e. Yield curve
f. Demand-pull inflation
g. Administrative inflation
2. Briefly explain the loanable funds theory of interest rates.
3. Identify and describe the factors, in addition to supply and demand, that determine market or
nominal interest rates.
4. List and briefly describe the three basic theories used to describe the term structure of interest
rates (or shape of the yield curve).
5. Briefly describe how default risk premiums are estimated.
8-23
Concept Check Questions

SECTION 8.1
What is the price of loanable funds in financial markets called?

a. Interest rate
b. Disequilibrium interest rate
c. Supply of loanable funds
d. Demand for loanable funds
ANSWER: a
Which of the following time periods was associated with decreasing/low long-term interest rates?
a. 1905-1920
b. 1927-1933
c. 1946-1982
d. 1982-present
ANSWER: d
What one of the following is not a source of loanable funds?

a. Current savings
b. Fed’s sale of government securities
c. Fed’s purchase of government securities
d. Expansion of deposits by depository institutions
ANSWER: b
SECTION 8.2
The risk-free interest rate can be expressed as a function of which of the following?
a. Real rate of interest and the inflation premium
b. Real rate of interest, inflation premium, and the default risk premium
c. Deflation premium, real rate of interest, and the default risk premium
d. Default risk premium, market risk premium, and the liquidity premium
ANSWER: a
8-24
The compensation for financial debt instruments that cannot be easily converted to cash at prices
close to their estimated fair market values is called which of the following?
a. Inflation premium
b. Default-risk premium
c. Maturity risk premium
d. Liquidity premium
ANSWER: d
Which of the following is the name for the risk of changes in the price or value of fixed-rate debt
instruments resulting from changes in market interest rates?
a. Default risk
b. Interest rate risk
c. Liquidity risk
d. Inflation risk
ANSWER: b
SECTION 8.3
The risk-free interest rate is made up of which of the following components in addition to a real
rate of interest?
a. Inflation premium
b. Default risk premium
c. Market risk premium
d. Liquidity premium
ANSWER: a
Which of the following Treasury securities are issued on a discount basis and mature at par?
a. Treasury bonds
b. Treasury notes
c. Treasury bills
d. All marketable Treasury securities
ANSWER: c
The largest private ownership group of public debt of U.S. Treasury securities is which of the
following?
a. State and local governments
b. Foreign and international investors
c. Depository institutions
d. Mutual funds
ANSWER: b
8-25
SECTION 8.4
The relationship between interest rates and the time to maturity for debt instruments of
comparable quality is called which of the following?
a. Default risk premium
b. Liquidity premium
c. Term structure of interest rates
d. Term structure of nonmarketable government securities
ANSWER: c
Which of the following describes a yield curve?

a. A numerical presentation of the term structure of interest rates at a point in time
b. A graphic presentation of the term structure of interest rates at a point in time
c. A graphic presentation of the default risk premium at a point in time
d. A numerical presentation of the default risk premium relative to length of maturity
ANSWER: b
Which of the following is not a major theory commonly used to explain the term structure of
interest rates?
a. Expectations theory
b. Liquidity preference theory
c. Market segmentation theory
d. Inflation projections theory
ANSWER: d
SECTION 8.5
Inflation is best described as which of the following?

a. Increase in the price of goods or services that is offset by an increase in quality
b. Increase in the price of goods or services that is not offset by an increase in quality
c. Decrease in the price of goods or services that is offset by an increase in quality
d. Decrease in the price of goods or services that is not offset by an increase in quality
ANSWER: b
Which of the following was not a major inflationary period in the United States?
a. Revolutionary War
b. Civil War
c. Early 1980s
d. 2000 to present
ANSWER: d
8-26
What is the inflation that occurs when prices are raised to cover rising production costs such as
wages?
a. Cost-push inflation
b. Demand-pull inflation
c. Speculative inflation
d. Administrative inflation
ANSWER: a
SECTION 8.6
What does the risk-return finance principal imply?

a. Higher returns are expected for taking on more risk
b. Lower returns are expected for taking on more risk
c. Money has a time value
d. Default risk premiums are zero
ANSWER: a
If the risk free rate is 1 percent, the expected inflation premium is 2 percent, and the expected
return on a corporate bond is 6 percent, what would be the default risk premium on the corporate
bond?
a. 1 percent
b. 2 percent
c. 3 percent
d. 4 percent
ANSWER: c
Which corporate bonds have bond ratings of Baa or higher and meet financial institution
investment standards?
a. High-yield bonds
b. Junk bonds
c. Below investment grade bonds
d. Investment grade bonds
ANSWER: d
8-27

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Introduction To Finance Markets Investments and Financial Management 16th Edition Melicher Solutions Manual

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Introduction to Finance Markets

Investments and Financial Management

I. (8.1) SUPPLY AND DEMAND FOR LOANABLE FUNDS

2. Factors Affecting the Supply of and Demand for Loanable Funds

II. (8.2) COMPONENTS OF MARKET INTEREST RATES

III. (8.3) DEFAULT RISK-FREE SECURITIES: U.S. TREASURY DEBT INSTRUMENTS

IV. (8.4) TERM OR MATURITY STRUCTURE OF INTEREST RATES

V. (8.5) INFLATION PREMIUMS AND PRICE MOVEMENTS

VI. (8.6) DEFAULT RISK PREMIUMS

I. (8.1) SUPPLY AND DEMAND FOR LOANABLE FUNDS

II. (8.2) COMPONENTS OF MARKET INTEREST RATES

III. (8.3) DEFAULT RISK-FREE SECURITIES: U.S. TREASURY DEBT INSTRUMENTS

IV. (8.4) TERM OR MATURITY STRUCTURE OF INTEREST RATES

V. (8.5) INFLATION PREMIUMS AND PRICE MOVEMENTS

VI. (8.6) DEFAULT RISK PREMIUMS

REVIEW QUESTIONS AND ANSWERS

1. (LO 8.1) What is the “interest rate,” and how is it determined?

12. What is the tax status of income from federal securities?

15. Describe the process of advance refunding of the federal debt.

25. What is meant by default risk and a default risk premium?

26. How can a default risk premium change over time?

EXERCISES AND ANSWERS

PROBLEMS AND ANSWERS

r = RR + IP = 2.0% + 0.5% = 2.5%

r = RR + IP + DRP + MRP + LP,

Government debt rate = real rate + inflation premium

Risky debt rate = government debt rate + default risk premium

Government debt rate = real rate + inflation premium

Corporate debt rate = government debt rate + default risk premium

IP = TBR – RR = 6% – 2.5% = 3.5%

Maturity Rate Government Security

Corporate Treasury Default Risk

Average annual expected inflation rates:

2-5 years: (15.0% -1.5%)/4 = 13.5%/4 = 3.375%

Nominal Risk-free Maturity Risk

5-year maturities: 3.0% - 1.5% = 1.5%

1. Define or discuss briefly:

Concept Check Questions

What is the price of loanable funds in financial markets called?

What one of the following is not a source of loanable funds?

Which of the following describes a yield curve?

Inflation is best described as which of the following?

What does the risk-return finance principal imply?

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