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Textbook Problems

Chapter 6
1. a. Plot a yield curve based on these data.

7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%

Series1

6

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ye
ar
2
ye
ar
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3
ye
ar
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4
ye
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5
ye
a
10 rs
ye
a
20 rs
ye
a
30 rs
ye
ar
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Yield

Yield Curve

Maturity

b. Yield curve shape: Upward sloping
c. Explanation for shape: Either that inflation is expected to increase or that there is
an increasing maturity risk premium
d. Borrow short-term or long term: Borrow long term because interest rates are
expected to rise so lock-in the long-term rate.
2. Yield on 30-day T-bills = 5.5% = rRF
Inflation premium = 3.25%
Liquidity premium = 0.6%
MRP = 1.8%
DRP = 2.15%
What is the real risk-free rate?
5.5% = r* + 3.25%
3. r* = 3%

I1 = 2%

I2 = 4%

rT2 = r* + IP2
IP2 = (2% + 4%)/2 = 3%
rT2 = 3% + 3% = 6%

r* = 5.5% - 3.25% = 2.25%
I3 = 4%

MRP = 0

rT2 = ?

rT3 = ?

3108)1/2 X = 8.2% 6.2% 3% + 3% + MRP = 6.06) – 1 = 0.3% = 6.5% 9.3% IP = 2.5% DRP = LP = 0 rT7 = ? r = r* + IP + MRP + LP + DRP IP = (3% + 4% + 3.1(t – 1) . rC5 = 7.33% = 6.5% 8.5% + DRP = 8% 6% + 0.16) -1 = 0.05)(1.75% LP = 1% rT5 = 5.5% DRP = ? rT10 = r* + IP10 + MRP10 = 6% rC10 = (r* + IP10 + MRP10) + 0.05(7 – 1) = 0. r* = 5% IP1 = IP2 = IP3 = IP4 = 16% MRP = LP = DRP = 0 r4 = rRF rRF = (1 + .rT3 = r* + IP3 IP3 = (2% + 4% + 4%)/3 = 3.5% + DRP = 8% DRP = 1.055 = 5.8% r4 = ? 7.5%)/7 = 3. rT1 = r* + IP1 = 2% + 3% = 5% rT3 = rT1 + 2% = 5% + 2% = 7% rT3 = 7% = r* + IP3 7% = 2% + IP3 IP3 = 5% 11. X = yield on 2-year securities 4 years from now (1.075)6 (1 + X)2 = (1.05(t – 1) IP2 = 4% IP3 = IP4 = IP5 = IP6 = IP7 = 3.5% +3.5% +3.2% rT2 = 6.07)4 1 + X = (1.5% +3.218 = 21.5% MRP = 0. rT10 = 6% rC10 = 8% LP = 0.5% MRP = 0.05)(1 + 0.33% rT3 = 3% + 3.2% DRP = ? r* = 2. rT1 = 5% 1rT1 = 6% rT2 = ? rT2 = (1.8% 10.5433/1.33% 4.5% 5.3% rT7 = 3% + 3.5% + 3. r* = 3% IP1 = 3% IP2 = 3% IP2 = (3% + 3%)/2 = 3% rT2 = r* + IP2 + MRP = 6. r* = 3% IP1 = 3% MRP = 0.075)6/(1.07)4(1 + X)2 = (1.2% MRP = 0.5% + 0.

75% rT3 = 6.775% 14.2% IP3 = IP4 = IP5 = 3.75%]/8 = 3.75% + 3.5% + 3.8% IP5 = IP6 = IP7 = IP8 =3.1% = 5.2% + 3.5% + 3.4% + 1% + DRP DRP = 1.6% + 3.55% 12.3% LP = 0.3% rT5 = 6. rT2 = 4.5% = 4.6% + 3.8% = 2.3% + MRP5 MRP5 = .1% rT3 = 6.05 X = 9.25% = r* + IP3 + MRP3 IP3 = (2. (1.75% + 3.2% = 3% r1 = 5% r2 = 7% 1r2 =? .045)2 = (1.3% + 2.25% = 2.8%) + 4(3.6%)/5 = 3.25% rT3 = 6.022% Note that the average inflation rate for the two years is (2% + 5%)/2 = 3.3% = 2.03 X = 6.1(5 – 1) = 0.75% MRP5 – MRP3 = 0.75% = 2.5% + 3.5% and that rT2 = 1% + 3.75% MRP = 0 rC8 = 8.4% RC5 = 7.07)2 = (1.75% + DRP DRP = 1.1% + MRP3 MRP3 = .022% .75% DRP = ? IP8 = [4(2.MRP = .05)(1 + X) 1 + X = 1.5% rT5 = 6.5% IP1 = IP2 = IP3 = IP4 =2.4% IP5 = (2.038% IP1 = 5% .35% 13.4% = 0.022% b.6% MRP5 – MRP3 = ? r* = 2.8% IP2 = 3. IP1 = 3% .09203/1. IP1 = 2.1449/1.275% rC8 = 8.1% = 2% IP2 = 6.6%)/3 = 3.275% + 0 + 0. r* = 2.5% 15.2% + 3.5% rT1 = 3% r* = 1% MRP = 0 1rT1 =? a. r* = 2% MRP = 0 (1.5% + 0.03)(1 + X) 1 + X = 1.75% – 0.

SEE GRAPH IN INSTRUCTOR MANUAL.4% MRP3 = 0.4 7.3 7.0 1.06 = (1 + X) X = 14% 17. r6 = 20.0% Years to Maturity 1 2 3 4 5 10 20 19.4 0. IP1 = 13% r* 2% 2 2 2 2 2 2 IP 7% 6 5 4.84% MRP = LP = DRP = 0 r* = 6% IP6 = ? 1.6% MRP4 = 0.5 4. Average inflation = (13% + 9% + 7% + 6% + 6%)/5 = 8.2% = 5%.5% + 0 rT5 = 5.2% MRP2 = 0.8% MRP5 = 1.2 6.2% = 3.2% 8.3 IP4+ = 6% a.6 0.6 6.2% 0.6 3.2 3.6 7.2% rT10 = 6.2% 18.9% + 1.5% rT10 = 6. 125 16. p.4% = 3.3 IP2 = 9% MRP 0.2% .06)(1 + X) 1.3% + 0 + 2% = 7.0 IP3 = 7% rT 9.0 1.2084/1. The inflation rate reflected in the one year interest rate for year 2 is 7% while the average inflation rate reflected in the average rate for the two year period is (7% + 3%)/2 = 5% or 7% . rT5 = 5.4% IP10 = 2.2% = 7% The average interest rate for the two year period (7%) differs from the one year interest rate for year 2 (9%) because the inflation rate reflected in the two rates is different.9% + 2.9% + IP5 + 0 MRP = 0 rC5 = ? r* = 3.4% = r* + IP10 + MRP = r* + 2.8 1.5% + 0 + LP + DRP LP + DRP = 2% rC5 = 3.2084 = (1.4% rC10 = 8.IP2 = 9% .9% IP5 = 1. IP1 = 7% IP2 = 5% IP3 = 3% r* = 2% MRP0 = 0 MRP1 = 0.3% rC10 = r* + IP10 + MRP + LP + DRP 8.

4 0.2% = 10.55 MRP 0. The normal yield curve is upward sloping because inflation is not expected to trend either up or down.15 10.2 7.1 6. the yield curve typically slopes up especially steeply because inflation and consequently short-term interest rates are currently low.1% 0.5 1.2 0. e. yet people expect inflation and interest rates to rise as the economy comes out of the recession.0 rT 15. r* = 2% MRP = 0.1 10. If inflation rates are expected to be constant the the pure expectations theory would predict a horizontal yield curve. .2 12.2% c. the MRP would probably increase with the maturity of the bond so the yield curve would be upward sloping.b.0 11. so the yield curve slopes up. However.1 x t% Years to Maturity 1 2 3 4 5 10 20 r* 2% 2 2 2 2 2 2 IP 13% 11 9.7 8.75 8.7 10. Average 5-year nominal rate = 2% + 8.1% 13.0 2. During a recession.3 0. so IP is the same for all debt maturities.55 d. but the MRP increases with maturity.