FIN221 Chapter 2

TUTORIAL Part two

Questions
◦ Q1. If we observe a one-year Treasury security rate higher than the two-year Treasury security rate, what can we
infer about the one-year rate expected one year from now?

◦ Based on the unbiased expectation theory, the expected one-year rate is less than the interest rate today
◦  
Questions
◦ Q2. 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.
Answer
The fair interest rate on a financial security is calculated as:
i* = IP + RFR + DRP + LRP + SCP + MP
8% = 1.75% + 3.5% + DRP + 0.25% + 0% + 0.85%
Thus, DRP = 8% - 1.75% - 3.5% - 0.25% - 0% - 0.85% = 1.65%
Questions

◦ Q3. 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 earnings 3.25 percent. Your broker has
determined the following information about economic activity and Moore Corporation bonds:
◦ Real risk-free interest rate = 2.25%
◦ Default risk premium = 1.15%
Liquidity risk premium = 0.50%
Maturity risk premium = 1.75%
◦ What is the inflation premium?
◦ What is the fair interest rate on Moore Corporation 30-year bonds?
Answer
a. IP = i* – RFR = 3.25% - 2.25% = 1.00%
b. ij* = 1.00% + 2.25% + 1.15% + 0.50% + 1.75% = 6.65%
Questions
◦ Q4. 4. Suppose we observe the following rates: 1R1 = 8%, 1R2 = 10%. If the unbiased expectation theory of term
structure of interest rates holds, what is the one-year interest rate expected two-years from now, E(2r1)?
Questions

Q5. Suppose we observe the three-year Treasury security rate 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 expectation theory of term structure of interest rates holds, what is the one-year Treasury security rate?

◦ 1.12 = {(1 + 1R1)(1 + E(2r1))(1 + E(3r1))}1/3

◦ 1.12 = {(1 + 1R1)(1.08)(1.10)}1/3
◦ 1.4049 = (1 + 1R1 )(1.08)(1.10)
◦ 1 + 1R1 = 1.4049/{(1.08)(1.10)}
◦ 1R1 = 0.1826 = 18.26%
Questions

◦ Q6. A recent edition of The Wall Street Journal reported interest rates of 2.25 percent, 2.60 percent, 2.98 percent
and 3.25 percent for three-year, four-year, five-year, and six-year Treasury notes, respectively. According to the
unbiased expectation theory of the term structure of interest rates, what are the expected one-year rates during
years 4,5, and 6 ?
Answer
1 + 1R4 = {(1 + 1R3)3(1 + E(4r1))}1/4
1.026 = {(1.0225)3(1 + E(4r1))}1/4
(1.026)4 = (1.0225)3(1 + E(4r1))
(1.026)4/(1.0225)3 = 1 + E(4r1)
1 + E(4r1) = 1.03657
E(4r1) = 3.657%

1 + 1R5 = {(1 + 1R4)4(1 + E(5r1))}1/5

1.0298 = {(1.026)4(1 + E(5r1))}1/5
(1.0298)5 = (1.026)4 (1 + E(5r1))
(1.0298)5/(1.026)4 = 1 + E(5r1)
1 + E(5r1) = 1.04514
E(5r1) = 4.514%
 
1 + 1R6 = {(1 + 1R5)5(1 + E(6r1))}1/6
1.0325 = {(1.0298)5(1 + E(6r1))}1/6
(1.0325)6 = (1.0298)5(1 + E(6r1))
(1.0325)6/(1.0298)5 = 1 + E(6r1)
1 + E(6r1) = 1.04611
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◦ Q7. Suppose we observe the following rates: 1R1 = 10%, 1R2 = 14%, E(2r1) = 18%. If the liquidity premium
theory of the term structure of interest rates holds, what is the liquidity premium for year 2?

(1 + 1R2) = {(1 + 1R1)(1 + E(2r1) + L2)}1/2

1.14 = {(1.10) (1 + 0.18 + L2)}1/2
1.2996 = (1.10) (1 + 0.18 + L2)
1.2996/1.10 = 1 + 0.18 + L2
1.18145 = 1 + 0.18 + L2
L2 = 0.00145 = 0.145%