Chapter 07 - Inflation, Yield Curve, and Duration: Impact on Interest Rates and Asset Prices

Chapter 7
Inflation, Yield Curve, and Duration:
Impact on Interest Rates and Asset Prices

Learning Objectives
You will discover what inflation is all about and how inflation can impact
interest rates and the prices of financial assets.
You will see how yield curves arise and view the controversy over what
determines the shape of the yield curve.
You will discover how yield curves can be a useful tool for those interested in
investing their money and in tracking the health of the economy.
You will be explore the concept of duration a measure of the maturity of a
financial instrument and see how it can be used to assist in making
investment choices and in protecting against the risk of changes in interest
rates.

Key Topics Outline

Inflation: What is it? How Does It Affect Interest Rates?
The Fisher Effect.
Alternative Views: Inflation, Changes in the Economy, and Interest Rates.
Inflation and Stock Prices: What Are the Links?
TIPS and Other Inflation-Indexed Instruments.
The Expectations Hypothesis and Other Views about Yield Curves.
Uses for Yield Curves.
Duration, Price Elasticity, Convexity, and Portfolio Immunization.

Chapter Outline
7.1. Introduction
7.2. Inflation and Interest Rates
7.2.1. The Correlation between Inflation and Interest Rates
7.2.2. Nominal and Real Interest Rates
7.2.3. The Fisher Effect
7.2.4. Alternative Views about Inflation and Interest Rates
7.2.4.1. The Harrod-Keynes Effect of Inflation
7.2.4.2. Anticipated versus Unanticipated Inflation
7.2.4.3. The Inflation-Risk Premium
7.2.4.4. The Inflation-Caused Income Tax Effect
7.2.4.5. Conclusion from Recent Research on Inflation and Interest
Rates
7.3. Inflation and Stock Prices
7.4. The Development of Inflation-Adjusted Securities
7.5. The Maturity of a Loan
7.5.1. The Yield Curve and the Term Structure of Interest Rates
7.5.2. Types of Yield Curves

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Chapter 07 - Inflation, Yield Curve, and Duration: Impact on Interest Rates and Asset Prices

7.5.3. The Unbiased Expectations Hypothesis

7.5.4. Policy Implications of the Unbiased Expectations Hypothesis
7.5.5. The Liquidity Premium View of the Yield Curve
7.6. The Segmented-Markets and Preferred Habitat Arguments
7.6.1. The Possible Impact of Segmented Markets on the Yield Curve
7.6.2. Policy Implications of the Segmented-Markets Theory
7.6.3. The Preferred Habitat or Composite Theory of the Yield Curve
7.6.4. Research Evidence on the Yield Curve
7.7. Uses of the Yield Curve
7.7.1. Forecasting Interest Rates
7.7.2. Uses for Financial Intermediaries
7.7.3. Detecting Overpriced and Underpriced Financial Assets
7.7.4. Indicating Trade-Offs between Maturity and Yield
7.7.5. Riding the Yield Curve
7.8. Duration: A Different Approach to Maturity
7.8.1. The Price Elasticity of a Bond or Other Debt Security
7.8.2. The Impact of Varying Coupon Rates
7.8.3. An Alternative Maturity Index for a Financial Asset: Duration
7.8.4. The Convexity Factor
7.8.5. Uses of Duration
7.8.5.1. Portfolio Immunization
7.8.6. Limitations of Duration

Key Terms Appearing in This Chapter

inflation, 176 yield curve, 188
nominal interest rate, 177 unbiased expectations hypothesis, 189
real interest rate, 177 liquidity premium, 192
inflation premium, 177 market segmentation argument, 193
Fisher effect, 178 preferred habitat, 194
Harrod-Keynes effect, 179 price elasticity, 199
inflation-risk premium, 180 coupon effect, 201
inflation-caused income tax effect, 180 duration, 201
nominal contracts, 183 convexity, 203
TIPS, 184 portfolio immunization, 205
maturity, 188

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Questions to Help You Study

1. What is inflation? Why is it important?
Answer: Inflation refers to a rise in the average level of prices for all goods and
services in an economy. Inflation creates distortions in the allocation of scarce
resources and definitely hurts certain groups. For example, it tends to discourage
savings - it tends to encourage consumption at a faster rate to stay ahead of rising
prices. In turn, the decline in the savings rate tends to discourage capital investment,
and hence the economy's growth in productivity. The fall in productivity means that
the supply of new goods and services cannot keep pace with rising demands, putting
further upward pressure on prices. At the same time, workers usually seek cost-of-
living adjustments in wages and salaries, leading to an increase in labor costs. If
inflation is on the rise, groups whose incomes are fixed or rise slowly often
experience a decline in their real standard of living.

2. Explain how inflation affects interest rates. What is the Fisher effect? What
does it assume?
Answer: Interest rates represent the "price" of credit, so interest rates are also affected
by inflation, although there is considerable debate as to exactly how and by how much
inflation affects interest rates.
The nominal interest rate is the rate quoted by lenders to investors. The real
interest rate is the purchasing power return to the lender of funds. If the lender
expects prices to rise during the life of a loan, he or she will have to adjust the
nominal rate of interest to keep pace with inflation so that the lenders purchasing
power is protected. Therefore, inflation tends to drive up interest rates.
Irving Fisher argued that the nominal interest rate is the sum of the real rate
plus the inflation premium. He contended that the real rate is relatively stable so that
inflation only affects the nominal rate. Expected inflation causes the expected nominal
rate of interest to increase by the same amount. The Fisher effect assumes that
inflation is fully anticipated.

3. Explain how nominal contracts may cause inflation to affect the stock prices of
some firms differently than it affects the stock prices of other firms.
Answer: The nominal contracts theory examines the responsiveness of business
revenues and expenses as well as the composition of a firms balance sheet to changes
in the rate of inflation. Companies that have pricing flexibility often gain additional
revenues as prices go up due to inflation and may secure larger profits if their
expenses are more or less fixed. Their stock prices tend to rise in such situations. In
contrast, other firms may experience rapidly rising expenses due to inflation and
possibly their stock price as well.

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Chapter 07 - Inflation, Yield Curve, and Duration: Impact on Interest Rates and Asset Prices

4. What is meant by deflation? How does deflation appear to impact interest

rates and the economy? Which nation has experienced deflation on a significant
scale in recent years?
Answer: Deflation is a fall in the average price level for all or a group of goods and
services. Past experiences indicate that price deflation can result in lower output
(production) of goods and services, and force real interest rates upward. Japan for
much of the past decade has experienced falling prices along with rising
unemployment and nominal interest rates hovering close to zero.

5. What are TIPS? What advantages do they offer investors? Any disadvantages?
Answer: Treasury inflation protected securities are issued in order to help protect
investors in U.S. government securities from lower rates of return due to inflation.
The coupon interest income and the principal payment from the indexed bonds are
both fixed in terms of purchasing power. However, not all inflation risk is eliminated
by TIPS because rising inflation can drive an investor into a higher tax bracket,
resulting in an after-tax rate of return somewhat less than the full inflation-adjusted
real interest income from these special Treasury bonds. Moreover, TIPS are subject to
market risk if an investor wishes to sell them ahead of their maturity date.

6. Explain the meaning of the phrase term structure of interest rates. What is a
yield curve? What assumptions are necessary to construct a yield curve?
Answer: The term structure of interest rates refers to the relationship between the
rates of return (yield) on financial instruments and their maturity. A yield curve is a
visual representation of the term structure of rates for all securities of equivalent grade
or quality. The yield curve represents only one moment in time with all other factors
held constant.

7. Explain the difference between the expectations, market segmentation,

preferred habitat, and liquidity premium views of the yield curve. What does each
of these theories assume?
Answer: The expectations hypothesis says that the shape of the yield curve is
determined by investors expectations regarding future short-term interest rates. The
liquidity premium theory says that the upward slope of most yield curves is caused by
the interest-rate premium that must be paid to investors to encourage them to
surrender liquidity and purchase long-term securities. The segmented markets theory
says that investors have maturity preferences for their investments in securities and
they are segmented into subgroups by these preferences. The supply and demand
conditions within each maturity segment, in turn, are important factors shaping the
structure of interest rates within that range. While the expectations theory holds that
investors are profit maximizes who will seek securities offering the highest rate of
return (regardless of maturity), the segmented markets theory says that investors will
not stray from their maturity preferences unless they are induced by significantly
higher yields or other favorable terms on securities with different maturities.

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The preferred habitat view is closely allied with the market segmentation view,
though it also brings in elements of the expectations and liquidity premium
arguments, thus providing a composite theory of the determinants of the yield curve.
Preferred habitat argues that investors select a preferred maturity range along the yield
curve on the basis of their risk preferences, tax exposure, liquidity requirements,
binding regulations, expectations, and other factors. Each investor will tend to stay in
his or her preferred maturity habitat unless induced to leave by higher yields or other
considerations. Moreover, investors expect that interest rates will tend to move back
toward their normal range based on historical experience.
The expectations hypothesis implies that changes in the volume of long-term
versus short-term securities will not affect the shape of the yield curve. Thus, the
central bank or the government cannot alter the shape of the yield curve by changing
the relative amounts of long-term and short-term securities. If the segmented-markets
or preferred-habitat theories are true, however, the government could alter the shape
of the yield curve by changing the supply of securities in one or more market
segments.

8. What are the implications for investors and for public policy of each of the
yield-curve ideas mentioned in the preceding question?
Answer: While the expectations theory holds that investors are profit maximizes who
will seek securities offering the highest rate of return (regardless of maturity), the
segmented markets theory says that investors will not stray from their maturity
preferences unless they are induced by significantly higher yields or other favorable
terms on securities with different maturities.
Preferred habitat argues that investors select a preferred maturity range along
the yield curve on the basis of their risk preferences, tax exposure, liquidity
requirements, binding regulations, expectations, and other factors. Each investor will
tend to stay in his or her preferred maturity habitat unless induced to leave by higher
yields or other considerations. Moreover, investors expect that interest rates will tend
to move back toward their normal range based on historical experience.
The expectations hypothesis implies that changes in the volume of long-term
versus short-term securities will not affect the shape of the yield curve. Thus, the
central bank or the government cannot alter the shape of the yield curve by changing
the relative amounts of long-term and short-term securities. If the segmented-markets
or preferred-habitat theories are true however, the government could alter the shape of
the yield curve by changing the supply of securities in one or more market segments.

9. What uses does the yield curve have? Why is each possible use of potential
value to borrowers and lenders of funds?
Answer: One use of the yield curve is to forecast interest rates. The slope of the yield
curve can signal borrowers and lenders of funds to move away from or towards long-
term securities or short-term securities. For example, if the yield curve is upward-
sloping, rates are expected to rise. Lenders (investors) should move toward short-
term securities whose prices will fall less as rates rise. Borrowers should try to
borrow longer-term.

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A second use of the yield curve is by financial intermediaries who should

adjust the maturity structure of their assets and liabilities as the yield curve changes.
A savings and loan, for example, should try to lengthen the maturity of its deposits
and shorten the maturity of its loans (or offer more variable-rate loans) if the yield
curve is upward-sloping.
Thirdly, investors can use the yield curve to detect underpriced or overpriced
securities. The investor can plot the yield for a variety of securities in the same risk
class. If a particular security lies above or below the resulting yield curve, it is either
underpriced (rate is above the yield curve) or overpriced (rate is below the yield
curve).
Fourth, the yield curve can be used by borrowers and lenders to calculate the
gain or loss resulting from changing the maturity structure of their portfolio. An
investor can benefit from shortening the maturity structure of the bond portfolio if the
yield curve is downward-sloping. A borrower may benefit by borrowing longer-term.
Fifth, investors can ride the yield curve. When the yield curve is positively-
sloped, the investor can buy six-month securities, sell them three months later and buy
new six-month securities. The investor is taking advantage of the lower yield (and
higher price) on three-month securities.

10. What conclusions can you draw from recent research regarding the
determinants of the yield curve? Which theory of the yield curve appears to be
most supported by recent research studies?
Answer: A number of research studies seem to reject the unbiased expectations
hypothesis and find that the yield curve does not have significant predictive power in
forecasting interest rates.
Recent research has delved more deeply into the issue of what kinds of events
cause the yield curves overall shape to change. Statistically, yield curves may change
along any of at least three different dimensions: level, slope, or curvature. A change in
level of the yield curve means that interest rates all along the curve move roughly in
parallel, shifting the whole curve up or down. The curves slope or steepness changes
when shorter-term interest rates rise or fall by greater amounts than longer-term
interest rates. The curvature of a yield curve may change when interest rates in the
middle of the maturity spectrum are impacted. This development would tend to give
the yield curve a greater or lesser hump along its midsection. These various
dimensions of a yield curve suggest that these curves are far more complex and more
intimately connected with the economy and government policy than was once
thought.

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11. What is the price elasticity of a financial asset, and what useful information
can it provide to an investor or portfolio manager?
Answer: Price elasticity is the measure of how responsive of a bond or other debt
securitys price is to changes in the interest rates Usually the price elasticity attached
to a bond or other debt security must be negative, because rising interest rates (yields)
result in falling debt security prices, and conversely.
It is useful information for an investor or portfolio manager, because higher
price elasticity means that an asset goes through a greater price change for a given
change in market rates of interest. Longer-term debt securities generally carry greater
price risk (their price elasticity is larger) than shorter-term debt securities.

12. What is the coupon effect? How would it figure into the assessment of
selecting financial assets for an investment portfolio?
Answer: The coupon effect is the relationship between the annual coupon rate and the
price of a debt security. The price of low-coupon securities tend to rise faster than the
prices of high-coupon securities when market interest rate decline. Similarly, a period
of rising interest rate will cause the prices of low-coupon securities to fall faster than
the prices of high-coupon securities. Thus, the potential for capital gains and capital
losses is greater for low-coupon than for high-coupon securities.

13. What is meant by the term convexity as it relates to the price of a financial
asset? In what way could it be useful information to an investor?
Answer: The relationship between price risk and yield can be quantified by a measure
called convexity, which measures the rate of change of the elasticity of prices with
respect to yield, or how rapidly the investors risk diminishes as interest rate rise. The
convexity measure for an asset would give the investor a precise relationship between
changes in price elasticity and yield, and could assist him in choosing fixed-income
securities he may wish to incorporate into his investment portfolio.

14. Explain the meaning and importance of the concept of duration.

Answer: Duration is a measure of the maturity of a debt that weights time to maturity
by the present value of the expected cash flows (principal and interest payments) from
the security. Duration yields an index of security price volatility or elasticity. The
longer a securitys duration, the greater its price elasticity.
A portfolio manager can minimize the damage that fluctuating interest rates
can do to an investors total return from a security or portfolio by setting the duration
of the securities involved equal to the investors holding period. This step causes
coupon reinvestment risk and principal (or price) risk to offset each other, freezing the
investors total return.

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15. What is portfolio immunization? How does it work?

Answer: Portfolio immunization is a hedging technique that protects the value of a
portfolio against the effects of changing interest rates. Portfolio immunization is
achieved by setting the duration of the portfolio equal to the planned holding period.
If this is done, the effect is to hold the investors total return constant regardless of
whether interest rates rise or fall. In the absence of borrower default, the investors
realized return can be no less than the return he has been promised by the borrower.
Only if the future course of interest rates were known for certain would portfolio
immunization be a less than optimal strategy.

16. What are the limitations of duration and the portfolio immunization
technique?
Answer: The limitations are that are often difficult to find a collection of assets
whose average portfolio duration exactly matches the investors planned holding
period. Another limitation is always some risk associated with the use of conventional
measures of duration due to uncertainty about future interest rate movements
(stochastic process risk). For immunization using duration to work well, the interest
rate movements should have the parallel change in all interest rates, but in reality the
interest rates of various maturities tend to change in accordance with the level, slope
and curvature of the yield curve. However, the duration model seems to be robust
under a variety of market conditions.

Problems and Issues

1. According to the Fisher effect, if the real interest rate is 3 percent and the
nominal interest rate is 8 percent, what rate of inflation is the financial
marketplace expecting? Explain the reasoning behind your answer. If the
nominal rate rises to 11 percent and following the Fisher effect, what would
you conclude about the expected inflation rate? The real rate?
ANSWER:
Nominal Rate = Expected Real Rate + Inflation Premium
Then: 8% = 3% + 5%, the rate of inflation is 5 %
And when the nominal rate rises to 11%
11% = 3% + 8%, the rate of inflation is 8%
Because the real rate is unchanged (3%), the expected inflation rate will rise by 3
percentage points to 8%. Lenders will attempt to compensate themselves fully for
expected inflation by adjusting their posted nominal rates on loans.

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Chapter 07 - Inflation, Yield Curve, and Duration: Impact on Interest Rates and Asset Prices

2. Mark wants a 3 percent real rate of return to invest in stock XYZ, and a 5
percent real rate of return to invest in stock ABC. Heidi believes that both
stocks are less risky than Mark, and is willing to accept real rates of return of
2 percent on XYZ and 4 percent on ABC. Mark expects the inflation rate to
be 3 percent and Heidi expects the inflation rate to be 5 percent. If the
current yield on both XYZ and ABC is 6 percent, then:
(A) Mark would be willing to invest in XYZ, but not in ABC, while Heidi
would not want to invest in either.
(B) Mark would invest in both XYZ and ABC, while Heidi would not invest
in either.
(C) Both Mark and Heidi would be willing to invest in XYZ, but not in ABC.
(D) Both Mark and Heidi would be willing to invest in both XYZ and ABC.
ANSWER: (A)

3. An investor buys a U.S. Treasury bond whose current yield to maturity is 10

percent. The investor is subject to a 33 percent federal income tax rate on
any new income received. His real after-tax return from this bond is 2
percent. What is the expected inflation rate in the financial marketplace?
ANSWER: 2% = 10% - (10% x 33%) - Inflation Premium
Solving for the inflation premium, we find that it equals 4.7 percent.

4. The Liquidity premium:

(A) is negative only during an economic recession.
(B) is the result of greater price volatility for longer-term assets.
(C) biases the slope of the yield curve downward.
(D) causes long rates to always exceed short rates.
ANSWER: (B)

5. Suppose that the actual U.S. Treasury yield curve is approximately flat. This
yield curve would suggest that the markets are expecting:
(A) short rates to remain essentially unchanged in the future.
(B) long rates to fall in the future.
(C) long rates to increase in the future.
(D) short rates to fall in the future.
ANSWER: (D)

6. The unbiased expectation hypothesis of the term structure of interest rates:

(A) applies only to assets that have the same maturity.
(B) applies only to assets that have the same default risk.
(C) ignores maturity of assets.
(D) ignores the market risk of assets.
ANSWER: (B)

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7. An investor wishes to ride the yield curve to higher profits on an investment

of $1,000. He observes in the market a zero-coupon T-note with one year left
to maturity yielding 5 percent and another zero-coupon with two years left to
maturity T-note yielding 7 percent. What investment strategy should he
pursue? Show how this investment strategy would be superior to a simple
buy and hold strategy. Under what conditions will this strategy succeed?
When will it fail?
ANSWER: Under the strategy buy-and-hold by holding T-note yielding 7 percent, the
total return after 2 years is:
Total Return of buy-and-hold = $1,000 (1+R1)2 = $1,000 (1.07)2 = $1,144.90
Under the strategy roll-over by investing in one year left to maturity yielding 5
percent, the total return after 2 years is:
Total Return of roll-over = $1,000 (1+r1) (1+Er2)
= $1,000 (1.05) (1+Er2) = $1,050.00 (1+Er2)
Hence the strategy of buy-and-hold will succeed if:
Total Return of buy-and-hold > Total Return of roll-over
Or, $1,144.90 > $1,050.00 (1+Er2) and Er2 < 0.0904 or 9.04%
Hence the strategy buy-and-hold will fail if:
Total Return of buy-and-hold < Total Return of roll-over
Or, $1,144.90 < $1,050.00 (1+Er2) and Er2 > 0.0904 or 9.04%

8. Repeat problem 7, but where the market interest rates are: 7 percent for the
one-year, zero-coupon bond and 5 percent for the two-year, zero-coupon
bond.
ANSWER: Under the strategy buy-and-hold by holding T-note yielding 5 percent, the
total return after 2 years is:
Total Return of buy-and-hold = $1,000 (1+R1)2 = $1,000 (1.05)2 = $1,102.50
Under the strategy roll-over by investing in one year left to maturity yielding 7
percent, the total return after 2 years is:
Total Return of roll-over = $1,000 (1+r1) (1+Er2)
= $1,000 (1.07) (1+Er2) = $1,070.00 (1+Er2)
Hence the strategy buy-and-hold will succeed if:
Total Return of buy-and-hold > Total Return of roll-over
Or, $1,102.50 > $1,070.00 (1+Er2) and Er2 < 0.0304 or 3.04%
Hence the strategy buy-and-hold will fail if:
Total Return of buy-and-hold < Total Return of roll-over
Or, $1,102.50 < $1,070.00 (1+Er2) and Er2 > 0.0304 or 3.04%

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9. Calculate the price elasticity of a 15-year bond around its $1,000 par value
and 10 percent coupon rate if market interest rates on comparable bonds
drop to 6 percent. The market price of the bond at a 6 percent yield to
maturity is $1,392. Suppose now that the yield to maturity climbs to 14
percent. If the bonds price falls to $751.80, what is the bonds price
elasticity?
ANSWER: From price elasticity equation (7.14):
The price elasticity from a 10% yield drop to 6% yield is:
1,392 1,000
1,000 0.392
Price Elasticity = 0.98
0.06 0.10 0.4
0.10
The price elasticity from a 6% yield climb to 14% yield is:
751.80 1,392
1,392 0.460
Price Elasticity = 0.345
0.14 0.06 1.33
0.06
The price elasticity from a 14% yield drop to 10% yield is:
1,000 751.80
751.80 0.330
Price Elasticity = 1.155
0.10 0.14 0.286
0.14

10. Calculate the value of duration for a four-year, $1,000 par value U.S.
government bond purchased today at a yield to maturity of 15 percent. The
bonds coupon rate is 12 percent, and it pays interest at years end. Now
suppose the market interest rate on comparable bonds falls to 14 percent.
What percentage change in this bonds price will result?
ANSWER:
Expected Present value of
Cash Flows expected Cash Time Period Present Value
Period from Flows (at 15% Rate Cash is to be of Expected
Security of Discount) Received (t) cash flows x t
1 120 104.35 1 104.35
2 120 90.74 2 181.47
3 120 78.90 3 236.71
4 120 68.61 4 274.44
4 1,000 571.75 4 2,287.01
$914.35 $3,083.98
Duration = $3083.98/$914.35 = 3.37 years.
Present value of the bond at a 14% yield to maturity:

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 Chapter 07 - Inflation, Yield Curve, and Duration: Impact on Interest Rates and Asset Prices

Expected Present value

Period Cash Flows of expected Cash
from Security Flows(at 14% Rate
of Discount)
1 120 105.26
2 120 92.34
3 120 81.00
4 120 71.05
4 1,000 592.08
$941.73
Price of the bond at a 14% yield to maturity = 941.73
So the percentage change in the price of the bond is:
($941.73 - $914.35)/$914.35 = 2.99%

11. A bank buying bonds is concerned about possible fluctuations in earnings due
to changes in interest rates. Currently the banks investment officer is
looking at a $1,000 par-value bond that matures in four years and carries a
coupon rate of 12 percent. Market interest rates are also at 12 percent, but
the banks officer believes there is a significant probability that interest rates
could drop to 10 percent or rise to 14 percent during the first year and stay
there until the bond matures. What would be this bonds total earnings over
the next four years if interest rates rise to 14 percent? Fall to 10 percent?
Remain at 12 percent? What will happen to total earnings if the investment
officer finds another bond whose maturity is reached in five years but whose
duration is four years--the same as the banks planned holding period?
ANSWER:
Earnings at 12 percent

First Years Second Years Third Years Fourth Years

Interest Earnings + Interest Earnings + Interest Earnings + Interest Earnings +
$120 $120 $120 $120

Accumulated Interest Accumulated Interest Accumulated Interest

on the First Years + on the Second Years + on the Third Years +
Interest Income Interest Income Interest Income
$48.59 $30.53 $14.40

Par Value Total Return Received

at Maturity = at 12% Interest Rate
$1,000 $1,573.52

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Earnings at 10 percent

First Years Second Years Third Years Fourth Years

Interest Earnings + Interest Earnings + Interest Earnings + Interest Earnings +
$120 $120 $120 $120

Accumulated Interest Accumulated Interest Accumulated Interest

on the First Years + on the Second Years + on the Third Years +
Interest Income Interest Income Interest Income
$39.72 $27.72 $12

Par Value Total Return Received

at Maturity = at 12% Interest Rate
$1,000 $1,559.44

Earnings at 14 percent

First Years Second Years Third Years Fourth Years

Interest Earnings + Interest Earnings + Interest Earnings + Interest Earnings +
$120 $120 $120 $120

Accumulated Interest Accumulated Interest Accumulated Interest

on the First Years + on the Second Years + on the Third Years +
Interest Income Interest Income Interest Income
$57.78 $35.95 $16.80

Par Value Total Return Received

at Maturity = at 12% Interest Rate
$1,000 $1,590.53
Clearly a rise in interest rates (to 14 percent) raises the total return received to
$1,590.53, while a drop in interest rates (to 10 percent) results in lower total returns of
just $1,559.44.
If the bank could find a bond with four-year duration the total return would be
stabilized above $1,559.44, but below $1,590.53.

12. The 10year Treasury bond rate is trading at 6.08 percent, while the one-year
bond rate carries a yield to maturity of 5.35 percent. What is the yield spread
between these instruments? What is this yield spread forecasting for the
economy in the period ahead? Please explain.
ANSWER: The current yield spread is 73 basis points. The yield spread is forecasting
that investors expect somewhat higher short-term interest rates in the future.
Suppose the 10year T-bond rate falls to 5.57 percent, while the oneyear
T-bond yield rises to 6.04 percent. What change in yield spread has
occurred? What is the expected outlook for economic conditions following
this particular change in the yield spread? Can you explain why?
ANSWER: The yield spread is now negative at 47 basis points. The downward
slope suggests the likelihood of near-term declines in short-term interest rates and a
slowing of the economy.

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13. Synchron Corporation borrowed long-term capital at an interest rate of 8.5

percent under the expectation that the annual inflation rate over the life of
this borrowing was likely to be 5 percent. However, shortly after the loan
contract was signed, the actual inflation rate climbed to 5.5 percent, where it
is expected to remain until Synchrons loan reaches maturity. What is likely
to happen to the market value per share of Synchrons common stock?
Explain your reasoning.
ANSWER: It depends. It is possible that the stock price could increase since
Synchrons is now repaying debt with dollars worth slightly less than anticipated. On
the other hand, it could fall since Synchrons shareholders may now have a higher
required rate of return, and the marginal cost of all of Synchrons new debt has
increased.

14. A four-year TIPS bond promises a real annual coupon return of 4 percent
and its face value is $1,000. While the annual inflation rate was
approximately zero when the bond was first issued, the inflation rate
suddenly accelerated to 3 percent and is expected to remain at that level for
the bonds four-year term. What will be the amount of interest paid in
nominal dollars each year of the bonds life? What will be the face (nominal)
value of the bond at the end of each year of its life?
ANSWER: The results show in the table:
Nominal Interest
Actual TIPS's Pricipal Nominal Interest Payment from a
Annual Rate Nominal Value at Payment to the TIPS Conventional
of Inflation the End of Each Bond's Holder at Year (Non-Inflation-
Period (%) Year End Adjusted) Bond
First Year 3% 1030.00 41.20 $40
Second Year 3% 1060.90 42.44 $40
Third Year 3% 1092.73 43.71 $40
Fourth Year 3% 1125.51 45.02 $40

EXCEL 15. Jon wishes to invest $10,000 in U.S. Treasury securities for 10 years.
He is considering the following investment strategies: (1) Buy a 10-year T-Note
and hold it to maturity; (2) Buy a 5-year T-Note and upon maturity roll-over the
principal and interest in a second 5-year T-Note; (3) Buy a Treasury with one
year to maturity, and continuously roll-over the investment in one-year Treasury
for 10 years. The current yields are: 2 percent on the 1-year Treasury; 4.25
percent on the 5-year T-Note; and 4.5 percent on the 10-year T-Note. Jons
financial analysis indicates that market expectations are for the 1-year Treasury
yield to rise by 50 basis points every year for the first 5 years, and then remain
unchanged for the next 5 years, and for the 5-year T-Note to be the same in 5
years as it is today. Using a spreadsheet, display the total return (including the
initial investment) that Jon would have FROM his investment in each of the 10
years under each of the three investment strategies. (Hint: Let column one
display the value of the investment (1) after one year in the first row, after 2
years in the second row, etc., then repeat for investment (2) in column 2, and for
investment (3) in column 3. Use additional columns for questions d, e, and f.)

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ANSWER: The total return of 3 strategies:

Period 10-year T-Note 5-year T-Note roll-over 1-year T-note roll-over
1 10450.00 10425.00 10,200.00
2 10920.25 10868.06 10,455.00
3 11411.66 11329.96 10,768.65
4 11925.19 11811.48 11,145.55
5 12461.82 12313.47 11,591.37
6 13022.60 12836.79 12,055.03
7 13608.62 13382.35 12,537.23
8 14221.01 13951.10 13,038.72
9 14860.95 14544.02 13,560.27
10 15529.69 15162.14 14,102.68
The 10-year T-Note gives Jon the highest total return $15,529.69.
a. What is todays liquidity premium in the 10-year yield versus the 1-year
yield?
ANSWER: The liquidity premium from equation (7.13):
(1 R1 ) n (1 r1 )(1 Er2 )(1 Er3 ) (1 Er10 )

(1 0.045)10 (1 0.02)(1 0.025)(1 0.03)(1 0.035)(1 0.04)(1 0.04) 5

0.1427
b. What is todays liquidity premium in the 5-year yield versus the 1-year yield?
ANSWER:
(1 0.0425) 5 (1 0.02)(1 0.025)(1 0.03)(1 0.035)(1 0.04)
0.0722
c. What is todays liquidity premium in the 10-year yield versus the 5-year
yield?
ANSWER:
(1 0.045)10 (1 0.0425) 5 (1 0.0425) 5
0.0368

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d. Suppose that the actual short rate remained unchanged during the entire 10
years, how would that affect the 10-year rate of return on investment (3)?
ANSWER: The total return on unchanged actual short rate is:
5-year T-Note 1-year T-note 1-year T-note
Period 10-year T-Note roll-over roll-over (unchanged)
1 10450.00 10425.00 10,200.00 10200.00
2 10920.25 10868.06 10,455.00 10404.00
3 11411.66 11329.96 10,768.65 10612.08
4 11925.19 11811.48 11,145.55 10824.32
5 12461.82 12313.47 11,591.37 11040.81
6 13022.60 12836.79 12,055.03 11261.62
7 13608.62 13382.35 12,537.23 11486.86
8 14221.01 13951.10 13,038.72 11716.59
9 14860.95 14544.02 13,560.27 11950.93
10 15529.69 15162.14 14,102.68 12189.94
e. What would happen to the investments 10-year rate of return if the one-year
rate continued to rise at 50 basis points per year for years 5 through 10?
ANSWER: The total return on rising 50 basis points for 10 years in short rate is:
5-year T-Note 1-year T-note 1-year T-note (50 basis
Period 10-year T-Note roll-over roll-over points for 10 yrs)
1 10450.00 10425.00 10,200.00 10,200.00
2 10920.25 10868.06 10,455.00 10,455.00
3 11411.66 11329.96 10,768.65 10,768.65
4 11925.19 11811.48 11,145.55 11,145.55
5 12461.82 12313.47 11,591.37 11,591.37
6 13022.60 12836.79 12,055.03 12,112.99
7 13608.62 13382.35 12,537.23 12,718.64
8 14221.01 13951.10 13,038.72 13,418.16
9 14860.95 14544.02 13,560.27 14,223.25
10 15529.69 15162.14 14,102.68 15,147.76
f. If the 5-year T-Note yield fell 50 basis points after five years, how much
would this reduce the 10-year rate of return on investment (2)?

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ANSWER: The total return on reducing 50 basis points in 5-year T-Note:

5-year T-Note 1-year T-note 5-year T-note (50
Period 10-year T-Note roll-over roll-over basis reduce)
1 10450.00 10425.00 10,200.00 10,425.00
2 10920.25 10868.06 10,455.00 10,868.06
3 11411.66 11329.96 10,768.65 11,329.96
4 11925.19 11811.48 11,145.55 11,811.48
5 12461.82 12313.47 11,591.37 12,313.47
6 13022.60 12836.79 12,055.03 12,775.22
7 13608.62 13382.35 12,537.23 13,254.29
8 14221.01 13951.10 13,038.72 13,751.33
9 14860.95 14544.02 13,560.27 14,267.00
10 15529.69 15162.14 14,102.68 14,802.02
g. If the 5-year T-Note yield rose 50 basis points after five years, how much
would this increase the 10-year rate of return on investment (2)?
ANSWER: The total return on rising 50 basis points in 5-year T-Note:
10-year T- 5-year T-Note 1-year T-note 5-year T-note (50
Period Note roll-over roll-over basis rise)
1 10450.00 10425.00 10,200.00 10,425.00
2 10920.25 10868.06 10,455.00 10,868.06
3 11411.66 11329.96 10,768.65 11,329.96
4 11925.19 11811.48 11,145.55 11,811.48
5 12461.82 12313.47 11,591.37 12,313.47
6 13022.60 12836.79 12,055.03 12,898.36
7 13608.62 13382.35 12,537.23 13,511.03
8 14221.01 13951.10 13,038.72 14,152.80
9 14860.95 14544.02 13,560.27 14,825.06
10 15529.69 15162.14 14,102.68 15,529.25
h. Do exercise d., e., f., and g. illustrate why the liquidity premium is positive?
Please explain.
ANSWER: The liquidity premium is always positive, because the long-term financial
assets tend to have more volatile market prices than short-term assets. Therefore, the
investor faces greater risk of capital loss when buying long-term financial
instruments. To overcome the risk of capital loss, investors must be paid an extra
return in the form of an interest rate (term) premium to encourage them to purchase
long-term financial instruments. Hence the liquidity premium would tend to give yield
curves a bias toward a positive slope.

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Web-Based Problems
1. Yield curves can be constructed for assets drawn from similar risk classes.
Traditionally there are three types of yield curves that are typically followed
in the financial markets. The dominant one is for U.S. Treasury securities. It
is a plot of the yields on on-the-run (or most frequently issued) Treasuries
for maturities: 3-months, 6-months, 2-years, 3-years, 5-years, 10-years, and
30-years. It is a simple matter to find this information from a wide variety of
internet sites, such as the U.S. Treasury Department, the Federal Reserve, etc.
This question asks you to search the internet for the information you need to
construct the other two yield curves that are often followed in the financial
press. One is for the highest quality debt of major U.S. corporations, which
would range from 30-day commercial paper rates to 30-year corporate bonds.
The second is similarly rated municipal bonds. These debt instruments of
state and local governments have a much higher volume at longer maturities
than shorter maturities, but see how much of the maturity spectrum from 3
months to 30 years you can find. Once you have gathered these data, plot all
three yield curves on the same graph. You should see similar patterns in all
three. Why? However, you should also see that the corporate yield curve lies
everywhere above the Treasury yield curve. Why? And the Treasury yield
curve should lie everywhere above the municipal yield curve. Why?

Answer: From http://finance.yahoo.com/bonds/composite_bond_rates:

Maturity Period U.S. Treasuries Corporate Bonds Municipal Bonds
3-months 4.80
6-months 4.86
2-years 4.88 5.38 3.70
3-years 4.89
5-years 4.96 5.52 3.82
10-years 5.06 5.95 4.05
20-years 6.27 4.58
30-years 5.14 4.71

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The corporate bonds always give the highest yield to investors because of their
greater default risk. Municipal bonds typically offer lower yields than Treasury
securities because their interest payments are tax exempt. Hence the yield curve of
corporate bonds lies above the yield curve of U.S. Treasury bonds and then Municipal
bonds.

2. During the late 1970s the inflation rate in the United States was in double
digits. In response, the Federal Reserve decided to raise short-term interest
rates dramatically to bring it down.
a. What would you expect the yield curve to look like after this policy
change?
Answer: The yield curve will tilt up at the shorter-term side and it will slope
downward.
b. Visit the Feds web site at www.federalreserve.gov and click on the
Economic Research and Data tab; then click on the Statistics: Releases
and Historical Data tab and obtain historical data on Selected Interest
Rates from the H.15 release. From these data construct a Treasury yield
curve for April 1980 and for the most recent month you can find.
Answer: Compare the Treasury yield rate between 1980 and July 16, 2007:
Maturity Period U.S. Treasuries in 1980 U.S. Treasuries on July 16, 2007
3-months 4.74
6-months 4.95
1-years 12.00 4.96
2-years 11.73 4.98
3-years 11.51 5.00
5-years 11.45 5.03
7-years 11.40 5.05
10-years 11.43 5.10
20-years 11.36 5.29
30-years 11.27 5.20

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Chapter 07 - Inflation, Yield Curve, and Duration: Impact on Interest Rates and Asset Prices

c. Search the Internet for data on the current inflation rate (measured by
the CPI) in the United States and the U.S. inflation rate in 1980. Does this
information help you to explain the shapes of the yield curves for these
two time periods?
Answer: Yes, the inflation rate information helps explain the shapes of the yield
curves on both cases. Higher inflation rates tend to shift the yield curve upward.

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