Topic 3: Interest Rates II, Tutorial Solutions

1.a) If a yield curve looks like the one below, what is the market predicting about the movement
of future short-term interest rates? What might the yield curve indicate about the market’s
predictions about the inflation rate in the future?

Answer:
The steep upward-sloping yield curve at shorter maturities suggests that short-term interest rates
are expected to rise moderately in the near future because the initial, steep upward slope
indicates that the average of expected short-term interest rates in the near future is above the
current short-term interest rate. The downward slope for longer maturities indicates that short-
term interest rates are eventually expected to fall sharply. With a positive risk premium on long-
term bonds, as in the liquidity premium theory, a downward slope of the yield curve occurs only
if the average of expected short-term interest rates is declining, which occurs only if short-term
interest rates far into the future are falling. Since interest rates and expected inflation move
together, the yield curve suggests that the market expects inflation to rise moderately in the near
future but fall later on.
1.b)

Answer:
The flat yield curve at shorter maturities suggests that short-term interest rates are expected to fall
moderately in the near future, while the steep upward slope of the yield curve at longer maturities
indicates that interest rates further into the future are expected to rise. Because interest rates and expected
inflation move together, the yield curve suggests that the market expects inflation to fall moderately in the
near future but to rise later on.

2) Predict what will happen to interest rates on a corporation’s bonds if the federal
government guarantees today that it will pay creditors if the corporation goes bankrupt in
the future. What will happen to the interest rates on Treasury securities?
Answer:
The government guarantee will reduce the default risk on corporate bonds, making them more
desirable relative to Treasury securities. The increased demand for corporate bonds and
decreased demand for Treasury securities will lower interest rates on corporate bonds and raise
them on Treasury bonds.
3) Predict what would happen to the risk premiums on corporate bonds if brokerage
commissions were lowered in the corporate bond market.
Answer:
Lower brokerage commissions for corporate bonds would make them more liquid and thus increase their
demand, which would lower their risk premium.

4) If the income tax exemption on municipal bonds were abolished, what would happen to
the interest rates on these bonds? What effect would it have on interest rates on US
Treasury securities?
Answer:

Abolishing the tax-exempt feature of municipal bonds would make them less desirable relative to
Treasury bonds. The resulting decline in the demand for municipal bonds and increase in
demand for Treasury bonds would raise the interest rates on municipal bonds, while the interest
rates on Treasury bonds would fall.

5) The one-year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%, 9%, 10.5%, 13%,
14.5%, 16%, 17.5%. (a) Using the pure expectations theory, what will be the interest rates on a 3-
year bond and 6-year bond? (b) now assume that the investor prefers holding short-term bonds. A
liquidity premium of 10 basis points is required for each year of a bond’s maturity. What will be
the interest rates on a 3-year bond and 6-year bond?
a: 3-year bond  [(3  4.5  6)]/(3)  4.5%
6-year bond  [(3  4.5  6  7.5  9  10.5)]/(6)  6.75%
b: To solve this problem, you will need to use the following equation:
it  ite1  ite 2     ite n 1
int  lnt 
n
3-year bond  (0.30)  [(3  4.5  6)]/(3)  4.8%
6-year bond  (0.60)  [(3  4.5  6  7.5  9  10.5)]/(6)  7.35%
 6) One-year T-bill rates are 2% currently. If interest rates are expected to go up after 3 years by 2%
every year, what should be the required interest rate on a 10-year bond issued today?
2  2  2  2(1.02)  2(1.02)2      2(1.02)7
Solution: I (10-year bond) 
10
 21.165 /10  2.1165%

7) At your favorite bond store, Bonds-R-Us, you see the following prices:
a. 1-year $100 zero selling for $90.19
b. 3-year 10% coupon $1000 par bond selling for $1000
c. 2-year 10% coupon $1000 par bond selling for $1000
Assume that the pure expectations theory for the term structure of interest rates holds, no liquidity or
maturity premium exists, and the bonds are equally risky. What is the implied 1-year rate two years from
now?
Solution: From (a), you know that the 1-year rate today is 10.877%.
Using this information, (c) tells you that:
1000  100/1.10877  1100/(1  2-year rate)2
So, the 2-year rate today is 9.95%.
Using these two rates, (b) tells you that:
1000  100/1.10877  100/1.09952  1100/(1  3-year rate)3
So, the 3-year rate today is 9.97%
1-year rate 2 years from now  (3  9.97% – 2  9.95%)  10.01%

8) If the interest rates on one- to five-year bonds are currently 4%, 5%, 6%, 7%, and 8%, and the term
premiums for one- to five-year bonds are 0%, 0.25%, 0.35%, 0.40%, and 0.50%, predict what the one-
year interest rate will be two years from now.

Solution: The expected one-year interest rate two years from now is
ite 2  [(1  i3t  k3t)3/(1  i2t  k2t)2]  1
[(1  0.06  0.0035)3/(1  0.05  0.0025)2]  1
   0.075  7.5%.