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Tutorial Answer for Chapter 5
1. Which should have the higher risk premium on its interest rates, a corporate bond with a
Moody’s Baa rating or a corporate bond with a C’s rating? Why? The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its demand and raises its interest rate relative to that of the Baa bond.
2. Why do US treasury bills have lower interest rates than large-denomination negotiable bank
CDs? U.S. Treasury bills have lower default risk and more liquidity than negotiable CDs. Consequently, the demand for Treasury bills is higher, and they have a lower interest rate.
Quantitative Problems
1. The 1- year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%, 9%, 10.5%, 13%,
14.5%, 16%, and 17.5%. Using the expectations theory, what will be the interest rate on 3- year bond, 6-year bond and 9-year bond? Solution: Average out the interest rate by the period of bond 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% 9-year bond = [(3 + 4.5 + 6 + 7.5 + 9 + 10.5 + 13 + 14.5 + 16)]/ (9) = 9.333%
2. Using the information from the previous question, now assume that investors prefer holding
short-term bonds. A liquidity premium of 10 basis points is required for each year of bond’s maturity. What will be the interest rates on a 3-year bond, 6-year bond, and 9-year bond? Solution: to solve the problem, you need to use the equation (of liquidity theory page 145): 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% 9-year bond = (0.90) + [(3 + 4.5 + 6 + 7.5 + 9 + 10.5 + 13 + 14.5 + 16)]/ (9) = 10.233%
Answer for Tutorial Chapter 6
1.
If higher money growth is associated with higher future inflation and if announced money growth turns out to be extremely high but is still less than the market expected, what do you think would happen to long-term bond
1. Which should have the higher risk premium on its interest rates, a corporate bond with a
Moody’s Baa rating or a corporate bond with a C’s rating? Why? The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its demand and raises its interest rate relative to that of the Baa bond.
2. Why do US treasury bills have lower interest rates than large-denomination negotiable bank
CDs? U.S. Treasury bills have lower default risk and more liquidity than negotiable CDs. Consequently, the demand for Treasury bills is higher, and they have a lower interest rate.
Quantitative Problems
1. The 1- year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%, 9%, 10.5%, 13%,
14.5%, 16%, and 17.5%. Using the expectations theory, what will be the interest rate on 3- year bond, 6-year bond and 9-year bond? Solution: Average out the interest rate by the period of bond 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% 9-year bond = [(3 + 4.5 + 6 + 7.5 + 9 + 10.5 + 13 + 14.5 + 16)]/ (9) = 9.333%
2. Using the information from the previous question, now assume that investors prefer holding
short-term bonds. A liquidity premium of 10 basis points is required for each year of bond’s maturity. What will be the interest rates on a 3-year bond, 6-year bond, and 9-year bond? Solution: to solve the problem, you need to use the equation (of liquidity theory page 145): 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% 9-year bond = (0.90) + [(3 + 4.5 + 6 + 7.5 + 9 + 10.5 + 13 + 14.5 + 16)]/ (9) = 10.233%
Answer for Tutorial Chapter 6
1.
If higher money growth is associated with higher future inflation and if announced money growth turns out to be extremely high but is still less than the market expected, what do you think would happen to long-term bond