1. Maturity risk premium.
An investor in Treasury securities expects inflation
to be 2.5% in Year 1, 3.2% in Year 2, and 3.6% each year thereafter.
Assume that the real risk-free rate is 2.75% and that this rate will remain
constant. Three-year Treasury securities yield 6.25%, while 5-year Treasury
securities yield 6.80%. What is the difference in the maturity risk premium
(MRPS) on the two securities; that is, what is MRP5 - MRP3?
2. Suppose a CFO is seeking to borrow money for longer than 1 year. He
looks at the US Treasury yield curve and it is upward-sloping. Would it
make sense for him to borrow short- term and renew the loan or borrow
long-term? Explain.
a. Short-Term
b. Long-Term
3. What effect would each of the following events likely have on the level of
nominal interest rates?
a) Households dramatically increase their savings rate.
b) Corporations increase their demand for funds following an increase in
investment opportunities.
c) The government runs a larger-than-expected budget deficit.
d) There is an increase in expected inflation.
e) The economy falls into a recession.
4. Yield curves. Suppose the inflation rate is expected to be 7 percent next
year, 5 percent the following year, and 3 percent thereafter. Assume that
the real risk-free rate, r*, will remain at 2 percent and that maturity risk
premiums on Treasury securities rise from zero on very short-term bonds
(those that mature in a few days) to 0.2 percent for 1-year securities.
Furthermore, maturity risk premiums increase 0.2 percent for each year to
maturity, up to a limit of 1.0 percent on 5-year or longer-term T-bonds.
a) Calculate the interest rate on 1-, 2-, 3-, 4-, 5-, 10-, and 20-year Treasury
securities, and plot the yield curve.
b) Now suppose Exxon Mobil, an AAA-rated company, had bonds with the
same maturities as the Treasury bonds. As an approximation, plot an
Exxon Mobil yield curve on the same graph with the Treasury bond yield
curve. (Hint: Think about the default risk premium on ExxonMobil’s long-
term versus its short-term bonds.)
5. Evaluating lump sums and annuities. Crissie just won the lottery, and she
must choose between three award options. She can elect to receive a
lump sum today of $61 million, to receive 10 end-of-year payments of $9.5
million, or 30 end-of-year payments of $5.5 million.
a) If she thinks she can earn 7 percent annually, which should she choose?
b) If she expects to earn 8 percent annually, which is the best choice?
c) If she expects to earn 9 percent annually, which would you recommend?
d) Explain how interest rates influence the optimal choice.
6. Interest portions and remaining balance. The Jackson family is interested
in buying a home. The family is applying for a $150,000, 30-year
mortgage. Under the terms of the mortgage, they will receive $150,000
today to help purchase their home. The loan will be fully amortized over
the next 30 years. Current mortgage rates are 8 percent. Interest is
compounded monthly and all payments are due at the end of the month.
a) What is the monthly mortgage payment?
b) What will be the remaining balance on the mortgage after the first
year?
