Running Head: HOMEWORK CHAPTER #5

Chapter 5 Homework Solutions

Questions

1.1 Briefly explain why bonds that have the same maturities often do not have the same interest
rates.
The reason why bond that have the same maturities often do not have the same interest rates
is because they may differ with other features that investors consider crucial such as taxation,
liquidity, information cost and risks. Favorable bonds have lower interest rates because investors are
willing to accept lower expected return on those bonds. In the same form, bonds that are less
favorable have higher interest rates because investors expect higher returns on those bonds.
Economists call this effect “risk structure of interest rates”.

1.4 What are the two types of income an investor can earn on a bond? How is each taxed?

The first type of income is the interest from coupon payments. These payments are included
in the income when paying taxes, and the tax of each coupon depends on who issued the bond and
where the investor lives. For instance, corporate bonds are taxed by some state and local governments,
and the federal government apply taxes to Corporate Bonds and U.S. Treasury Bonds. Municipal
bonds are tax-free.
The second type of income is the capital gains (or losses) from price changes on the bonds.
Interest income is taxed at the same rates as wage and salary income. Taxes apply only if the investor
sells the bond for a higher price than he or she paid for it. In other words, when it is realized.

2.2 How does the Treasury yield curve illustrate the term structure of interest rates?

The Treasury Yield is the relationship on a particular day among the interest rates on Treasury
bonds with different maturities. When short-term are lower than long-term rates, there is an upward-
sloping yield curve; and when short-term interest rates are higher than long-term interest rates, which
happens not often, there is a downward-sloping curve. The last one is also called inverted yield
curves. Additionally, interest rates on bonds of different maturities tend to move together.

2.4 Briefly describe the three theories of the term structures.

1) Expectations Theory: this basically consists in viewing bonds of different maturities as being
perfect substitutes for one another. This theory assumes that the returns from two strategies,
such as buy-and-hold and rollover, must be the same.

2) Segmented Markets Theory: this theory holds that the interest rate on a bond of a particular
maturity is determined only by the demand and supply of bonds of that maturity. This implies
that investors have not all the same objective and do not see bonds of different maturities as
being perfect substitutes for each other.
3) Liquid Premium Theory or Preferred Habitat Theory: holds that the interest rate on a long-
term bond is an average of the interest rates investors expect on short-term bonds over the
lifetime of the long-term bond, plus a term premium. This is the additional interest investors
require in order to be willing to buy a long-term bond rather than a comparable sequence of
short-term bonds.
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Problems
1.7 According to Moody’s, “Obligations rated Aaa are judged to be of the highest quality,
subject to the lowest level of credit risk.”
a. What “obligations” is Moody’s referring to?

Moody´s refer to the obligations relies on the payments of interests or principles that the bond
issuer needs to pay to the bond holder.

b. What does Moody’s mean by “credit risk”?

Moody´s mean by credit risk to the risk that a bond issuer will have to make (or default) to
make payments of interest or principal.

1.16 Suppose that, holding yield constant, investors are indifferent as to whether they hold
bonds issued by the federal government or bonds issued by state and local governments (that is,
they consider the bonds the same with respect to default risk, information costs, and liquidity).
Suppose that state governments have issued perpetuities (or consoles) with $75 coupons and
that the federal government has also issued perpetuities with $75 coupons. If the state and
federal perpetuities both have after-tax yields of 8%, what are their pretax yields? (Assume that
the relevant federal income tax rate is 39.6%.)
Pretax yield = (8%) / (1-39.6%) = 0.1324 = 13.24%
2.8 Suppose that the interest rate on a one-year Treasury bill is currently 1% and that
investors expect that the interest rates on one-year Treasury bills over the next three years will
be 2%, 3%, and 2%. Use the expectations theory to calculate the current interest rates on two-
year, three-year, and four-year Treasury notes.
e
i1 t+i 1 t +1
i2 t=
2

2- year = (1% + 2%) / 2 = 1.50%

i1 t+i e1 t +1 i e1 t +2
i3 t=
3

3-year = (1% + 2% + 3%) / 3 = 2.00%

e e e
i1 t+i 1 t +1+i 1 t +2 +i 1t +3
i 4 t=
4

4-year = (1% + 2% + 3%) / 4 = 2.00%

2.12 [Related to Solved Problem 5.2B on page 163] Use the data on Treasury securities in the
table to answer the following question:
1 year 2 year 3 year
0.75% 1.25% 2.00%

Assuming that the liquidity premium theory is correct, what did investors on this day expect the
interest rate to be on the one-year Treasury bill two years from now if the term premium on a
HOMEWORK CHAPTER #5

two-year Treasury note was 0.10% and the term premium on a three-year Treasury note
was 0.25%? Assume that all three securities are discount bonds that pay no coupons.

I1t = 0.75%

I2t = (0.75% + 1.25% / 2) + 0.10% = 1.10%

I2t = (0.75% + 1.25% + 2.00% / 3) + 0.25% = 1.58%