UNIT 2: INTEREST RATE DETERMINATION

Numerical Questions

1. The real risk-free rate of interest is 3 percent. Inflation is expected to be 6 percent this year, 7 percent in
the second year and 8 percent in the third year. Assume that the maturity risk premium is zero. What is
the yield on 2-year Treasury securities? What is the yield on 3-year Treasury securities? (Ans: 9.5%;
10%)

2. Assume that the yield on Treasury bill is 5.5 percent. A security analyst has estimated the following
current interest rate premiums:
Inflation premium=3.25%
Liquidity premium=0.6%
Maturity risk premium=1.8%
Default risk premium=2.15%
On the basis of these data, what is the real risk-free rate of return? (Ans: 2.25%)

3. Suppose you and most other investors expect the inflation rate to be 7 percent next year, to fall to 5
percent during the following year, then to remain at a rate of 3 percent thereafter. Assume that the real
risk-free rate 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 a level of 0.2 percentage point on 1-
year securities. Furthermore, maturity risk premium increase 0.2 percentage point for each year to
maturity up to a limit of 1.0 percentage point on 5-year or longer-term T bonds. Calculate the interest
rate on 1,2,3.4,5,10 and 20-year treasury securities. (Ans: 9.2; 8.4;7.6; 7.3; 7.2; 6.6; 6.3)

4. Assume that it is now January 1, 2021. The rate of inflation is expected to be 6 percent throughout 2021.
However, increased government deficits and renewed vigor in the economy are then expected to push
inflation rates higher. Investors expect the inflation rate to be 7 percent in 2022, 8 percent in 2023 and 9
percent in 2024. The real risk-free rate currently is 3 percent. Assume that no maturity risk premiums are
required on bonds with 5 years or less to maturity. The current interest rate on 5-year T-bonds in 11
percent.
a. What is the average expected inflation rate over the next 4 years? (7.5%)
b. What should be the prevailing interest rate on 4-year T bonds? (10.5%)
c. What is the implied expected inflation rate in 2025, or year 5, given that bonds which mature in
that year yield 11 percent? (10%)

5. It is now January 1, 2021. Inflation is about 3 percent, throughout 2021. The government took action to
maintain inflation at this level. However, the economy is in a recovery, and reports indicate that inflation
is expected to increase during the next 4 years. Assume that at the beginning of 2022, the rate of
inflation expected for 2022 is 4 percent; for 2023, it is expected to be 5 percent; for 2024, it is expected
to be 6 percent and expected to settle at this level thereafter.
a. What is the average expected inflation rate over the next 4-year period 2022-2025? (5.25%)

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 b. What average nominal interest rate, over the 4-year period 2022-2025, would be expected to produce
3 percent real risk-free rate of return on 4-year Treasury securities? (8.25%)
c. Assume a real risk-free rate of 3 percent and a maturity risk premium which starts at 0.05 percent
and increase by 0.05 percent each year, estimate the interest rate in January 2022 on the bonds that
mature in 1,2, 5, 10,20 years? (7.05; 7.60; 8.65; 9.20; 9.85)
d. Describe the general economic condition that could be expected to produce an upward sloping yield
curve.

6. Assume that the real risk-free rate is 3 percent and the inflation is expected to be 8 percent in year 1, 5
percent in year 2, and 4 percent thereafter. Assume also that all Treasury bonds are highly liquid and
free of default risk. If 2-year and 5-year Treasury bonds both yield 10 percent.
a. What is the maturity premium on 2-year bond? (0.5%)
b. What is the maturity premium on 5-year bond? (2%)
c. Why does maturity premium on two bonds differ? (Longer term bonds are exposed to more
interest rate risk)

7. Due to the recession, the rate of inflation expected for the coming year is only 3 percent. However, the
rate of inflation in year 2 and thereafter is expected to be constant at some level above 3 percent.
Assume that the real risk-free rate is 2 percent for all the maturities and the expectation theory fully
explains the yield curve, so there are no maturity premiums. If 3-year Treasury bonds yield 2 percentage
points more than 1-year bonds, what rate of inflation is expected after year 1? (6%)

8. The real risk-free rate is 3.5 percent. Inflation is expected to average 2.8 percent a year for the next four
years, after which time inflation is expected to average 3.75 percent a year. Assume that there is no
maturity risk premium. An 8-year corporate bond has yield of 8.3 percent. Assume that liquidity risk
premium on the corporate bond is 0.5 percent. What is the default risk premium on the corporate bond?
(1.025%)

9. 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 rate is 2.75%, and that this rate will remain constant over time.
Three-year Treasury securities yield 6.25% while 5-year Treasury securities yield 6.80%. What is the
difference in the maturity risk premium (MRP) on the two securities, i.e., what is MRP5 – MRP3?
(0.35%)

10. The real risk-free rate is 5 %. Inflation is expected to be 8 % in year 1 and 9 % thereafter. What is the
yield on 1-year securities? What is the yield on 4 years securities? Why the yields on long-term
securities are greater? (13%; 13.75%)