a.

What effect would each of the following events likely have on the level of nominal
interest rates?

1. Households dramatically increase their savings rate.

- The nominal interest rate rises as a result to increases in household savings account rates.
This is because nominal rates rise when households receive substantial returns on their
treasury bills or bond. There is a chance that demand will rise in line with an increase in
the interest rate on household accounts for savings.

2. Corporations increase their demand for funds following an increase in investment

opportunities.
- It is a common knowledge that every corporations need a fund in order to increase the
demand for the product. And when increasing a fund, it could also mean increasing the
rate. Therefore, an increase in the nominal rate would lead to a rise in the demand for
corporate funding.

3. The government runs a larger-than-expected budget deficit.

- This occurrence is also related to the second question, which is when a corporation
increase their budget for funds, it also mean that they will increase the rate, and resulting
to an increase in nominal interest rate. And in this case, when the government have a
budget larger than they expected, it will also lead to an increase in nominal interest rate.
Because, the government will most likely issue investment securities and increase
interest to balance the budget, on the level that they expected, thus resulting to an
increase in nominal rates.

4. There is an increase in expected inflation.

- As we all know, inflation refest to the occurrence where the price of goods and other
commodities increases that could lead to a decrease in purchasing power of the
consumers. When expected inflation rises, the nominal interest rate tends to increase to
compensate for the eroding purchasing power of money. Thus, resulting in an increase
in nominal interest rates.
Beah Toni L. Pacundo
BSA 2-4
b. Suppose you are considering two possible investment opportunities: a 12-year
Treasury bond and a 7-year, A-rated corporate bond. The current real risk-free rate
is 4%, and inflation is expected to be 2% for the next 2 years, 3% for the following
4 years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP
5 0.02(t 2 1)%. The liquidity premium (LP) for the corporate bond is estimated to be 0.3%.
You may determine the default risk premium (DRP), given the company’s bond rating,
from the table below. Remember to subtract the bond’s LP from the corporate spread
given in the table to arrive at the bond’s DRP. What yield would you predict for each of
these two investments?

ANSWER:
12-year Treasury Bond

IP = ((2% x 2) + (3% x4)+(4% × 6))/12= 0.03333 x 100% = 3.33%

MRP=0.02 (12-1)% = 0.22%

Treasury Bond = 4%+3.33% +0.22% = 7.55%

7-year, A-rated Corporate Bond

A-rated Corporate Bond = 4% + (((2% x 2) (3% x 4) 4%) / 7) + (0.02 ) (7-1) %+ 0.54% 0.3% =
7.82%

c. Given the following Treasury bond yield information, construct a graph of the yield
curve.

Beah Toni L. Pacundo

BSA 2-4

d. Based on the information about the corporate bond provided in part b, calculate yieldsand
then construct a new yield curve graph that shows both the Treasury and the corporate
bonds.

12-year Treasury Bond

IP = ((2% x 2) + (3% x4)+(4% × 6))/12= 0.03333 x 100% = 3.33%

MRP=0.02 (12-1)% = 0.22%

Treasury Bond = 4%+3.33% +0.22% = 7.55%

7- year AAA Corporate Bond

= 4% +2.86% +0.12% +0.10% = 7.08%

7-year AA Corporate Bond

= 4%+2.86% +0.12% +0.46% = 7.44%

7-year A Corporate Bond

= 4% + 2.86% + 0.12% + 0.84% = 7.82%

Beah Toni L. Pacundo

BSA 2-4

e. Which part of the yield curve (the left side or right side) is likely to be most volatile
over time?
- The right side of the yield curve would be more volatile as it increases the yield of the bond.

f. Using the Treasury yield information in part c, calculate the following rates using geo
metric averages:
 1. One-year rate, 1 year from now…

(1.0547) ^ 2 = (1.0537)(1 + x)

1.11239209 = 1.0537 + 1.0537x

1.11239209 - 1.0537 = 1.0537x

0.05869209 = 1.0537x

0.05869209/1.0537 1.0537 x/1.0537

0.055700949 = x

x = 5.57%

2. Five-year rate, 5 years from now…

(1.0575) ^ 10 = (1.0564) ^ 5 * (1 + x) ^ 5

1.749056185 = 1.315654825 * (x + 1) ^ 5

1.315654825 * (x + 1) ^ 5 = 1.749056185

(1.315654825 * (x + 1)) / 1.315654825 = 1.749056185 / 1.315654825

(x + 1) ^ 5 = 1.329418744

((x + 1) ^ 5) ^ (1/5) = 1.329418744 ^ (1/5)

x + 1 = 1.058601145

x = 1.058601145 - 1

x = 5.86%
Beah Toni L. Pacundo
BSA 2-4

3. The Ten-year rate, 10 years from now…

(1.0633) ^ 20 = (1.0575) ^ 10 * (1 + x) ^ 10

3.412842745 = 1.749056185 * (x + 1) ^ 10

1.749056185 * (x + 1) ^ 10 = 3.412842745

(1.749056185(x+1)^10) / (1.749056185) = 3.412842745 / 1.749056185

 (x + 1) ^ 10 = 1.951248207

((x + 1) ^ 10) ^ (1/10) = 1.951248207 ^ (1/10)

x+1=1.069131811

x = 1.069131811 - 1

x= 6.91%

4. The Ten-year rate, 20 years from now…

(1.0594) ^ 30 = (1.0633) ^ 20 * (1 + x) ^ 10

5.646756468 = 3.412842745 * (x + 1) ^ 10

3.412842745 * (x + 1) ^ 10 = 5.646756468

(3.412842745 * (x + 1) ^ 10)/3.412842745 = 5.646756468 / 3.412842745

(x + 1) ^ 10 = 1.654560989

((x + 1) ^ 10) ^ (1/10) = 1.654560989 ^ (1/10)

x + 1 = 1.05164286

x=1.051642861-1

x= 5.16%