Chapter 15 The Term Structure of Interest Rates
57. What is the yield to maturity of a 1-year bond? A) 4.6% B) 4.9% C) 5.2% D) 5.5% E) 5.8%
Answer: A Difficulty: Moderate Rationale: 4.6% (given in table)
58. What is the yield to maturity of a 5-year bond? A) 4.6% B) 4.9% C) 5.2% D) 5.5% E) 5.8%
Answer: C Difficulty: Moderate Rationale: [(1.046)(1.049)(1.052)(1.055)(1.058)]1/5 -1 = 5.2%
59. What is the yield to maturity of a 4-year bond? A) 4.69% B) 4.95% C) 5.02% D) 5.05% E) 5.08%
Answer: C Difficulty: Moderate Rationale: [(1.046)(1.049)(1.052)(1.055)]1/4 -1 = 5.05%
60. What is the yield to maturity of a 3-year bond? A) 4.6% B) 4.9% C) 5.2% D) 5.5% E) 5.8%
Answer: B Difficulty: Moderate Rationale: [(1.046)(1.049)(1.052)]1/3 -1 = 4.9%
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Chapter 15 The Term Structure of Interest Rates
61. What is the yield to maturity of a 2-year bond? A) 4.6% B) 4.9% C) 5.2% D) 4.7% E) 5.8%
Answer: D Difficulty: Moderate Rationale: [(1.046)(1.049)]1/2 -1 = 4.7%
Essay Questions
62. Discuss the three theories of the term structure of interest rates. Include in your
discussion the differences in the theories, and the advantages/disadvantages of each.
Difficulty: Moderate
Answer:
The expectations hypothesis is the most commonly accepted theory of term structure. The theory states that the forward rate equals the market consensus expectation of future short-term rates. Thus, yield to maturity is determined solely by current and expected future one-period interest rates. An upward sloping, or normal, yield curve would indicate that investors anticipate an increase in interest rates. An inverted, or downward sloping, yield curve would indicate an expectation of decreased interest rates. A horizontal yield curve would indicate an expectation of no interest rate changes.
The liquidity preference theory of term structure maintains that short-term investors dominate the market; thus, in general, the forward rate exceeds the expected short-term rate. In other words, investors prefer to be liquid to illiquid, all else equal, and will demand a liquidity premium in order to go long term. Thus, liquidity preference readily explains the upward sloping, or normal, yield curve. However, liquidity preference does not readily explain other yield curve shapes.
Market segmentation and preferred habitat theories indicate that the markets for
different maturity debt instruments are segmented. Market segmentation maintains that the rates for the different maturities are determined by the intersection of the supply and demand curves for the different maturity instruments. Market segmentation readily explains all shapes of yield curves. However, market segmentation is not observed in the real world. Investors and issuers will leave their preferred maturity habitats if yields are attractive enough on other maturities.
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Chapter 15 The Term Structure of Interest Rates
The purpose of this question is to ascertain that students understand the various explanations (and deficiencies of these explanations) of term structure.
63. Term structure of interest rates is the relationship between what variables? What is
assumed about other variables? How is term structure of interest rates depicted graphically?
Difficulty: Moderate
Answer:
Term structure of interest rates is the relationship between yield to maturity and term to maturity, all else equal. The \interest rates is depicted graphically by the yield curve, which is usually a graph of U.S. governments of different yields and different terms to maturity. The use of U.S. governments allows one to examine the relationship between yield and maturity,
holding risk constant. The yield curve depicts this relationship at one point in time only.
This question is designed to ascertain that students understand the relationships involved in term structure, the restrictions on the relationships, and how the relationships are depicted graphically.
64. Although the expectations of increases in future interest rates can result in an upward
sloping yield curve; an upward sloping yield curve does not in and of itself imply the expectations of higher future interest rates. Explain.
Difficulty: Moderate
Answer:
The effects of possible liquidity premiums confound any simple attempt to extract expectation from the term structure. That is, the upward sloping yield curve may be due to expectations of interest rate increases, or due to the requirement of a liquidity premium, or both. The liquidity premium could more than offset expectations of decreased interest rates, and an upward sloping yield would result.
The purpose of this question is to assure that the student understands the confounding of the liquidity premium with the expectations hypothesis, and that the interpretations of term structure are not clear-cut.
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Chapter 15 The Term Structure of Interest Rates
65. Explain what the following terms mean: spot rate, short rate, and forward rate. Which
of these is (are) observable today?
Difficulty: Moderate
Answer:
From the answer to Concept Check 2, on page 516: “The n-period spot rate is the yield to maturity on a zero-coupon bond with a maturity of n periods. The short rate for period n is the one-period interest rate that will prevail in period n. The forward rate for period n is the short rate that would satisfy a “break-even condition” equating the total returns on two n-period investment strategies. The first strategy is an investment in an n-period zero-coupon bond. The second is an investment in an n-1 period zero-coupon bond “rolled over” into an investment in a one-period zero. Spot rates and forward rates are observable today, but because interest rates evolve with uncertainty, future short rates are not. In the special case in which there is no uncertainty in future interest rates, the forward rate calculated from the yield curve would equal the short rate that will prevail in that period.”
This question checks whether the student understands the difference between each kind of rate.
66. Answer the following questions that relate to bonds.
? A 2-year zero-coupon bond is selling for $890.00. What is the yield to maturity of
this bond?
? The price of a 1-year zero coupon bond is $931.97. What is the yield to maturity of
this bond?
? Calculate the forward rate for the second year.
? How can you construct a synthetic one-year forward loan (you are agreeing now to
loan in one year)? State the strategy and show the corresponding cash flows. Assume that you can purchase and sell fractional portions of bonds. Show all calculations and discuss the meaning of the transactions.
Difficulty: Difficult
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Chapter 15 The Term Structure of Interest Rates
Answer:
Calculations are shown in the table below.
? Calculations for YTM of the 2-year zero: N=2, PV=-890.00, PMT=0, FV=1000,
CPT I?6.0.
? Calculations for YTM of the 1-year zero: N=1, PV=-931.97, PMT=0, FV=1000,
CPT I?7.3.
? Calculations for f2: (1.06)2/(1.073) - 1 = .047157502, f2 = 4.7157502%
? As shown by the calculations below, you purchase enough 2-year zeros to offset the
cost of the 1-year zero. At time 1 the 1-year zero matures and you get $1,000. At time 2 the 2-year zeros mature and you have to pay 1.047157502 * $1,000 = $1,047.16. You are effectively borrowing $1,000 a year from now and paying $1,047.16 a year from then. The rate on this forward loan is $1,047.16/$1,000 - 1 = .04716, which equals the forward rate for the second year (f2).
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