Chapter5HowDoRiskandTermStructureAffectInterestRates?

49

Quantitative Problems Chapter 5

1.

(a)Theyieldtomaturitywouldbe5%foraoneyearbond,6%foratwoyearbond,6.33%fora
threeyearbond,6.5%forafouryearbond,and6.6%forafiveyearbond.(b)Theyieldtomaturity
wouldbe5%foraoneyearbond,4.5%foratwoyearbond,4.33%forathreeyearbond,4.25%for
afouryearbond,and4.2%forafiveyearbond.Theupwardslopingyieldcurvein(a)wouldbe
evensteeperifpeoplepreferredshorttermbondsoverlongtermbondsbecauselongtermbonds
wouldthenhaveapositiveriskpremium.Thedownwardslopingyieldcurvein(b)wouldbeless
steepandmightevenhaveaslightpositiveupwardslopeifthelongtermbondshaveapositiverisk
premium.

2.

GovernmenteconomistshaveforecastedoneyearTbillratesforthefollowingfiveyears,asfollows:
Year
1
2
3
4
5

1yearrate
4.25%
5.15%
5.50%
6.25%
7.10%

Youhaveliquiditypremium0.25%forthenexttwoyearsand0.50%thereafter.Wouldyoube
willingtopurchaseafouryearTbondata5.75%interestrate?
Solution: Yourrequiredinterestrateona4yearbondAverageintereston4oneyearbonds
LiquidityPremium
(4.25%5.15%5.50%6.25%)/40.5%
5.29%0.50%5.79%
Atarateof5.75%,theTbondisjustbelowyourrequiredrate.
3.

Whatistheyieldona$1,000,000municipalbondwithacouponrateof8%,payinginterestannually,
versustheyieldofa$1,000,000corporatebondwithacouponrateof10%payinginterestannually?
Assumethatyouareinthe25%taxbracket.
Solution: Municipalbondcouponpaymentsequal$80,000peryear.Notaxesarededucted;
therefore,theyieldwouldequal8%.
Thecouponpaymentsonacorporatebondequal$100,000peryear.Butyouonly
keep$75,000becauseyouareinthe25%taxbracket.Thereforeyouraftertaxyield
isonly7.5%

Chapter5HowDoRiskandTermStructureAffectInterestRates?50

4.

Considerthedecisiontopurchaseeithera5yearcorporatebondora5yearmunicipalbond.The
corporatebondisa12%annualcouponbondwithaparvalueof$1,000.Itiscurrentlyyielding
11.5%.Themunicipalbondhasan8.5%annualcouponandaparvalueof$1,000.Itiscurrently
yielding7%.Whichofthetwobondswouldbemorebeneficialtoyou?Assumethatyourmarginal
taxrateis35%.
Solution: Municipal
PurchasePrice
$1,061.50
AftertaxCouponPayment $85
ParValue
$1,000
CalculatedYTM
CorporateBond
PurchasePrice
AftertaxCouponPayment
ParValue

7%
$1,018.25
$78
$1,000

CalculatedYTM
7.35%
Thecorporatebondoffersahigheryield,andisthebetterbuy.
5.

DebtissuedbySoutheasternCorporationcurrentlyyields12%.Amunicipalbondofequalrisk
currentlyyields8%.Atwhatmarginaltaxratewouldaninvestorbeindifferentbetweenthesetwo
bonds?
Solution: CorporateBonds(1TaxRate)MunicipalBonds
12%*(1TaxRate)8%
1TaxRate0.67,orTaxRate0.33

6.

1yearTbillratesareexpectedtosteadilyincreaseby150basispointsperyearoverthenext6years.
Determinetherequiredinterestrateona3yearTbondanda6yearTbondifthecurrent1year
interestrateis7.5%.AssumethatthePureExpectationsHypothesisforinterestratesholds.
Solution: 3yearbond:
year1interestrate7.5%
year2interestrate9.0%
year3interestrate10.5%
numberofyears3
(7.5%9.0%10.5%)/39.0%
6yearbond:
year1interestrate7.5%
year2interestrate9.0%
year3interestrate10.5%
year4interestrate12%
year5interestrate13.5%
year6interestrate15%
(7.5%9.0%10.5%12%13.5%15%)/611.25%

Chapter5HowDoRiskandTermStructureAffectInterestRates?51

7.

Theoneyearinterestrateoverthenext10yearswillbe3%,4.5%,6%,7.5%,9%,10.5%,13%,
14.5%,16%,17.5%.Usingthepureexpectationstheory,whatwillbetheinterestratesona3year
bond,6yearbond,and9yearbond?
Solution: 3yearbond[(34.56)]/(3)4.5%
6yearbond[(34.567.5910.5)]/(6)6.75%
9yearbond[(34.567.5910.51314.516)]/(9)9.333%

8.

Usingtheinformationforthepreviousquestion,nowassumethatinvestorpreferholdingshortterm
bonds.Aliquiditypremiumof10basispointsisrequiredforeachyearofabondsmaturity.What
willbetheinterestratesona3yearbond,6yearbond,and9yearbond?
Solution: Tosolvethisproblem,youwillneedtousethefollowingequation:
it ite1 ite 2 ite n 1
n
3yearbond(0.30)[(34.56)]/(3)4.8%
6yearbond(0.60)[(34.567.5910.5)]/(6)7.35%
9yearbond(0.90)[(34.567.5910.51314.516)]/(9)10.233%
int lnt

9.

Whichbondwouldproduceagreaterreturnifthepureexpectationstheorywastoholdtrue,a2year
bondwithaninterestrateof15%ortwo1yearbondswithsequentialinterestpaymentof13%and
17%?
Solution: Bothofthebondswouldproducethesamereturn.Two2yearbonds:
(13%17%)/2
15%

10. LittleMonstersInc.borrowed$1,000,000fortwoyearsfromNorthernBankInc.atan11.5%interest
rate.Thecurrentriskfreerateis2%andLittleMonsterssfinancialconditionwarrantsadefaultrisk
premiumof3%andaliquidityriskpremiumof2%.Thematurityriskpremiumfortwoyearloanis
1%andinflationisexpectedtobe3%nextyear.Whatdoesthisinformationimplyabouttherateof
inflationinthesecondyear?
Solution: Ifinflationwereexpectedtoremainconstantat3%overthelifeoftheloan,theinterest
rateonthetwoyearloanwouldbe11%.Sincetheactualtwoyearinterestrateis11.5%,
theoneyearinterestrateinyear2mustbe12%,since11.5(1112)/2.
Therequiredrateof12%RfDRPLPMRPInflationPremium.
2%3%2%1%InflationPremium.
So,theInflationPremiuminyear2is4%.Butthisisanaveragepremiumovertwoyears.
InflationPremium4%(Year1InflationYear2Inflation)/2
(3%x)/2
Or,x5%

Chapter5HowDoRiskandTermStructureAffectInterestRates?52

11. OneyearTbillratesare2%currently.Ifinterestratesareexpectedtogoup,after3years,by2%
everyyear,whatshouldbetherequiredinterestrateona10yearbondissuedtoday?

Chapter5HowDoRiskandTermStructureAffectInterestRates?53

Solution:
2 2 2 2(1.02) 2(1.02)2 2(1.02)7
10
21.165/10 2.1165%

I (10yearbond)

12. OneyearTbillratesoverthenext4yearsareexpectedtobe3%,4%,5%,&5.5%.If4yearTbonds
areyielding4.5%,whatistheliquiditypremiumonthisbond?
Solution: 4.5%(3%4%5%5.5%)/4LP
4.5%4.375%LP
0.125%LP
13. Atyourfavoritebondstore,BondsRUs,youseethefollowingprices:
(a) 1year$100zerosellingfor$90.19
(b) 3year10%coupon$1000parbondsellingfor$1000
(c) 2year10%coupon$1000parbondsellingfor$1000
Assumethatthepureexpectationstheoryforthetermstructureofinterestratesholds,noliquidityor
maturitypremiumexists,andthebondsareequallyrisky.Whatistheimplied1yearratetwoyears
fromnow?
Solution: From(a),youknowthatthe1yearratetodayis10.877%.
Usingthisinformation,(c)tellsyouthat:
1000100/1.108771100/(12yearrate)2
So,the2yearratetodayis9.95%.
Usingthesetworates,(b)tellsyouthat:
1000100/1.10877100/1.099521100/(13yearrate)3
So,the3yearratetodayis9.97%
1yearrate2yearsfromnow(39.97%29.95%)10.01%
14. Youobservethefollowingmarketinterestrates,forbothborrowingandlending:
oneyearrate5%
twoyearrate6%
oneyearrateoneyearfromnow7.25%
Howcanyoutakeadvantageoftheseratestoearnarisklessprofit?AssumethatthePureExpectation
Theoryforinterestratesholds.
Solution: Borrow$100todayatthetwoyearrate.Youwillberequiredtopayback$100(1.06)2,
or$112.36intwoyears.

Chapter5HowDoRiskandTermStructureAffectInterestRates?54

Simultaneously,lendthe$100youborrowedattheoneyearrateof5%.Ayearlater,you
willhave$105.Again,lendthe$105attheoneyearrateof7.25%.Attheendofthatyear,
youwillhave$105(1.0725)$112.6125.
Usethe$112.6125topayoffthe$112.36youowe.Thisleaves$0.2525inprofit.Recall
thatthisrequirednocashupfront.Aslongasthefuturerateof7.25%isguaranteed,you
canrisklesslymakeaprofit.
15. Theexpectedoneyearinterestratetwoyearsfromnowis ite 2 [(1i3tk3t)3/(1i2tk2t)2]1
[(10.060.0035)3/(10.050.0025)2]10.0757.5%.