CHAPTER 4: THE LEVEL AND TERM STRUCTURE OF INTEREST RATES

PROBLEMS AND QUESTIONS WITH SOLUTIONS

1. Explain the impacts of the following cases on the level of interest rates.
a. Expansionary open market operation
b. Economic Recession
c. Treasury financing of a government deficit
d. Economic Expansion
e. China Purchase of U.S. Treasury Securities

a. Expansionary Open Market Operation: Central Bank buys bonds, decreasing the
bond supply. The impact would be an increase in bond prices and a decrease in interest
rates. Intuitively, as the central bank buys bonds, they will push the price of bonds up
and interest rates down.

b. Economic Recession: In an economic recession, there is less capital formation and

therefore fewer bonds are sold. This leads to a decrease in bond supply. The decrease in
supply initially leads to an excess demand for bonds given fewer bonds; this excess
demand increases bond prices and lowers interest rates. The recession may also lead to a
decrease in bond demand. This would, in turn, cause bond prices to fall and rates to
increase. If the supply effect dominates the demand effect, then rates will fall; if the
demand effect dominates, then rates will increase.

c. Treasury Financing of a Deficit: With a government deficit, the Treasury will have to
sell more bonds to finance the shortfall. Their sale of bonds will increase the supply of
bonds, creating an excess supply of bonds. This excess supply will force bond prices
down and interest rates up.

d. Economic Expansion: In a period of economic expansion, there is an increase in capital

formation and therefore more bonds are being sold to finance the capital expansion.
This leads to an increase in bond supply. The increase in supply initially leads to an
excess supply for bonds, decreasing bond prices and increasing interest rates. The
expansion may also lead to an increase in bond demand. This would, in turn, cause bond
prices to increase and rates to decrease. If the supply effect dominates the demand effect,
then rates will increase; if the demand effect dominates, then rates will decrease.

e. China Purchase of U.S. Treasury Securities: If we limit the definition of bond

supply to those bonds held by the public and not the central bank or foreigner central
banks, then, like an expansionary OMO, the purchase of U.S. Treasuries by China
would lead to a decrease in the supply of bonds, creating an excess demand that
would push U.S. bond prices up and rates down.

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2. Given two identical bonds that are priced with the same yields, explain the
adjustments that would takes place if events were to occur that would make one of the
bonds more risky.

The increased riskiness on the one bond would cause its demand to decrease. That bonds
riskiness would also make the other bond more attractive, increasing its demand. At the new
equilibriums, the riskier bonds price is lower and its rate greater than the other. The
different risk associated with bonds leads to a market adjustment in which at the new
equilibrium there is a positive risk premium.

3. Given two identical bonds that are priced with the same yields, explain the market
adjustments that would takes place if events were to occur that would make one of the
bonds less liquid.

The decrease in liquidity on one of the bonds would cause its demand to decrease. The
decrease in that bonds liquidity would also make the other bond relatively more liquid,
increasing its demand. Once the markets adjust to the liquidity difference between the
bonds, then the less liquid bonds price would be lower and its yield greater than the more
liquid bond. Thus, the difference in liquidity between the bonds leads to a market adjustment
in which there is a difference between rates due to their different liquidity features.

4. Explain how the YTM on some high quality municipal bonds that are subject to
some default have historically been less than the YTM on T-bonds that are default
free.

Municipals are tax-exempt. As a result, they can trade at lower before-tax YTM than
many other bonds that are taxable.

5. Using the Market Segmentation Theory, outline the impacts on the term structure
of interest rates of the following cases:
a. Economic Recession
b. Economic Expansion
c. Expansionary open market operation in which the Central Bank buys S-T
Treasuries.
d. Treasury sale of long-term Treasury bonds.
e. Treasury purchase of long-term Treasury bonds

a. Outline: Decrease in capital formation (S-T and L-T) Fewer bonds sold (S-T and
L-T) Excess demand for bonds (S-T and L-T) Bond prices increase and rates
decrease. Downward shift in YC.

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b. Outline: Increase in capital formation (S-T and L-T) More bonds sold (S-T and L-
T) Excess supply of bonds (S-T and L-T) Bond prices decrease and rates
increase. Upward shift in YC.

c. Outline: Central Bank buys S-T Treasuries (T-bills) T-bill prices increase and rates
decrease Substitution effect in which the demand for S-T corporate securities
increase, causing their prices to increase and their yields to decrease. Tendency for
YC to become positively sloped.

d. Outline: Treasury sells L-T Treasuries (T-Bonds) T-Bond prices decrease and
yields increase Substitution effect in which the demand for L-T corporate
securities decrease, causing their prices to decrease and their rates to increase.
Tendency for YC to become positively sloped.

e. Outline: Treasury buys L-T Treasuries (T-Bonds) T-Bond prices increase and
yields decrease Substitution effect in which the demand for L-T corporate
securities increase, causing their prices to increase and their rates to decrease.
Tendency for YC to become negatively sloped

6. Explain the equilibrium adjustments that would occur in the short-term and long-
term bond markets for the following cases:
a. Investors in corporate securities, on average, prefer short-term to long-term
instruments, whereas corporations have a greater need to finance long-term
assets than short-term, and therefore prefer to issue more long-term bonds
than short-term.
b. Investors in corporate securities, on average, prefer long-term to short-term
instruments, whereas corporations have a greater need to finance short-term
assets than long-term, and therefore prefer to issue more short-term bonds
than long-term.

a. The combination of investors preferring short-term bonds investments, while

corporations prefer to sell long-term bonds would lead to an excess demand for short-
term bonds and an excess supply for long-term claims. An equilibrium adjustment
would have to occur in both markets. Specifically, the excess supply in the long-term
market would force issuers to lower their bond prices, thus increasing bond yields and
inducing some investors to change their short-term investment demands. In the short-
term market, the excess demand would cause bond prices to increase and rates to fall,
inducing some corporations to finance their long-term assets by selling short-term
claims. Ultimately, equilibriums in both markets would be reached with long-term
rates higher than short-term rates, a premium necessary to compensate investors and
borrowers/issuers for the risk they have assumed.

b. In this case the combination of investors preferring long-term bonds investments,

while corporations prefer to sell short-term bonds would lead to an excess supply for
short-term bonds and an excess demand for long-term claims. The excess supply in

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 the short-term market would force issuers to lower their bond prices, thus increasing
bond yields and inducing some investors to change their long-term investment
demands. In the long-term market, the excess demand would cause bond prices to
increase and rates to fall, inducing some corporations to finance their long-term assets
by selling long-term claims. Equilibriums in both markets would be reached with
long-term rates lower than short-term rates.

7. Explain Expectations Theory intuitively and with an example. In your example

assume a flat yield curve with one- and two-year bonds at 6% and an expectation of
next year's yield curve being flat with one- and two-year bonds at 8%. Explain the
theory only in terms of the response to the expectation by investors with one-year
and two-year horizon dates.

Investors with horizon dates of two years can buy the two-year bond with an annual rate
of 6%, or they can buy the one-year bond yielding 6%, then reinvest the principal and
interest one year later in another one-year bond expected to yield 8%. In a risk-neutral
market, such investors would prefer the latter investment since it yields a higher expected
average annual rate for the two years of 7%:

E ( R ) [(1.06)(1.08)]1 / 2 1 .07

Similarly, investors with one-year horizon dates would also find it advantageous to buy a
one-year bond yielding 6% than a two-year bond (priced at $890 = $1,000/1.06 2) that they
would sell one year later to earn an expected rate of only 4.037%:

$1,000
PMt P20 $890
(1.06) 2
$1,000
E (P11 ) $925.93
(1.08)1
$925.93 $890
E (R ) .04037
$890

Thus, in a risk-neutral market with an expectation of higher rates next year, both
investors with one-year horizon dates and investors with two-year horizon dates would
purchase one-year instead of two-year bonds. If enough investors do this, an increase in
the demand for one-year bonds and a decrease in the demand for two-year bonds would
occur until the average annual rate on the two-year bond is equal to the equivalent annual
rate from the series of one-year investments (or the one-year bond's rate is equal to the
rate expected on the two-year bond held one year). For example, if the price on a two-
year bond fell such that it traded at a YTM of 7%, and the rate on a one-year bond stayed
at 6%, then risk-neutral investors with two-year horizon dates would be indifferent
between a two-year bond yielding a certain 7% and a series of one-year bonds yielding
6% and 8%, for an expected rate of 7%. Investors with one-year horizon dates would

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likewise be indifferent between a one-year bond yielding 6% and a two-year bond
purchased at 7% (price of $873.44 = $1,000/(1.07)2) and sold one year later at 8% (price
of $925.93 = $1,000/1.08) for an expected one-year rate of 6% (= ($925.93 $873.44)/
$873.44). Thus in this case, the impact of the market's expectation of higher rates would
be to push the longer-term rates up. Moreover, when the equilibrium YTM on the two-
year bond is 7% and the equilibrium YTM on the one-year bond is 6%, the implied
forward rate on one year bond one year from now is 8%the same as the expected rate
on a one-year bond, one year from:
YTM 2 [(1 YTM 1 )(1 f11 )]1 / 2 1
(1 YTM 2 ) 2
f11 1
(1 YTM 1 )
(1.07) 2
f11 1 .08
(1.06)

Thus in equilibrium, the implied forward rate is equal to the expected spot rate.

B2D P2B r2

YTM

8%


7%
6%

M
1 yr 2 yr

8. Explain how borrowers/issuers with one-year and two-year assets to finance would
respond to the market expectations case in Question 7. Do the impacts of their
actions on the yield curve complement the actions of investors?

In terms of question 7, a bond issuer financing a two-year asset (a two-year borrower)

would consider issuing either a two-year bond at 6% or a series of one-year bonds: one-
year today at 6% and a one-year bond one year later at 8% for an average rate of 7%.

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Given this choice, the two-year borrower would therefore prefer to issue two-year bonds
at 6%. On the other hand, a bond issuer financing a one-year asset (a one-year borrower)
could issue either one-year bonds at 6% or issue a two-year bond at 6% (for example,
borrowing $890 = $1,000/(1.06)2) and then buy the bond back in the market (or prepay)
one year later when rates are at 8% and the price on bond is $952.93 (= $1,000/1.08),
paying a one-year borrowing rate of 4.037% (= ($952.93 /$890) 1). Thus, given this
choice, a one-year borrower would also prefer to issue two-year bonds instead of one-
year. In the two-year market, the expectation of higher rates would cause the supply of
two-year bonds to increase, lowering their price and increasing the two-year yield. This
would, in turn, reinforce the demand impact where the demand and price for two-year
bonds are decreasing, causing two-year yields to increase. In the one-year market, the
expectation of higher rates would cause the supply of one-year bonds to decrease,
increasing their price and lowering the one-year yield. This would, in turn, reinforce the
demand impact where the demand and price for one-year bonds are increasing, causing
one-year yields to decrease.

In equilibrium, the increase in the supply of two-year bonds and the decrease in the
supply for one-year bonds, combined with the demand adjustments of one-year bond
demand increasing and two-year bond demand decreasing will continue until the average
annual rate on the two-year bond is equal to the equivalent annual rate from the series of
one-year loans (or the one-year bond's rate is equal to the rate expected on the two-year
bond held one year). This is the same equilibrium condition governing bond investors.
Thus, similar to investors, the response of issuers/borrowers to the expectation of higher
rates contributes to the steepening of the yield curves.

9. Outline the impacts the following market expectations have on the yield curve:

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 a. A flat yield curve at 8% with a market expectation of a flat yield curve at 12%
one year later.
b. A flat yield curve at 10% with a market expectation of a flat yield curve at 8%
one year later.
c. A yield curve with one-year bonds at 6% and two-year at 7%, with the
expectation of a flat yield curve at 8% one year later.

a. Outline: (1) Given HD = 2 years, investors would prefer a series of one-year bonds at
10% = [(1.08)(1.12)]1/2 1 to a two-year bond at 8% (also holds for investors with
HD = 1 year). (2) Market Response: Demand for 2-year bonds would decrease,
causing their price to decrease and their yield to increase and the demand for 1-year
bonds would increase, causing their price to increase and their yield to decrease.
Impact: Tendency for YC to become positively sloped.

Outline: (1) Given the expectation of higher rates in the future, borrowers wishing to
finance 2-year assets would prefer to issue two year bonds at 8% than sell a series of
one-year bonds at 10% = [(1.08)(1.12)]1/2 1. (2) Market Response: The supply of 2-
year bonds would increase, causing their price to decrease and their yield to increase
and the supply of 1-year bonds would decrease, causing their price to increase and
their yield to decrease. Impact: Tendency for YC to become positively sloped,
complementing the impact of investors response to the expectation.

b. Outline: (1) Given HD = 2 years, investors would prefer a 2-year bond at 10% to a
series of one-year bonds at 9% = [(1.10)(1.08)]1/2 1 (also holds for investors with
HD = 1 year). (2) Market Response: Demand for 2-year bonds would increase,
causing their price to increase and their yield to decrease and the demand for 1-year
bonds would decrease, causing their price to decrease and their yield to increase.
Impact: Tendency for YC to become negatively sloped.

Outline: (1) Given the expectation of lower rates in the future, borrowers wishing to
finance 2-year assets would prefer to issue a series of one-year bonds at 9% = [(1.08)
(1.10)]1/2 1 to two-year bonds at 10%. (2) Market Response: The supply of 2-year
bonds would decrease, causing their price to increase and their yield to decrease and
the supply of 1-year bonds would increase, causing their price to decrease and their
yield to increase. Impact: Tendency for YC to become negatively sloped,
complementing the impact of investors response to the expectation.

c. Outline: (1) Given HD = 2 years, investors would be indifferent to a 2-year bond at

7% and a series of one-year bonds at 7% = [(1.06)(1.08)]1/2 1 (also holds for
investors with HD = 1 year). (2) Market Response: No change in the yield curve.

Outline: (1) Given HD = 2 years, borrowers would be indifferent to issuing a 2-year

bond at 7% and a series of one-year bonds at 7% = [(1.06)(1.08)]1/2 1. (2) Market
Response: No change in the yield curve.

10. Assume the following yield curve for zero-coupon bonds with a face value of 100:

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 Maturity YTM
1 Year 7%
2 Years8%
3 Years8%
4 Years7%
5 Years6%

a. Using implied forward rates estimate the yield curve one year from the present
(rates on 1-year, 2-year, 3-year and 4-year bonds).
b. Using implied forward rates estimate the yield curve two years from the present
(rates on 1-year, 2-year, and 3-year bonds).
c. If you bought the three-year bond and held it one year, what would your
expected rate of return be if your expectations were based on implied forward
rates?
d. Without calculating, if you bought a bond of any maturity and held it one year,
what would your expected rate of return be if your expectations were based on
implied forward rates?
e. If you bought the four-year bond and held it two year, what would your
expected rate of return be if your expectations were based on implied forward
rates?
f. Without calculating, if you bought a bond of any maturity and held it two years,
what would your expected rate of return be if your expectations were based on
implied forward rates?

a.
1/ M
(1 y M 1 ) M 1
f M1 1
(1 y1 )
(1 y 2 ) 2 (1.08) 2
f11 1 1 .09
(1 y1 ) (1.07)
1/ 2 1/ 2
(1 y 3 )3 (1.08)3
f 21 1 1 .085
(1 y1 ) (1.07)
1/ 3 1/ 3
(1 y 4 ) 4 (1.07) 4
f 31 1 1 .070
(1 y1 ) (1.07)
1/ 4 1/ 4
(1 y 5 )5 (1.06)5
f 41 1 1 .05751
(1 y1 ) (1.07)
b. (1 y M 2 ) M 2
1/ M

fM2 2 1
(1 y 2 )
(1 y 3 )3 (1.08)3
f12 1 1 .08
(1 y 2 ) 2 (1.08) 2
1/ 2 1/ 2
(1 y 4 ) 4 (1.07) 4
f 22 2
1 2
1 .0601
(1 y 2 ) (1.08)
1/ 3
8 1/ 3
(1 y 5 )5 (1.06)5
f 32 2
1 2
1 .0469
(1 y 2 ) (1.08)
 c. The expected rate of return from buying a 3-year bond and selling it one year later
is equal to the yield on the one-year bond of 7% if the implied forward rate, f 21, is
used as the expected rate on a 2-year bond one year later.

100
P3 79.383
(1.08) 3
100
E ( P21 ) 84.9455
(1.085) 2
84.9455
E(R ) 1 .07
79.383

d. The expected rate of return from buying a bond of any maturity and selling it one
year later is equal to the yield on the one-year bond of 7% if the implied forward
rate is used as the expected rate on the bond one year later.

e. The expected rate of return from buying a 4-year bond and selling it two years
later is equal to the yield on the two-year bond of 8% if the implied forward rate,
f22, is used as the expected rate on a 2-year bond two years later.

100
P4 76.2895
(1.07) 4
100
E ( P22 ) 88.98285
(1.0601) 2
1/ 2
88.98285
E ( R 20 ) 1 .08
76.2895

f. The expected rate of return from buying a bond of any maturity and selling it two
years later is equal to the yield on the two-year bond of 8% if the implied forward
rate is used as the expected rate on the bond two years later.

11. Given the following spot yield curve:

Maturity YTM
1 Year 6.0%
2 Years 6.5%
3 Years 7.0%
4 Years 7.5%

a. What is the equilibrium price of a four-year, 7% annual coupon bond paying a

principal of $100 at maturity?

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b. Using implied forward rates estimate the yield curve one year from the present
(1-year, 2-year, and 3-year spot rates).
c. What is the expected equilibrium price one year from now of a three-year, 7%
annual coupon bond paying a principal of $100 at maturity?
d. What is the one-year expected rate of return from investing in the four-year, 7%
coupon bond if your expectations were based on implied forward rates?
e. Using implied forward rates estimate the yields for 1-year and 2-year spot rate
two years from now.
f. Show that the expected rate from holding the four-year, 7% coupon bond for
two years is equal to the 2-year spot rate of 6.5%.

a.
7 7 7 107
P0* 98.61113
(1.06) (1.065) 2 (1.070) 3 (1.075) 4
b.
1/ M
(1 y M 1 ) M 1
f M1 1
(1 y 1 )
(1 y 2 ) 2
(1.065) 2
f 11 1 1 .07002
(1 y1 ) (1.06)
1/ 2 1/ 2
(1 y 3 ) 3 (1.07) 3
f 21 1 1 .075035
(1 y1 ) (1.06)
1/ 3 1/ 3
(1 y 4 ) 4 (1.075) 4
f 31 1 1 .080047
(1 y1 ) (1.06)

c.
7 7 107
*
E ( P31 ) 2
97.5278
(1.07002) (1.075035) (1.080047) 3

d. If bonds are equal to their equilibrium prices and the implied forward rates are
used as estimate of futures rates, then the one-year expected rates will be equal to
the current one-year rate. The one-year expected rate on the four-year, 7% bond
held one year is 6%the same as the one-year rate:

7 97.5278
E(R ) 1 .06
98.61113

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 e.
1/ M
(1 y M 2 ) M 2
fM2 2 1
(1 y 2 )
(1 y 3 ) 3 (1.07)3
f12 1 1 .080071
(1 y 2 ) 2 (1.065) 2
1/ 2 1/ 2
(1 y 4 ) 4 (1.075) 4
f 22 2
1 2
1 .085094
(1 y 2 ) (1.065)

f. The expected price on the four-year, 7% coupon bond two years later is 97.357:

7 107
*
E (P22 ) 97.357
(1.080071) (1.085094) 2

Assuming that the $7 coupon is reinvested to year 2 at f 11 of 7%, the expected rate of
return for holding the four-year, 7% bond two years is 6.5%the same as the 2-year
spot rate:

1/ 2
7(1.07) 7 97.357
E (R 22 ) 1 .065
98.61113

12. Using the theories of term structure of interest rates identify several scenarios that
would have a tendency of causing the yield curve to become negatively sloped.

(1) A contractionary open market operation in which the central bank sells short-term
government securities.

(2) A Treasury purchase of long-term Treasury securities.

(3) A poorly hedged economy in which investors prefer long-term investments and
borrowers prefer short-term.

(4) A market expectation of lower interest rates.

13. Explain the Liquidity Premium Theory.

The Liquidity Premium Theory (LPT) posits that there is a liquidity premium for long-
term bonds over short-term bonds because the prices of long-term securities tend to be
more volatile and therefore more risky than short-term securities. According to LPT, if

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investors were risk averse, then they would require some additional return (liquidity
premium) in order to hold long-term bonds instead of short-term ones.

14. Short-Answer Questions:

a. If the yield curve includes investors expectations, then a positively sloped yield
curve would reflect what type of expectation about futures interest rates?
b. If the yield curve includes investors expectations, then a negatively sloped yield
curve would reflect what type of expectation about futures interest rates?
c. How is an implied forward rate used as a cutoff rate?
d. Define the preferred habitat theory.

a. The market expects higher interest rates in the future.

b. The market expects lower interest rates in the future.

c. Expected rates for holding bonds for a specified period (e.g., one year, two years) will
be equal to the applicable current rate if expected rates are equal to implied forward.
If investors expect a future rate to be less than the applicable implied forward rate,
then their expected holding period yield would exceed the current rates. Thus, the
implied forward rates can be used as a cutoff rate in evaluating and selecting bonds.

d. The preferred habitat theory posits that investors and borrowers will move away from
their preferred maturity segment if rates are attractive enough to compensate them for
foregoing their preferences.

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