CHAPTER 2: INTEREST RATES

Chapter 3: What Do Interest Rates Mean and What Is Their Role in

 QUESTIONS:
1. What is the concept of present value? What is discounting?
2. What is the yield to maturity? Why it is considered as a good measure of
interest rates?

 QUANTITATIVE PROBLEMS:
1. Calculate the present value of a $1,000 zero-coupon bond with six years to
maturity if the yield to maturity is 7%.
2. Consider a coupon bond which has a $1,000 par value and a coupon rate of
20%. The bond is currently selling for $2,300 and has 16 years to maturity.
Calculate the bond’s yield to maturity.
3. Calculate the yield to maturity on the bond that has a price of $1,000 and pays
$50 dividend for the life of the bond. What will happen if the dividend is $25
instead of $50?
4. Suppose you bought a land that costs $500,000 today. You will need to continue
to pay tax on the land, and the rate is 3% of your purchase. Calculate the PV of
your payment, using a 10% discount rate. Assume that there are no changes in
the land’s price and tax rate.
5. Suppose that you want to take out a loan at a bank that wants to charge you an
annual real interest rate equal to 5%. Assuming that the expected rate of
inflation during the life of the loan is 2%, what will be the nominal interest rate
that the bank will charge you? If the real inflation was 3% instead of the
expected 2%, what was the actual real interest rate on the loan?
6. Suppose that you have a bond with a face value of $1,000 and a coupon rate of
8% for one year and that you buy another one after one year. What will be your
gain if the interest rate increases up to 10%? How will your answer change if
the interest rate falls to 6%? What conclusion can you draw from these cases?

Chapter 5: How Do Risk and Term Structure Affect Interest Rates?

 QUESTIONS:
1. What is the relationship between a corporate bond rating and a risk premium?
2. What is default risk and risk premium? How can default risk influence interest
rates?
3. “Corporate bonds and stocks are a bad combination of investments as both
have different characteristics that do not complement each other.” Discuss.
4. Describe the relationship between bond prices and interest rates during a
recession.
5. Just before the collapse of the subprime mortgage market in 2007, the most
important credit-rating agencies rated mortgage-backed securities with Aaa and
AAA ratings. Explain how it was possible that a few months into 2008, the same
securities had the lowest possible ratings. Should we always trust credit-rating
agencies?
6. If a yield curve looks like the one shown here, what is the market predicting
about the movement of future short-term interest rates? What might the yield curve
indicate about the market’s predictions concerning the inflation rate in the future?

7. If a yield curve looks like the one below, what is the market predicting about
the movement of future short-term interest rates? What might the yield curve
indicate about the market’s predictions concerning the inflation rate in the
future?

8. How will a reduction in tax rates affect an individual’s prefernce for municipal
bonds compared to Treasury bonds? What conclusion can you draw regarding
tax rates and interest rates on securities?

 QUANTITATIVE PROBLEMS:
1. Assuming that the expectations theory is the correct one of the term structure,
calculate the interest rates in the term structure for maturities one to six years:
a. 4%, 4%, 5%, 6%, 6%, 6%
b. 5%, 5%, 4%, 4%, 4%, 4%
 Explain what is happening to yield curve.
2. Refer to the previous problem. Assume that instead of the expectations theory,
the liquidity premium theory takes place. What will be your answer to parts a
and b, if the following liquidity premiums are expected? 0%; 0.25%, 0.5%,
0.75%, 1%, and 1.25% respectively?
3. How does the after-tax yield on a $1,000,000 municipal bond with a coupon
rate of 8% paying interest annually compare with that of a $1,000,000 corporate
bond with a coupon rate of 10% paying interest annually? Assume that you are
in the 25% tax bracket.
4. Consider the decision to purchase either a five-year corporate bond or a five-
year municipal bond. The corporate bond is a 14% annual coupon bond with a
par value of $1,000. It is currently yielding 12%. The municipal bond has a
10% annual coupon and a par value of $1,000. It is currently yielding 8%.
Which of the two bonds would be more beneficial to you? Assume that your
marginal tax rate is 25%.
5. Debt issued by Southwest Airways currently yields 24%. A municipal bond of
equal risk currently yields 16%. At what marginal tax rate would an investor be
indifferent between these two bonds?
6. One-year T-bill rates are expected to steadily increase by 250 basis points per
year over the next nine years. Determine the required interest rate on a five-year
T-bond and a nine-year T-bond if the current one-year interest rate is 15.5%.
Assume that the expectations hypothesis for interest rates holds.
7. The one-year interest rate over the next eight years will be 4%, 5.5%, 6%,
8.5%, 10%, 11.5%, 14%, and 15.5%. Using the expectations theory, what will
be the interest rates on a four-year bond, a six-year bond, and an eight-year
bond?
8. The one-year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%,
9%, 10.5%, 13%, 14.5%, 16%, and 17.5%. Assume that investors prefer
holding short-term bonds so that a liquidity premium of 10 basis points is
required for each year of a bond’s maturity. What will be the interest rates on a
threeyear bond, a six-year bond, and a nine-year bond?
9. Suppose that the expectations theory is true and that you can buy a three-year
bond with an interest rate of 6% or three consecutive one-year bonds with
interest rates of 4%, 5%, and 6%. Which option would you choose to
undertake?
10. Suppose you are asked to make a loan for 10% from one year for now; you
decided to compare interest rates with Government bonds and make at least 2%
premium over that. One year bond has 5% and two year rate 7%. You have been
harmed about liquidity risk, so you evaluated it at 0.5%. Given this data, are
you willing to make a loan?
11. One-year T-bill rates are 2% currently. If interest rates are expected to go up
after three years by 2% every year, what should be the required interest rate on
a 10-year bond issued today? Assume that the expectations theory holds.
12. One-year T-bill rates over the next five years are expected to be 4%, 5%, 6%,
6.5%, and 8%. If fiveyear T-bonds are yielding 35.5%, what is the liquidity
premium on this bond?
13. At your favorite bond store, Bonds-R-Us, you see the following prices:
One-year $100 zero selling for $90.19
Three-year 10% coupon $1,000 par bond sellingfor $1,000
Two-year 10% coupon $1,000 par bond selling for$1,000
Assume that the expectations theory for the term structure of interest rates
holds, no liquidity premium exists, and the bonds are equally risky. What is the
implied one-year rate two years from now?
14. Assume that you make investment decisions based on the expectations theory.
Based on research, you have obtained the following information about certain
market interest rates:
You can borrow at 5% and lend at 4.5% for one year
You can borrow at 6% and lend for 6.5% for two years
One-year rate one year from now is 7% for borrowing and lending
What decision is the most profitable for you? Show your calculations.
15. Predict the one-year interest rate three years from today if interest rates are
3.5%, 4.0%, 4.5%, and 5% for bonds with one to four years to maturity and
liquidity premiums are 0%, 0.1%, 0.25%, and 0.50%.