Chapter 7
The Risk and Term Structure of Interest Rates
Conceptual and Analytical Problems
1. Consider a firm that issued a large quantity of commercial paper in the period leading
to a financial crisis. (LO1)
a. How would you expect the credit rating of the commercial paper to evolve as the
instead issuing asset-backed commercial paper?
Answer:
a. Commercial paper is generally issued without collateral, so that its rating will
depend on the creditworthiness of the collateral.
2. Suppose that a major foreign government defaults on its debt. What, if anything, will
happen to the position and slope of the U.S. yield curve? (LO1)
Answer: If Treasury debt is a substitute for the foreign government debt, then U.S.
yield curve would shift downward, reflecting a flight to quality. If the holders of the
yield curve would shift down and become flatter.
3. What was the connection between house price movements, the growth in subprime
2007-2009 financial crisis? (LO1)
Answer: The viability of many subprime mortgages – and in particular ARMs –
depended on being able to refinance the loan before the interest rate reset to a higher
at an increasing rate. This, in turn, led to significant falls in the prices of securities
backed by subprime mortgages, causing difficulties for institutions that had sizable
4. Suppose that the interest rate on one-year bonds is currently 4 percent and is expected
hypothesis, compute the yield curve for the next three years. (LO3)
Answer:
Yield for one-year bond = 4%
5. *According to the liquidity premium theory, if the yield on both one-and two-year
higher, lower or the same? Explain your answer. (LO3)
Answer: According to the liquidity premium theory, the two-year yield (i2,t) is an
the longer maturity.
As we can see from the formula, if the current one-and two-year yields are the same
6. You have $1,000 to invest over an investment horizon of three years. The bond
Assuming annual compounding, compute the return on each of the three investments,
and discuss which one you would choose. (LO3)
Answer:
Expected return for (i) = (1.035) ×(1.04) × (1.05) – 1 = 13.02%
The second and third options have higher expected returns than the first, but both
options involve investing in longer-term bonds (three-year and two-year bonds,
first option, while someone with a three-year horizon should probably choose the
second option.
7. Suppose that the yield curve shows that the one-year bond yield is 3 percent, the
percent, and the risk premium on the three-year bond is 2 percent. (LO3)
a. What are the expected one-year interest rates next year and the following year?
b. If the risk premiums were all zero, as in the Expectations Hypothesis, what would
the slope of the yield curve be?
Answer:
a. With iit = 0.03, the risk premium on the two-year bond at 0.01, and with the
i3t = 0.02 + (0.03 + 0.03 + i1,t +2) / 3 = 0.05
b. As the solutions in part (a) show, the current and prospective one-year rates are
8. *If inflation and interest rates become more volatile, what would you expect to see
happen to the slope of the yield curve? (LO3)
Answer: Investors are likely to demand a higher risk premium in the face of increased
9. As economic conditions improve in countries with emerging markets, the cost of
borrowing funds there tends to fall. Explain why. (LO4)
Answer: As economic conditions improve, the chance that businesses will default on
10. Suppose your local government, threatened with bankruptcy, decided to tax the
woes. What would you expect to see happen to the yields on these bonds? (LO2)
Answer: You would expect the yields to rise to compensate investors for the loss of
11. *If, before the change in tax status, the yields on the bonds described in Problem 10
(LO1, LO2)
Answer: We can attribute the lower yields on the local government bonds versus
Treasury issues to their tax-exempt status, as investors would view the federal
compensate investors for the new tax obligation, so the spread would change sign.
12. Suppose the risk premium on U.S. corporate bonds increases. How would the change
affect your forecast of future economic activity, and why? (LO4)
Answer: An increasing risk premium can be a sign of an impending recession, so you
Treasury typically is not affected, increasing the risk premium on company debt.
13. If regulations restricting institutional investors to investment grade bonds were lifted,
what do you think would happen to the spreads between yields on investment grade
and speculative grade bonds? (LO1)
14. Consider a struggling emerging-market economy where, in contrast to developed
economies, the perceived risk associated with holding sovereign bonds is affected by
would you expect to happen to the yields on that country’s government bonds? (LO1,
LO4)
Answer: The ratings of the bonds would likely be upgraded, as the outlook for the
Bond prices would increase and yields would fall.
15. Consider again the economy described in Problem 14. Under which of the following
scenarios would you expect the impact of the mineral discovery on bond yields to be
larger?
i) Before the discovery, the government was heavily indebted with a
Answer: The impact would be larger in the case of a heavily indebted government,
especially if the debt was denominated in another currency, such as U.S. dollars.
high debt servicing costs than in a country where this risk was not an issue.