Chapter 6: Interest Rates
Learning Objectives
121
Chapter 6
Interest Rates
Learning Objectives
After reading this chapter, students should be able to:
◆ List the various factors that influence the cost of money.
◆ Discuss how market interest rates are affected by borrowers’ need for capital, expected inflation,
different securities’ risks, and securities’ liquidity.
◆ Explain what the yield curve is, what determines its shape, and how you can use the yield curve to help
forecast future interest rates.
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Lecture Suggestions
Chapter 6: Interest Rates
Lecture Suggestions
Chapter 6 is important because it lays the groundwork for the following chapters. Additionally, students
have a curiosity about interest rates, so this chapter stimulates their interest in the course.
DAYS ON CHAPTER: 1 OF 56 DAYS (50-minute periods)
Chapter 6: Interest Rates
Answers and Solutions
123
Answers to End-of-Chapter Questions
6-1 Regional mortgage rate differentials do exist, depending on supply/demand conditions in the
different regions. However, relatively high rates in one region would attract capital from other
6-2 Short-term interest rates are more volatile because (1) the Fed operates mainly in the short-term
6-3 Interest rates will fall as the recession takes hold because (1) business borrowings will decrease
and (2) the Fed will increase the money supply to stimulate the economy. Thus, it would be better
6-4 a. If transfers between the two markets are costly, interest rates would be different in the two
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Answers and Solutions
Chapter 6: Interest Rates
6-7 a. S&Ls would have a higher level of net income with a “normal” yield curve. In this situation their
b. It depends on the situation. A sharp increase in inflation would increase interest rates along
6-8 Treasury bonds, along with all other bonds, are available to investors as an alternative investment
6-9 A trade deficit occurs when the U.S. buys more than it sells. In other words, a trade deficit occurs
6-10 The yield on corporates is equal to:
Chapter 6: Interest Rates
Answers and Solutions
125
Solutions to End-of–Chapter Problems
6-1 a. Term Rate
6 months 5.1%
1 year 5.5
6-2 T-bill rate = r* + IP
6-3 r* = 3%; I1 = 2%; I2 = 4%; I3 = 4%; MRP = 0; rT2 = ?; rT3 = ?
10
Interest Rate
(%)
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Answers and Solutions
Chapter 6: Interest Rates
6-4 rT10 = 6%; rC10 = 8%; LP = 0.5%; DRP = ?
6-5 r* = 3%; IP2 = 3%; rT2 = 6.2%; MRP2 = ?
6-6 r* = 5%; IP4 = 16%; MRP = DRP = LP = 0; rRF4 = ?
6-7 rT1 = 5%; 1rT1 = 6%; rT2 = ?
6-8 Let X equal the yield on 2-year securities 4 years from now:
6-9 r7 = r* + IP7 + MRP7 + DRP + LP.
Chapter 6: Interest Rates
Answers and Solutions
127
6-10 Basic relevant equations:
We can set up this table:
r* I IPt r = r* + IPt
6-11 We’re given all the components to determine the yield on the bonds except the default risk
premium (DRP) and MRP. Calculate the MRP as 0.1%(5 – 1) = 0.4%. Now, we can solve for the
DRP as follows:
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Answers and Solutions
Chapter 6: Interest Rates
6-14 a. (1.045)2 = (1.03)(1 + X)
b. For riskless bonds under the expectations theory, the interest rate for a bond of any maturity is
6-15 r* = 2%; MRP = 0%; rT1 = 5%; rT2 = 7%; X = ?
X represents the one-year rate on a bond one year from now (Year 2).
6-16 rRF6 = 20.84%; MRP = DRP = LP = 0; r* = 6%; IP6 = ?
6-17 rT5 = 5.2%; rT10 = 6.4%; rC10 = 8.4%; IP10 = 2.5%; MRP = 0. For Treasury securities, DRP = LP = 0.
Chapter 6: Interest Rates
Answers and Solutions
129
6-18 a. Years to Real Risk-Free
Maturity Rate (r*) IPt** MRP rT = r* + IPt + MRPt
1 2% 7.00% 0.2% 9.20%
Thus, the yield curve would be as follows:
T-bonds
8.5
8.0
7.5
7.0
6.5
11.0
10.5
10.0
9.5
9.0
Interest Rate
(%)
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Answers and Solutions
Chapter 6: Interest Rates
b. The interest rate on the AAA–rated corporate bonds has the same components as the Treasury
securities, except that the AAA–rated corporate bonds have default risk, so a default risk premium
must be included. Therefore,
c. The lower-rated corporate bonds would have significantly more default risk than either
6-19 a. The average rate of inflation for the 5-year period is calculated as:
c. Here is the general situation:
Year
Expected Annual
Inflation (It)
IPt
r*
MRPt
rt
1
13%
13.0%
2%
0.1%
15.1%
2
5
(%)
Interest Rate
15.0
12.5
10.0
Chapter 6: Interest Rates
Answers and Solutions
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d. The “normal” yield curve is upward sloping because, in “normal” times, inflation is not expected to
e. If inflation rates are expected to be constant, then the expectations theory holds that the yield
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Comprehensive/Spreadsheet Problem
Chapter 6: Interest Rates
Comprehensive/Spreadsheet Problem
Note to Instructors:
The solution to this problem is not provided to students at the back of their text. Instructors
can access the
Excel
file on the textbook’s website.
6-20 a. 1. This action will increase the supply of money; therefore, interest rates will decline.
b.
12–year Treasury Bond
Real risk–free rate (r*): 4.000%
7–year Corporate Bond