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PR IDPM CHap 6

The document summarizes key concepts from Chapter 6 of a Financial Markets textbook. It includes: 1) Examples of calculating interest rates along the yield curve under different scenarios for future short-term rates. 2) An explanation that an upward sloping yield curve indicates expected future short-term rate increases, while a downward slope signals expected decreases. 3) That yield curves can provide insights into market expectations of future inflation. 4) Predictions that government guarantees on corporate bonds would lower their rates while raising Treasury rates. 5) That an unexpected drop in expected future short-term rates would cause the yield curve slope to shift downward.

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1K views8 pages

PR IDPM CHap 6

The document summarizes key concepts from Chapter 6 of a Financial Markets textbook. It includes: 1) Examples of calculating interest rates along the yield curve under different scenarios for future short-term rates. 2) An explanation that an upward sloping yield curve indicates expected future short-term rate increases, while a downward slope signals expected decreases. 3) That yield curves can provide insights into market expectations of future inflation. 4) Predictions that government guarantees on corporate bonds would lower their rates while raising Treasury rates. 5) That an unexpected drop in expected future short-term rates would cause the yield curve slope to shift downward.

Uploaded by

stevanset
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Financial Markets Chapter 6

Stevanus Setiawan 19090049


Natal Argawan 19090073

Financial Markets
Universitas Pelita Harapan
2010
1. (Number 6) Assuming that the expectation theory is the correct theory of the term structure,
calculate interest rates in the term structure for maturities of one to five years, and plot the
resulting yield curve for the following series of one-year interest rates over the next five years:
    (a) 5%,7%,7%,7%,7%
    (b) 5%,4%,4%,4%,4%
 How would your yield curves changes if people preferred shorter-tenn bonds over longer-term
bonds?
(a) The yield to maturity would be 5% for a one year bond
5 %+7 %
= 6% for a two-year bond
2
5 %+7 % +7 %
= 6.33% for a three-year bond
3
5 %+7 % +7 %+ 7 %
= 6.5% for a four-year bond
4
5 %+7 % +7 %+ 7 %+7 %
= 6.6% for five-year bond.
5

Interest Rates
7

4 Interest Rates

0
1 2 3 4 5
(b) The yield to maturity would be 5% for one-year bond
5 %+ 4 %
= 4.5% for two-year bond
2
5 %+ 4 %+ 4 %
= 4.33% for three-year bond
3
5 %+ 4 %+ 4 %+ 4 %
= 4.25% for four-year bond
4
5 %+ 4 %+ 4 %+ 4 %+ 4 %
= 4.2% for a five-year bond.
5

Interest Rates
5.2

4.8

4.6 Interest Rates

4.4

4.2

3.8
1 2 3 4 5
if people preferred short-term bonds over long-term bonds, the upward-sloping yield curve in
(a) would be even steeper because in this situation (long-term rate > short-term rate), the
average of future short-term rates expected to be higher than the current short-rate.

The downward-sloping yield curve in (b) would be less steep because when the expected short-
term rate will fall, people still preferred the short-term bonds, so short-term rate will fall
moderately.
2. (Number  8) If a yield curve looks like the one shown in (a), what is the market predicting about
the movement of future short-term interest rate? What might the yield curve indicate about the
market's predictions about the inflation rate in the future?
The flat yield curve at shorter maturities suggest that short-term interest rates are expected to
fall moderately in the near future

while the steep upward slope of the yield curve at longer maturities indicates that interest rates
further into the future are expected to rise.
Because interest rates and expected inflation move together

the yield
curve suggests that the market expects inflation to fall moderately in the near future but to rise
later on.
3. (Number 11) Predict what will happen to interest rate on a corporation’s bonds if the federal
government guarantees today that it will pay creditors if the corporation goes bankrupt in the
future. What will happen to interet rates on Treasury securities?
The corporation’s bonds interest rate will decrease and Treasury securities interest rates will
increase. The major reason is the Treasury securities currently pay a lower rate is that they are
guaranteed by the federal government. If corporate bonds had the same guarantee there would
be less risk so the interest rate would go down. If investors could get a higher interest rate with
similar safety from corporate bonds, they would demand more interest from Treasury securities.
4. (Number 15) If expectations of future short-term interest rates suddenly fall, what would
happen to the slope of the yield curve?
Long-term rates then will drop below short-term rates, because the average of expected future
short-term rates despite positive liquidity premium. The yield slope would fall at longer terms to
maturity (downward).

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