Answers to Review Questions
1. The real rate of interest is the rate that creates an equilibrium between the supply of savings and
demand for investment funds. The nominal rate of interest is the actual rate of interest charged by the
supplier and paid by the demander. The nominal rate of interest differs from the real rate of interest
due to two factors: (1) a premium due to inflationary expectations (IP) and (2) a premium due to
issuer and issue characteristic risks (RP). The nominal rate of interest for a security can be defined as
r1 r* IP RP. For a 3-month U.S. Treasury bill, the nominal rate of interest can be stated as r1
r* IP. The default risk premium, RP, is assumed to be ...view middle of the document...
states that long-term rates are generally higher than short-term rates due to the desire of
investors for greater liquidity, and thus a premium must be offered to attract adequate long-term
c. The market segmentation theory is another theory that can explain any of the three curve shapes.
Since the market for loans can be segmented based on maturity, sources of supply and demand for
loans within each segment determine the prevailing interest rate. If supply is greater than demand
for short-term funds at a time when demand for long-term loans is higher than the supply of
funding, the yield curve would be upward sloping. Obviously, the reverse also holds true.
5. In the Fisher equation, r r* IP RP, the risk premium, RP, consists of the following issuer- and
Default risk: The possibility that the issuer will not pay the contractual interest or principal as
Maturity (interest rate) risk: The possibility that changes in the interest rates on similar securities will
cause the value of the security to change by a greater amount the longer its maturity, and vice versa.
Liquidity risk: The ease with which securities can be converted to cash without a loss in value.
Contractual provisions: Covenants included in a debt agreement or stock issue defining the rights
and restrictions of the issuer and the purchaser. These can increase or reduce the risk of a security.
Tax risk: Certain securities issued by agencies of state and local governments are exempt from
federal, and in some cases state and local taxes, thereby reducing the nominal rate of interest by an
amount that brings the return into line with the after-tax return on a taxable issue of similar risk.
The risks that are debt specific are default, maturity, and contractual provisions.
6. Most corporate bonds are issued in denominations of $1,000 with maturities of 10 to 30 years. The
stated interest rate on a bond represents the percentage of the bond’s par value that will be paid out
annually, although the actual payments may be divided up and made quarterly or semiannually.
Both bond indentures and trustees are means of protecting the bondholders. The bond indenture is a
complex and lengthy legal document stating the conditions under which a bond is issued. The trustee
may be a paid individual, corporation, or commercial bank trust department that acts as a third-party
―watch dog‖ on behalf of the bondholders to ensure that the issuer does not default on its contractual
commitment to the bondholders.
7. Long-term lenders include restrictive covenants in loan agreements in order to place certain
operating and/or financial constraints on the borrower. These constraints are intended to assure the
lender that the borrowing firm will maintain a specified financial condition and managerial structure
during the term of the loan. Since the lender is committing funds for a long period of time, he seeks