Calculating Interest Rates Based on Expectations Theory
Suppose the real risk-free rate (r*) is 2%
Investors demand a 0.1% maturity risk premium per each year
remaing until maturity
We will further assume that DRP = 0 and LP = 0
-Treasury bonds have almost-zero default risk and liquidity risk
Finally, yearly inflations are expected to be:
1.0% in Year 1
1.8% in Year 2
2.0% in Year 3
Question: How do we calculate the inflation premium for 1-year
bond, 2-year bond, and 3-year bond?
Inflation Premium (IP) for N-year bond is calculated by:
IPN = (INFL1 + INFL2... + INFLN) / N
Let's get the interest rate for a 2-year Treasury Bond:
IP2 = (1.0% + 1.8%) / 2 = 1.4%
MRP2 = 0.1% x ...view middle of the document...
[(44-42) + 0.10]/42 = 5%
5-9) The interest rate on 1yr treasury bonds is 0.4%, the rate on 2yr
bonds is 0.8%, and the rate on 3yr bonds is 1.1%. Using the
expectations theory, compute the expected one-year interest rates
in (a) the 2nd yr (Y2) and (b) the 3rd yr (Y3).
1yr = 0.4% | 2yr = 0.8% (AVG Y1 & Y2) | 3yr = 1.1% (AVG Y1, Y2 & Y3)
Y1 = 0.4% | Y2 = 1.2% | Y3 = 1.7%
5-19) Suppose that the nominal risk-free rate will be 3.2% in the future.
You are evaluating 2 corp. bonds that are ID except their terms to mat..
The bonds have the same default risk and no liquidity premium.
Bond A matures in 5 yr and yield = 5.3%
Bond B matures in 8 yr and yield = 5.9%
Compute the annual MRP and the DRP.
3 yr difference | 0.6% difference | MRP = 0.6/3 = 0.2%
5.3 = 3.2 + DRP + (0.2 x 5) = 3.2 + DRP + 1 = 4.2 + DRP
1.1% = DRP
5.9 = 3.2 + DRP + (0.2 x 8) = 3.2 + DRP + 1.6 = 4.8 + DRP
1.1% = DRP
The “liquidity preference theory” would generally lead to an upward
sloping yield curve.
Debt is a loan to a firm, gov’t or individual. It is ID’d by 3 of its features:
1) Principal amount that must be repaid 2) Interest payments
3) Time to maturity | Debtholders have priority over stockholders with
regard to distribution of earnings and liquidation of assets. | Debtholders
do not have voting rights, so they cannot attain control of the firm
Principal Value = Face Value = Maturity Value = Par Value
-the amount owed to the lender (repaid at the maturity date)
Interest payments – in most cases, debtholders receive periodic payments
of interest (cf. discounted securities) | The interest is computed as a
percentage of the principal.
Maturity date – the date on which the principal amount is due
Short Term Debt – Debt instruments with original...