Financial Institution Martket Chap 5 solution

Topics: Bond, Yield curve, Bonds Pages: 7 (1697 words) Published: May 17, 2014
Chapter 5
 Answers to End-of-Chapter Questions
1.The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its demand and raises its interest rate relative to that on the Baa bond.
2.U.S. Treasury bills have lower default risk and more liquidity than negotiable CDs. Consequently, the demand for Treasury bills is higher, and they have a lower interest rate.
3.During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms.

4.True. When bonds of different maturities are close substitutes, a rise in interest rates for one bond causes the interest rates for others to rise because the expected returns on bonds of different maturities cannot get too far out of line.

5.If yield curves on average were flat, this would suggest that the risk premium on long-term relative to short-term bonds would equal zero and we would be more willing to accept the pure expectations theory.

6.The flat yield curve at shorter maturities suggests 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.

7.The steep upward-sloping yield curve at shorter maturities suggests that short-term interest rates are expected to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected short-term interest rates in the near future are above the current short-term interest rate. The downward slope for longer maturities indicates that short-term interest rates are eventually expected to fall sharply. With a positive risk premium on long-term bonds, as in the liquidity premium theory, a downward slope of the yield curve occurs only if the average of expected short-term interest rates is declining, which occurs only if short-term interest rates far into the future are falling. Since interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to rise moderately in the near future but fall later on.

8.The reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable, and they would be less desirable than taxable Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise interest rates on municipal bonds while causing interest rates on Treasury bonds to fall.

9.The government guarantee will reduce the default risk on corporate bonds, making them more desirable relative to Treasury securities. The increased demand for corporate bonds and decreased demand for Treasury securities will lower interest rates on corporate bonds and raise them on Treasury bonds. 10.Lower brokerage commissions for corporate bonds would make them more liquid and thus increase their demand, which would lower their risk premium. 11.Abolishing the tax-exempt feature of municipal bonds would make them less desirable relative to Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise the interest rates on municipal bonds, while the interest rates on Treasury bonds would fall.  Quantitative Problems

1.a.The yield to maturity would be 5% for a one-year bond, 6% for a two-year bond, 6.33% for a three-year bond, 6.5% for a four-year bond, and 6.6% for a five-year bond. (b) The yield to maturity would be 5%...
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