Define each of the following terms:
a. Production opportunities; time preferences for consumption; risk; inflation
b. Real risk-free rate of interest, r*; nominal (quoted) risk-free rate of interest, r RF
c. Inflation premium (IP)
d. Default risk premium (DRP)
e. Liquidity premium (LP); maturity risk premium (MRP)
f. Interest rate risk; reinvestment rate risk
g. Term structure of interest rates; yield curve
h. “Normal” yield curve; inverted (“abnormal”) yield curve; humped yield curve
i. Pure expectations theory
j. Foreign trade deficit; country risk; exchange rate risk
ST-2 Inflation and interest rates The real risk-free rate of interest, r*, is 3 percent, and it is
expected to remain constant over time. Inflation is expected to be 2 percent per year for
the next 3 years, and 4 percent per year for the next 5 years. The maturity risk premium
is equal to 0.1(t 1)%, where t the bond’s maturity. The default risk premium for a
BBB-rated bond is 1.3 percent.
a. What is the average expected inflation rate over the next 4 years?
b. What is the yield on a 4-year Treasury bond?
c. What is the yield on a 4-year BBB-rated corporate bond with a liquidity premium of 0.5 percent?
d. What is the yield on an 8-year Treasury bond?
e. What is the yield on an 8-year BBB-rated corporate bond with a liquidity premium
of 0.5 percent?
f. If the yield on a 9-year Treasury bond is 7.3 percent, what does that imply about
expected inflation in 9 years?
ST-3 Pure expectations theory The yield on one-year Treasury securities is 6 percent, 2-year
securities yield 6.2 percent, and three-year securities yield 6.3 percent. There is no maturity
risk premium. Using expectations theory, forecast the yields on the following securities:
a. A 1-year security, 1 year from now?
b. A 1-year security, 2 years from now?
c. A 2-year security, 1 year from now?
