Corporate Finance (4th Edition) (Pearson Series in Finance) - Standalone book
4th Edition
ISBN: 9780134083278
Author: Jonathan Berk, Peter DeMarzo
Publisher: PEARSON
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Chapter 3, Problem 18P
Summary Introduction
To determine: The current risk-free interest rate under no arbitrage opportunities.
Introduction:
Arbitrage pricing theory is an asset-pricing model. No arbitrage is an arbitrage-free condition. Under this situation, all the assets are priced appropriately and there are no chances of one’s gain to overcome the market gains without facing any risks.
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Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 6.60%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity.
What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid?
Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 4.00%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Include the cross-product term, i.e., if averaging is required, use the geometric average. (Round your final answer to 2 decimal places.)
Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a
maturity risk premium of 0.10% per year to maturity applies, i.e., MRP 0.10% (t), where t is the
years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you
expect on a 4-year Treasury security?
O 7.80%
O 7.90%
O 7.70%
O 8.10%
O 8.00%
Chapter 3 Solutions
Corporate Finance (4th Edition) (Pearson Series in Finance) - Standalone book
Ch. 3.1 - Prob. 1CCCh. 3.1 - If crude oil trades in a competitive market, would...Ch. 3.2 - How do you compare costs at different points in...Ch. 3.2 - Prob. 2CCCh. 3.3 - What is the NPV decision rule?Ch. 3.3 - Why doesnt the NPV decision rule depend on the...Ch. 3.4 - Prob. 1CCCh. 3.4 - Prob. 2CCCh. 3.5 - If a firm makes an investment that has a positive...Ch. 3.5 - Prob. 2CC
Ch. 3.5 - Prob. 3CCCh. 3.A - The table here shows the no-arbitrage prices of...Ch. 3.A - Suppose security Chas a payoff of 600 when the...Ch. 3.A - Prob. A.3PCh. 3.A - Prob. A.4PCh. 3.A - Prob. A.5PCh. 3.A - Consider a portfolio of two securities: one share...Ch. 3.A2 - Why does the expected return of a risky security...Ch. 3.A2 - Prob. 2CCCh. 3.A3 - Prob. 1CCCh. 3.A3 - Prob. 2CCCh. 3 - Honda Motor Company is considering offering a 2000...Ch. 3 - You are an international shrimp trader. A food...Ch. 3 - Prob. 3PCh. 3 - Prob. 4PCh. 3 - You have decided to take your daughter skiing in...Ch. 3 - Suppose the risk-free interest rate is 4%. a....Ch. 3 - You have an investment opportunity in Japan. It...Ch. 3 - Your firm has a risk-free investment opportunity...Ch. 3 - You run a construction firm. You have just won a...Ch. 3 - Your firm has identified three potential...Ch. 3 - Your computer manufacturing firm must purchase...Ch. 3 - Prob. 12PCh. 3 - Prob. 13PCh. 3 - An American Depositary Receipt (ADR) is security...Ch. 3 - Prob. 15PCh. 3 - An Exchange-Traded Fund (ETF) is a security that...Ch. 3 - Consider two securities that pay risk-free cash...Ch. 3 - Prob. 18P
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- suppose that real risk free rate is 3.40% and the future rate of inflation is expected to be constant at 1.50%. What rate of return would you expect on a Treasury Bill, assuming the pure expectations theory is valid.arrow_forwardAssume investors are indifferent among security maturities. Today, the annualized 2-year interest rate is 2.20 percent, and the 1-year interest rate is 2 percent. What is the forward rate according to the pure expectations theory? Group of answer choices 2.25% 2.20% 2.00% 2.40%arrow_forwardSuppose the real risk-free rate is 3.50%, the average future inflation rate is 2.25%, and a maturity premium of 0.10% per year to maturity applies, i.e., MRP = 0.10. What rate of return would you expect on a 1-year (short term) Treasury security?arrow_forward
- Suppose that you have revenues denominated in Japanese Yen expected in 6 months. How would you hedge this risk using money market instruments? How would a money market hedge compare to a forward hedge?arrow_forwardConsider two securities that pay risk-free cash flows over the next two years and that have the current market prices shown here: Security Price Today Cash Flow in One Year Cash Flow in Two Years B1 $192 $200 0 B2 $176 0 $200 What is the no-arbitrage price of a security that pays cash flows of $200 in one year and $200 in two years? What is the no-arbitrage price of a security that pays cash flows of $200 in one year and $1600 in two years? Suppose a security with cash flows of $100 in one year and $200 in two years is trading for a price of $260. What arbitrage opportunity is available?arrow_forwardUnder the liquidity preference theory, if inflation is expected to be falling over the next few years, long-term interest rates will be higher than short-term rates. True/false/uncertain? Why?arrow_forward
- It is given that dP/dt = rP (r being the annually compounded interest rate and P is the amount in the account at any given time). Suppose that an account earns at an annual rate of r percent compounded continuously and a person is drawing an income of H dollars per year withdrawn continuously (impossible, but a modeling assumption). Use phase line analysis to analyze the behavior of the account. Discuss the meaning of any equilibrium points and their stability. If r = 10% (a reasonable rate for long-term stock investments), and H = $10,000, how long should an initial investment of $50,000 be left untouched so that when withdrawals begin the capital is not depleted?arrow_forwardThe pure expectations theory, or the expectations hypothesis, asserts that long-term interest rates can be used to estimate future short-term interest rates. Based on the pure expectations theory, is the following statement true or false? Q1. A certificate of deposit (CD) for two years will have the same yield as a CD for one year followed by an investment in another one-year CD after one year. a. True b. False Q2. The yield on a one-year Treasury security is 4.9200%, and the two-year Treasury security has a 5.9040% yield. Assuming that the pure expectations theory is correct, what is the market’s estimate of the one-year Treasury rate one year from now? (Note: Do not round your intermediate calculations.) a. 5.8627% b. 6.8973% c. 7.8629% d. 8.7596% Q3. Recall that on a one-year Treasury security the yield is 4.9200% and 5.9040% on a two-year Treasury security. Suppose the one-year security does not have a maturity risk premium, but the two-year security does and it is 0.2%. What is…arrow_forwardSuppose we observe the 3-year Treasury security rate (1R3) to be 8 percent, the expected 1-year rate next year—E(2r1)—to be 4 percent, and the expected one-year rate the following year—E(3r1)—to be 6 percent. If the unbiased expectations theory of the term structure of interest rates holds, what is the 1-year Treasury security rate, 1R1?arrow_forward
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