Concept explainers
The graph which shows the relationship between yields and maturities on a particular date is known as the yield curve, and this relationship is simply called the term structure of securities. The yield curve could be upward sloping where the long-term yields are higher than the short-term yields and is also known as normal yield curve. However, if the long-term yields are lower than the short-term yields then the slope with be downward sloping and is referred to as inverted or abnormal yield curve.
Interest rate consists of risk-free rate, real risk-free rate and inflation premium, and a risk premium such as liquidity risk (LP), default risk (DRP) and maturity risk (MRP). Since, real risk-free rate generally remains constant, it is the changes in the expectation of risk premium and inflation which affects the interest rate of the security. Hence, inflation expectation is the most significant reason for changes in yield and determination of yield curve.
Interest rate or yield on treasuries can be determined using the below equation, where default risk premium DRP and liquidity premium (LP) is zero, as treasuries are considered as liquid and default free investment. Maturity risk premium (MRP) is there as they have differing maturity securities issued.
Expectation theory states that the shape of the yield curve depends on the expectation of future inflation rate and hence an increasing inflation rate will result in an upward sloping curve whereas a decreasing rate would result in downward sloping curve.
Inflation is expected to be 1.5% in Year 1 and Year 2 and would settle for a rate greater than 1.5% thereafter. Yield in year 1 and 2 will remain the same and on 3-year bond will be 0.5% more than yield in Year 1 and 2. The bond is risk free and has a real risk-free rate of 2%.
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Check out a sample textbook solution- The real risk-free rate is 3 percent. Inflation is expected to average 2 percent a year for the next 3 years, after which the inflation is expected to average 3.5 percent a year. Assume that there is no maturity risk premium. A 7-year corporate bond has a yield of 7.6 percent. Assume that the liquidity premium on the corporate bond is 0.4 percent. What is the default risk premium on the corporate bond?arrow_forwardAssume that the real risk-free rate is 1% and that the maturity risk premium is zero. If a 1-year Treasury bond yield is 6% and a 2-year Treasury bond yields 7%, what is the 1-year interest rate that is expected for Year 2? Calculate this yield using a geometric average. Do not round intermediate calculations. Round your answer to two decimal places. What inflation rate is expected during Year 2? Do not round intermediate calculations. Round your answer to two decimal places.arrow_forwardThe real risk-free rate of interest, r*, is 4 percent, and it is expected to remain constant over time. Inflation is expected to be 2 percent per year for the next three years, after which time inflation is expected to remain at a constant rate of 5 percent per year. The maturity risk premium is equal to 0.1(t - 1)%, where t = the bond’s maturity. What is the yield on a 10-year Treasury bond?arrow_forward
- Suppose the yield on a two-year-old Treasury bond is 5 percent and the yield on a one-year Treasury bond is a 4 percent. If the maturity risk premium (MRP) on these bonds is zero (0), what is the expected one-year interest rate during the second year (Year 2)?arrow_forwardIf the real rate of interest is 2%, inflation is expected to be 3% during the coming year, and the default risk premium, illiquidity risk premium, and maturity risk premium for the Bonds-R-Us Corporation are all 1% each, what would be the yield (stated rate) on a Bonds-R-Us bond?arrow_forwardSuppose that the current one-year rate (one-year spot rate) and expected one-year government bonds over years 2, 3 and 4 are as follows: 1R1 = 4.80%, E(2r1) = 5.45%, E(3r1) = 5.95%, E(4r1) = 6.10% Assume that there are no liquidity premiums. To the nearest basis point, what is the current rate for the four-year-maturity government bond? 5.57% 5.62% 5.83% 6.10%arrow_forward
- Suppose that the current one-year rate (one-year spot rate) and expected one-year government bonds over years 2, 3 and 4 are as follows: 1R₁ = 4.80%, E(2r₁) = 5.45%, E(3r₁) = 5.95%, E(41) = 6.10% Assume that there are no liquidity premiums. To the nearest basis point, what is the current rate for the four-year-maturity government bond? A. 5.57% B. 5.62% C. 5.83% D. 6.10%arrow_forwardSuppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 1.80%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T-bond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.arrow_forwardThe outstanding bonds of Winter Tires Inc. provide a real rate of return of 3.2 percent. If the current rate of inflation is 2.1 percent, what is the actual nominal rate of return on these bonds?arrow_forward
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