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Fundamental 15 Chapter 5

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Chapter 6: 6-1, 6-2, 6-5, 6-7, 6-15
6-1 Determinants of Interest Rates for Individual Securities A particular security’s default risk premium is 2 percent. For all securities, the inflation risk premium is 1.75 percent and the real interest rate is 3.5 percent. The security’s liquidity risk premium is 0.25 percent and maturity risk premium is 0.85 percent. The security has no special covenants. Calculate the security’s equilibrium rate of return. (LG6-4)
[1.035*1.0175] - 1 = 0.05311, or 5.311%
6-2 Determinants of Interest Rates for Individual Securities You are considering an investment in 30-year bonds issued by Moore Corporation. The bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 1.25 percent. Your broker has determined the following information about economic activity and Moore Corporation bonds: Real interest rate 0.75% Default risk premium 1.15% Liquidity risk premium 0.50% Maturity risk premium 1.75% a. What is the inflation premium? (LG6-4)

IP = 1.25% - 0.75 = 0.50%

b. What is the fair interest rate on Moore Corporation 30-year bonds? (LG6-4) I = (0.50 + .75% +1.15% +0.50% + 0 + 1.75%) I = 4.65%

6-5 Unbiased Expectations Theory Suppose that the current 1-year rate (1-year spot rate) and expected 1-year T-bill rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows: 1R1 = 6%, E(2r1) = 7%, E(3r1) = 7.5%, E(4r1) = 7.85% Using the unbiased expectations theory, calculate the current (long-term) rates for 1-, 2-, 3-, and 4-year-maturity Treasury securities. Plot the resulting yield curve. (LG6-5)
1r1 = 6%
1r2 = 6.50%
1r3 = 6.83%
1r4 = 7.09%

6-7 Liquidity Premium Hypothesis One-year Treasury bills currently earn 3.45 percent. You expect that one year from now, 1-year Treasury bill rates will increase to 3.65 percent.

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