Questions 1. Characteristics That Affect Security Yields. Yields. Identify the relevant characteristics of any security that can affect the security's yield. ANSWER The relevant characteristics are 1. !efault ris" #. $i%uidity &. Ta status (. )aturity *. S+ec S+ecia iall +rov +roviisions ions ,such such as a cal calll featu eaturre#. I+act of Credit Cred it Ris" on Yield. What effect does a hi/h credit ris" have on securities0 ANSWER Investors re%uire a hi/her ris" +reiu on securities ith a hi/h default ris". &. I+act of $i%uidity on Yield. !iscuss the relationshi+ 2eteen the yield and li%uidity of securities. ANSWER The /reater the li%uidity of a security3 the loer is the yield3 other thin/s 2ein/ e%ual. (. Ta Effects Effects on Yields. !o investors in hi/h ta 2rac"ets or those in lo ta 2rac"ets 2enefit ore fro ta4ee+t securities0 Why0 !o unici+al 2onds or cor+orate 2onds o ffer a hi/her 2efore4ta yield at a /iven +oint in tie0 Why0 Which Which has the hi/her after4ta yield0 If taes did not eist3 ould Treasury 2onds offer a hi/her or loer yield than unici+al 2onds ith the sae aturity0 Why0 ANSWER 5i/h4ta 2rac"et investors 2enefit ore fro ta4ee+t securities 2ecause their ta savin/s fro avoidin/ taes is /reater. Cor+orate 2onds offer a hi/her 2efore4ta yield3 since they are taa2le 2y the federal /overnent. The unici+al 2onds ay have a hi/her ta yield for investors su26ect to a hi/h ta rate. 7or 7o r lo4ta 2rac"et investors3 the cor+orate 2onds ould li"ely have a hi/her after4ta yield. If taes did not eist3 Treasury 2onds ould offer a loer yield than unici+al 2onds 2ecause they are +erceived to 2e ris"4free. Thus3 the re%uired return on Treasury 2onds ould 2e loer than on unici+al 2onds. *. 8ure E+ectations Theory. E+lain ho a yield curve ould shift in res+onse to a sudden e+ectation of risin/ interest rates3 accordin/ to the +ure e+ectations theory. ANSWER The deand for short4ter securities ould increase3 +lacin/ u+ard ,donard +ressure on their +rices ,yields-. The The deand for lon/4ter securities ould decrease3 +lacin/ donard ,u+ard- +ressure on their +rices ,yields-. If the yield curve as o ri/inally u+ard slo+ed3 it ould no have a stee+er slo+e as a result of the e+ectation. If it as ori/inally donard slo+ed3 it ould no 2e ore hori9ontal ,less stee+-3 or ay have even 2ecoe u+ard slo+in/. :. 7orard Rate. What is the eanin/ of the forard rate in the contet of the ter structure of
interest rates0 Why i/ht forard rates consistently ov erestiate future interest rates0 5o could such a 2ias 2e avoided0 ANSWER The forard rate is the e+ected interest rate at a future +oint in tie. If forard rates are estiated ithout considerin/ the li%uidity +reiu3 it ay overestiate the future interest rates. If a li%uidity +reiu is accounted for hen e stiatin/ the forard rate3 the 2ias can 2e eliinated. ;. 8ure E+ectations Theory. Assue there is a sudden e+e ctation of loer interest rates in the future. What ould 2e the effect on the sha+e of the yield curve0 E+lain. ANSWER The deand for short4ter securities ould decrease3 +lacin/ donard ,u+ard +ressure on their +rices ,yields-. The deand for lon/4ter securities ould increase3 +lacin/ u+ard ,donard- +ressure on their +rices ,yields-. If the yield curve as o ri/inally u+ard slo+ed3 it ould no 2e ore hori9ontal ,less stee+-. If it as donard slo+ed3 it ould no 2e ore stee+. <. $i%uidity 8reiu Theory. E+lain the li%uidity +reiu theory. ANSWER If investors 2elieve that securities ith lar/er aturities are less li%uid3 they ill re%uire a +reiu hen investin/ in such securities to co+ensate. This theory can 2e co2ined ith the other theories to e+lain the sha+e of a yield curve. =. I+act of Call 7eature. Would yields 2e hi/her for calla2le 2onds or noncalla2le 2onds that are siilar in all other res+ects0 Why0 ANSWER Yields are hi/her for calla2le 2onds than noncalla2le 2on ds 2ecause the call feature allos the issuer to retrieve 2onds fro investors. The issuer ust offer a hi/her yield on calla2le 2onds to co+ensate investors. 1>. Se/ented )ar"ets Theory. If a donard4slo+in/ yield curve is ainly attri2uted to se/ented ar"ets theory3 hat does that su//est a2out the deand for and su++ly of funds in the short4ter and lon/4ter aturity ar"ets0 ANSWER A donard4slo+ed yield curve su//ests that the deand for short4ter funds is hi/h relative to the su++ly of short4ter funds3 causin/ a hi/h yield. In addition3 the deand for lon/4ter funds is lo relative to the su++ly of lon/4ter funds3 causin/ a lo yield. 11. Se/ented )ar"ets Theory. If the se/ented ar"ets theory causes an u+ard4slo+in/ yield curve3 hat does this i+ly0 If ar"ets are not co+letely se/ented3 should e disiss the se/ented ar"ets theory as even a +artial e+lanation for the ter structure of interest rates0 E+lain. ANSWER An u+ard4slo+ed yield curve caused 2y se/ented ar"ets i+lies that the deand for short4ter funds is lo relative to the su++ly of short4ter funds. In addition3 the deand for lon/4ter funds is hi/h relative to the su++ly of lon/4ter funds. Even if ar"ets are not co+letely se/ented3 investors and 2orroers ay +refer a +articular aturity ar"et.
Therefore3 they ay only sitch to a different aturity if there is sufficient co+ensation ,such as a hi/her return for investors or a loer cost of 2orroin/ for 2orroers-. 1#. 8referred 5a2itat Theory. E+lain the +referred ha2 itat theory. ANSWER The +referred ha2itat theory su//ests that hile investors and 2orroers ay +refer a natural aturity3 they ay ander fro that aturity under conditions here they can 2enefit fro selectin/ a different aturity. 1&. Yield Curve. What factors influence the sha+e of the yield curve0 !escri2e ho financial ar"et +artici+ants use the yield curve. ANSWER The yield curve's sha+e is affected 2y the deand and su++ly conditions for securities in various aturity ar"ets. E+ectations of interest rates3 the desire for li%uidity3 and the desire 2y investors or 2orroers for a s+ecific aturity ill influence the deand and su++ly conditions. The yield curve can 2e used to deterine the ar"et's e+ectations of future interest rates. )ar"et +artici+ants can co+are their on e+ec tations to the ar"et's e+ectations in order to deterine their 2orroin/ or investin/ decisions.
Advanced Questions 1(. Se/ented )ar"ets Theory. Su++ose that the Treasury decided to finance its deficit ith ostly lon/4ter funds. 5o could this decision affect the ter structure of interest rates0 If short4ter and lon/4ter ar"ets are se/ented3 ould the Treasury's decision have a ore or less +ronounced i+act on the ter structure0 E+lain. ANSWER If the Treasury 2orroed heavily in the lon/4ter ar"ets3 it could +lace u+ard +ressure on lon/4ter rates ithout havin/ as uch of an i+act on short4ter rates ,assuin/ that ar"ets are soehat se/ented-. 1*. Yield Curve. If li%uidity and interest rate e+ectations are 2 oth i+ortant for e+lainin/ the sha+e of a yield curve3 hat does a flat yield curve indicate a2out the ar"et's +erce+tion of future interest rates0 ANSWER A flat yield curve ithout consideration of a li%uidity +reiu ould re+resent no e+ected chan/e in interest rates accordin/ to the +ure e+ectations theory. Therefore3 if the flat yield curve reflects the eistence of a li%uidity +reiu3 this curve ould actually have a sli/ht donard slo+e hen reovin/ the li%uidity +reiu. This su//ests e+ectations of a sli/ht decline in future interest rates. 1:. ?lo2al Interaction aon/ Yield Curves. Assue that the yield curves in the @nited States3 7rance3 and a+an are flat. If the @.S. yield curves then suddenly 2ecoe so +ositively slo+ed3 do you thin" the yield curves in 7rance and a+an ould 2e affected0 If so3 ho0 ANSWER The yield curves in other countries ould also 2e affected if the event +reci+itatin/ the shift in the @.S. yield curve affects either actual or e+ected interest rates in other countries.
If lon/4ter interest rates in the @nited States rise in res+onse to a /reater @.S. deand for lon/4 ter funds3 then the yield curve ay have an u+ard slo+e. To the etent that this event attracts lon/4ter funds in other countries3 there ould 2e a saller su++ly of lon/4ter funds in those countries3 hich could cause hi/her lon/4ter rates there. Conse%uently3 their yield curves ould have an u+ard slo+e. 1;. )ulti+le Effects on the Yield Curve. Assue that ,1- investors and 2orroers e+ect that the econoy ill ea"en and that inflation ill decline3 ,#- investors re%uire a sall li%uidity +reiu3 and ,&- ar"ets are +artially se/ented and the Treasury currently has a +reference for 2orroin/ in short4ter ar"ets. E+lain ho each of these forces ould affect the ter structure3 holdin/ other factors constant. Then e+lain the effect on the ter structure overall. ANSWER The ea" econoy creates the e+e ctation of a decline in interest rates3 so accordin/ to e+ectations theory3 there ould 2e a donard4slo+in/ yield curve. The li%uidity +reiu results in a sli/ht u+ard slo+e to the yield curve. The TreasuryBs +reference ould result in a donard4slo+in/ deand yield curve3 hen other factors are held constant. verall3 there ould 2e a donard4slo+in/ yield curve 2ecause the e+ectations and se/ented ar"ets effects ould overhel the li%uidity effect. 1<. Effect of Crises on the Yield Curve. !urin/ soe crises3 investors shift their funds out of the stoc" ar"et and into oney ar"et securities for safety3 even if they do not fear risin/ interest rates. E+lain ho and hy these actions 2y investors affect the yield curve. Is the shift due to the e+ectations theory3 li%uidity +reiu theory3 or se/ented ar"ets theory0 ANSWER The oveent into oney ar"et securities results in a lar/er su++ly of short4ter funds3 and loers short4ter interest rates. Thus3 the yield curve 2ecoes ore stee+ly slo+ed. The shift in the yield curve is due to a +reference for investors to ove their funds into safe short4ter securities3 hich reflects se/ented ar"ets theory. 8ro2les 1. 7orard Rate. a. Assue that as of today3 the annuali9ed to4year interest rate is 1& +ercent3 hile the one4year interest rate is 1# +ercent. @se only this inforation to estiate the one4year forard rate. ANSWER E)DE! E%uation.& 2.Assue that the li%uidity +reiu on a to4year security is >.& +ercent. @se this inforation to re4estiate the one4year forard rate. ANSWER E)DE! E%uation.& #. 7orard Rate. Assue that as of today3 the annuali9ed interest rate on a three4year security is 1> +ercent3 hile the annuali9ed interest rate on a to4year security is ; +ercent. @se only this inforation to estiate the one4year forard rate to years fro no. ANSWER E)DE! E%uation.&
&.7orard Rate. If 3 hat is the ar"et consensus forecast a2out the one4year forard rate one year fro no0 Is this rate a2ove or 2elo today's one4year interest rate0 E+lain. ANSWER The one4year forard rate one year fro no is E)DE! E%uation.& 3 then the one4year forard rate one year fro no ust 2e 2elo today's one4year interest rate. (. After4ta Yield. You need to choose 2eteen investin/ in a one4year unici+al 2ond ith a ; +ercent yield and a one4year cor+orate 2ond ith an 11 +ercent yield. If your ar/inal federal incoe ta rate is &> +ercent and no other differences eist 2eteen these to securities3 hich one ould you invest in0 ANSWER Yat Y2t ,1 F TYat 11G ,1 F >.&>- ;.;G HYou should +refer the cor+orate 2ond. !erivin/ Current Interest Rates. Assue that interest rates for one4year securities are e+ected to 2e # +ercent today3 ( +ercent one year fro no and : +ercent to years fro no. @sin/ only the +ure e+ectations theory3 hat are the current interest rates on to4year and three4year securities0 ANSWER ,1 J ti# -# ,1 J ti1- ,1 J tJ1r1,1 J ti# -# ,1 J >.>#- ,1 J >.>(,1 J ti# -# 1.>:>< 1J ti# 1.>#==* ti# >.>#== ,1 J ti&-& ,1 J ti1- ,1 J tJ1r1- ,1 J tJ#r1,1 J ti&-& ,1J>.>#- ,1J>.>(- ,1J>.>:,1 J ti&-& 1.1#(((< 1 J ti& 1.>&=< ti& >.>&=< :. Coercial 8a+er Yield. a. A cor+oration is +lannin/ to sell its =>4day coercial +a+er to investors offerin/ an <.( +ercent yield. If the three4onth T42illBs annuali9ed rate is ; +ercent3 the default ris" +reiu is estiated to 2e >.: +ercent and there is a >.( +ercent ta ad6ustent3 hat is the a++ro+riate li%uidity +reiu0 ANSWER Yc+3 n Rf3n J !8 J $8 J TA $8 Yc+3n F Rf3n F !8 F TA $8 <.(G F ;G F >.:G F >.(G $8 >.(G
2. If due to une+ected chan/es in the econoy the default ris" +reiu increases to >.< +ercent3 hat is the a++ro+riate yield to 2e offered on the coercial +a+er ,assuin/ no other chan/es occur-0 ANSWER Yc+3n Rf3n J !8 J $8 J TA Yc+3n ;G J >..(G J >.(G <.:G ;. 7orard Rate. a.@se the 7orard Interest Rate Te+late on the C! to deterine the forard rate for various one4year interest rate scenarios if the to4year interest rate is < +ercent3 assuin/ no li%uidity +reiu. E+lain the relationshi+ 2eteen the one4year interest rate and the one4year forard rate3 holdin/ the to4year interest rate constant. ANSWER As the one4year interest rate rises3 the forard rate declines. The one4year forard rate is 9ero once the one4year interest rate is e%ual to the to4year interest rate3 and it 2ecoes ne/ative if the one4year interest rate eceeds the to4year interest rate. The forard rate is reduced hen usin/ hi/her levels of a one4year interest rate3 holdin/ a to4year interest rate constant. The saller the differential 2eteen the to4year and one4year interest rates3 the loer is the interest rate in the second year that is needed so that the co2ination of the to one4year rates are e%ual to the to4year rate. 2. @se the 7orard Interest Rate Te+late on the C! to deterine the one4year forard rate for the sae one4year interest rate scenarios in %uestion ,a-3 assuin/ a li%uidity +reiu of >.( +ercent. !oes the relationshi+ 2eteen the one4year interest rate and the forard rate chan/es hen considerin/ a li%uidity +reiu0 ANSWER The /eneral relationshi+ 2eteen the one4year interest rate and the one4year forard rate still holds. c. At the 2e/innin/ of #>>13 the yield curve in the @nited States ehi2ited a sli/ht u+ard slo+e. When econoic conditions ea"ened su2stantially in #>>13 the one4year interest rate declined su2stantially3 2ut the to4year and lon/er4ter interest rates declined only sli/htly. @se the 7orard Interest Rate Te+late to siulate such chan/es in the one4year and to4year interest rates3 and e+lain ho the one4year forard rate as affected 2y these chan/es. Dased on your estiated chan/es in the forard rate3 ho ould the e+ected interest rate 2e affected0 Would your /eneral anser a2out the e+ected interest rate vary ith the li%uidity +reiu that you i/ht assue throu/hout this ea+le0 ANSWER As the short4ter interest rates declined to a /reater de/ree3 the forard rate ould have 2ecoe ore u+ard slo+in/. d. @se the 7orard Interest Rate Te+late to deterine ho the one4year forard rate ould 2e affected if the %uoted to4year interest rate rises3 holdin/ the %uoted one 4year interest rate and the li%uidity +reiu constant. E+lain the lo/ic of this relationshi+.
ANSWER The forard rate increases for hi/her levels of a to4year interest rate. The /reater the differential 2eteen the to4year and one4year interest rates3 the /reater is the interest rate in the second year that is needed so that the co2ination of the to one4year rates are e%ual to the to4year rate. e. @se the 7orard Interest Rate Te+late to deterine ho the one4year forard rate ould 2e affected if the li%uidity +reiu rises3 holdin/ the %uoted one4year and to4year interest rate constant. E+lain the lo/ic of this relationshi+. ANSWER The forard rate is reduced for hi/her levels of the li%uidity +reiu3 h oldin/ the one4year and to4year interest rates constant. The hi/her the li%uidity +reiu3 the /reater the +ro+ortion of the interest rate differential ,to4year rate inus one4year rate- that is due to interest rate e+ectations3 and the loer is the o ne4year forard rate. <. After4Ta Yield. @se the Ta4ad6usted Yield Te+late to deterine ho the after4ta yield is affected 2y hi/her ta rates3 holdin/ the 2efore4ta yield constant. E+lain the lo/ic of this relationshi+. ANSWER The after4ta yield is reduced for hi/her levels of the ta rate3 holdin/ the 2efore4ta yield constant. The hi/her the ta rate3 the /reater the +ro+ortion of the 2efore4ta yield that is allocated for taes3 and the saller the +ro+ortion of the 2efore4ta yield retained 2y the investor. !e2t Security Yield. a. @se the !e2t Security Yield Te+late to deterine ho the a++ro+riate yield to 2e offered on a security is affected 2y a hi/her ris"4free rate. E+lain the lo/ic of this relationshi+. ANSWER The a++ro+riate yield to 2e offered on a security ou ld need to 2e increased if the ris"4free rate rises. A hi/her yield ould 2e necessary to +lace the security3 as investors still ant a +articular +reiu a2ove the ris"4free rate. 2. @se the !e2t Security Yield Te+late to deterine ho the a++ro+riate yield to 2e offered on a security is affected 2y a hi/her default ris" +reiu. E+lain the lo/ic of this relationshi+. ANSWER The a++ro+riate yield to 2e offered on a security ou ld need to 2e increased if the default +reiu on the security increased3 2ecause the investors ould re%uire a hi/her return to co+ensate for the hi/her default ris". c. @se the !e2t Security Yield Te+late to deterine ho the a++ro+riate yield to 2e offered on a security is affected 2y a hi/her call +reiu. E+lain the lo/ic of this relationshi+. ANSWER The a++ro+riate yield to 2e offered on a security ou ld need to 2e increased if the call +reiu on the security increased3 2ecause the investors ould re%uire a hi/her return to co+ensate for the li"elihood that the security ill 2e called 2efore aturity. d. @se the !e2t Security Yield Te+late to deterine ho the a++ro+riate yield to 2e offered on a security is affected 2y the eistence of a converti2ility discount. E+lain the lo/ic of this relationshi+.
ANSWER The a++ro+riate yield to 2e offered on a security ou ld 2e reduced if the converti2ility discount eists3 2ecause the investors ould re%uire a loer return if the y could convert the de2t security into stoc".
