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Quiz 4 :

The Structure of Interest Rates

Quiz 4 :

The Structure of Interest Rates

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Why is the interest rate on a credit card usually higher than the interest rate on an automobile loan?
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A borrower will find the interest rate on a loan from the starting day. Here the interest rates are different at different debt securities, which will base on the supply and demand of securities like loan for a car is 7% and on business loans at 14 percent and at credit cards 14% these based on their characteristics.
They include expected return, risk maturity liquidity and taxation here if the borrower may fail to pay loan at car loan then they can hand over their car and they can sell that car and can get money back because it is at collateral.
However, the credit cards are not collateral. If the borrower fails to pay the amount, the lender cannot seize any of the borrower's assets instead. The lender must go to the court to get the payment by the force on borrower. This is an expensive process to the lender.
For example: the interest rate on credit card (14.7percent) is much higher than the interest rate on automobile loans (5.2percent) or on at fixed mortgage (5.0percent) both auto mobile loans and mortgage loans have a little risk to the lenders. Lender will offer the loan at collateral this difference is reflected in on the interest rates similarly on yields to maturity on bonds.

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Why is the interest rate on a security sold by a city government usually less than the interest rate on a security sold by a corporation if both have comparable default risk?
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The yield to maturity on local government bond is low-only 3.5 percent -primarily because interest earned on local government bonds is exempt from federal income taxes.
Here there is some risk at local government bonds because a city or state may go bankrupt. Most city and state government used to issue their bonds at credit and ratings and it may allow corporate credit rating on better financial ratings 6.3 and lower financial rating 8.3 on local government bond 3.5.
We can compare the yield to maturity of corporate bond and impact of tax on corporate bonds. Investors have pay taxes on interest earned but we need not pay at local government bonds and the interest rate is also low on government bonds and difference in yield to maturity reflects the investor used to buy the government bonds.

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Why is the interest rate on an on-the-run security usually less than the interest rate on an off-therun security?
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The treasury securities of a given time to maturity that was issued most recently in the primary market is called the on the run security. The treasury security that is not most recently issued is called off the run security. There is a source of difference to get a yield in liquidity comparing to the less liquid Securities, at the more liquid securities takes a lower cost of range.
Here the investor can get more, at more liquid securities but the yield to maturity of less liquid securities must be higher to persuade investors to hold them instead of more liquid securities. Many investor uses on the run security for buying and selling.
Either to speculate or to combine with other securities to reduce the risk in their portfolios by these its market is very liquid.
The yield to maturity of an on the run security is usually a bit lower than the yield to maturity of an off the run security.
For example: if the investor invests on on-the run-security at 30 years maturity at 4.4 % where as an off-the run security with 29 years to maturity the yield to maturity of 4.50% at a difference of 0.01% point.

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Explain what a yield curve shows. What must be held constant among the bonds whose interest rates are shown on a yield curve?
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Explain why investors might compare the interest rate on a long-term bond with the expected future interest rates on short-term bonds.
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Describe the shape of the yield curve if investors think that short-term interest rates are likely to increase in the future. Why does the yield curve have this shape?
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What is a term premium, and why does it exist?
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What characteristics of a debt security determine the size of its term premium?
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Is the term premium constant over time? If not, why not?
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What is the shape of the yield curve at the start of a recession? At the start of an economic expansion? In the middle of an economic expansion?
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Suppose that a corporate bond with a Baa credit rating and fi ve years to maturity has a yield to maturity of 8 percent. Suppose that the government of the city of Udwellum, which has a Baa credit rating, issues a bond with the same time to maturity in a market that is just as liquid as the market for corporate bonds. Suppose that investors have a federal tax rate of 30 percent. Calculate the interest rate that Udwellum should pay on its bonds if they will yield the same after-tax rate of return to investors as comparable corporate bonds. Show your work.
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Compare a two-year bond with two successive one-year bonds in a situation in which an investor buys a one-year bond today and then another one-year bond when the fi rst matures. Suppose that the two-year bond has an interest rate of 8 percent each year. a Now consider the pattern of interest rates on the one-year bonds listed below and explain whether an investor should buy the two-year bond or the one-year bond today, assuming that the only thing that matters to the investor is the amount of money he has at the end of the two years. In each case, how much would an investor have at the end of two years if he invested $1,000 today? (i) The one-year interest rate today is 7 percent; the one-year interest rate will be 9 percent one year from now. (ii) The one-year interest rate today is 5 percent; the one-year interest rate will be 11 percent one year from now. (iii) The one-year interest rate today is 3 percent; the one-year interest rate will be 13 percent one year from now. (iv) The one-year interest rate today is 0 percent; the one-year interest rate will be 16 percent one year from now. b From these results, is it reasonable to compare the average interest rates on alternative fi nancial investments? (In other words, how reasonable is the assumption that we can compare average interest rates on short-term bonds with the interest rate on long-term bonds instead of using the exact method?)
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You are given the following information on the bond market: Money available on January 1, 2011: $1,000 Interest rates on January 1, 2011, on bonds of different maturities: one year, 4 percent; two years, 5 percent; three years, 5.5 percent; four years, 6 percent Note: Consider these to be bonds that compound the interest at the rate given, that is, the three-year bond pays $1,000 _ 1.0553 at maturity. Expected future interest rates on one-year bonds: January 1, 2012 6.5 percent January 1, 2013 7 percent January 1, 2014 9 percent Investment horizon: 4 years, ending January 1, 2015 What should an investor buy to yield the largest stream of expected income over the period from January 1, 2011, to January 1, 2015?
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How would your answer to question 13 change if there is a $10 transactions cost for every bond purchased? In other words, if an investor has $1,000 now, she can spend only $990 on a bond because $10 goes for transactions costs. Each time she buys a new bond, she incurs the $10 fee.
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Suppose that the interest rate on a one-year bond is 7 percent today and the interest rates expected on one-year bonds in the future are 6 percent in one year, 5 percent in two years, and 4 percent in three years. a According to the expectations theory of the term structure, what are the interest rates today on a two-year bond, a three-year bond, and a four-year bond? b If the term premium is equal to 0.5 percent times the number of years to maturity of a bond for times to maturity of two, three, and four years, what are the interest rates today on a two-year bond, a three-year bond, and a four-year bond? (Assume no term premium on one-year bonds.)
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In Table 1, show the derivation of each of the following entries: a The interest rate of 5.1 percent on a bond sold in 2011 that matures in 7 years. b The interest rate of 4.4 percent on a bond sold in 2014 that matures in 5 years. c The interest rate of 4.5 percent on a bond sold in 2018 that matures in 2 years. Table 1 Equilibrium Interest Rates on Bonds with Differing Times to Maturity img
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Which would you rather hold if there is a decline in interest rates: long-term bonds or short-term bonds? Why?
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What would happen to the yield curve if investors were concerned about stability in foreign countries and rushed their money into the United States to buy long-term Treasury securities? How would you expect the term premium to change?
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If the newspaper reported that the interest rate on 10-year Treasury securities was 5 percent and the interest rate on three-month Treasury securities was 6 percent, would it be a good time to invest in the stock market? Explain your reasoning.
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If capital gains are taxed at a lower rate than interest income, would the determination of yields to maturity be affected? Consider the case in which a change in the market interest rate has occurred in an early year in the life of a bond, after which the market interest rate remains constant. You are considering two bonds: a used one with a capital gain or loss versus a new one paying interest at the market rate. Would it matter for your decision about which bond to buy whether the market interest rate today was lower or higher than the original interest rate on your bond?
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