Suppose 10-year t-bonds have a yield of 5.30

FIN3000-005 Assignment

Read Chapter 6 as well as the provided weblinked material, and follow the below instructions.

https://www.federalreserve.gov/faqs/money_12856.htm

http://www.bankrate.com/finance/mortgages/fed-affects-banks-rates-prices-and-jobs-1.aspx

https://www.lendingtree.com/mortgage/affect-of-fed-on-interest-rates-article

1) Define the following. (Short answers okay)

a. Opportunity Cost

b. Risk Free Rate

c. Inflation Premium

d. Default Risk Premium

2) Write an essay of no more than 1 page, that summarizes the role of the Federal Reserve Bank in setting interest rates.

3) Work the following Problems.

a. Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.

b. Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

c. Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.75%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is the default risk premium on corporate bonds?

d. Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.25%, 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.