BASIC PROBLEMS 81   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. (LG4)  82   Determinants of Interest Rates for Individual Securities You are considering an investment in 30year bonds issued by Moore Corporation. The bonds have no special covenants. The Wall Street Journal reports that oneyear Tbills are currently earning 3.25 percent. Your broker has determined the following information about economic activity and Moore Corporation bonds:  Real interest rate = 2.25%   Default risk premium = 1.15%   Liquidity risk premium = 0.50%   Maturity risk premium = 1.75% 
a.   What is the inflation premium? (LG4)  b.   What is the fair interest rate on Moore Corporation 30year bonds? (LG4) 

p. 201 83   Determinants of Interest Rates for Individual Securities Dakota Corporation 15year bonds have an equilibrium rate of return is 8 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 bond's default risk premium. (LG4)  84   Determinants of Interest Rates for Individual Securities A twoyear Treasury security currently earns 4.14 percent. Over the next two years, the real interest rate is expected to be 2.25 percent per year and the inflation premium is expected to be 1.75 percent per year. Calculate the maturity risk premium on the twoyear Treasury security. (LG4)  85   Unbiased Expectations Theory Suppose that the current oneyear rate (oneyear spot rate) and expected oneyear Tbill rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows: (K) Using the unbiased expectations theory, calculate the current (longterm) rates for one, two, three, and fouryearmaturity Treasury securities. Plot the resulting yield curve. (LG5)  86   Unbiased Expectations Theory Oneyear Treasury bills currently earn 3.45 percent. You expect that one year from now, oneyear Treasury bill rates will increase to 3.65 percent. If the unbiased expectations theory is correct, what should the current rate be on twoyear Treasury securities? (LG5)  87   Liquidity Premium Hypothesis Oneyear Treasury bills currently earn 3.45 percent. You expect that one year from now, oneyear Treasury bill rates will increase to 3.65 percent. The liquidity premium on twoyear securities is 0.05 percent. If the liquidity theory is correct, what should the current rate be on twoyear Treasury securities? (LG5)  88   Liquidity Premium Hypothesis Based on economists' forecasts and analyses, oneyear Treasury bill rates and liquidity premiums for the next four years are expected to be as follows: (K) Using the liquidity premium hypothesis, plot the current yield curve. Make sure you label the axes on the graph and identify the four annual rates on the curve both on the axes and on the yield curve itself. (LG5) 
INTERMEDIATE PROBLEMS 89   Determinants of Interest Rates for Individual Securities The Wall Street Journal reports that the rate on threeyear Treasury securities is 6.00 percent, and the sixyear Treasury rate is 6.20 percent. From discussions with your broker, you have determined that expected inflation premium is 2.25 percent next year, 2.50 percent in Year 2, and 2.60 percent in Year 3 and beyond. Further, you expect that real interest rates will be 3.4 percent annually for the foreseeable future. a.   Calculate the maturity risk premium on the threeyear Treasury security. (LG4)  b.   Calculate the maturity risk premium on the sixyear Treasury security. (LG4) 
 810   Determinants of Interest Rates for Individual Securities Nikki G's Corporation's 10year bonds are currently yielding a return of 8.15 percent. The expected inflation premium is 2.5 percent annually and the real interest rate is expected to be 3.10 percent annually over the next 10 years. The liquidity risk premium on Nikki G's bonds is 0.25 percent. The maturity risk premium is 0.10 percent on twoyear securities and increases by 0.05 percent for each additional year to maturity. Calculate the default risk premium on Nikki G's 10year bonds. (LG4) 
p. 202 811   Unbiased Expectations Theory Suppose we observe the following rates: (K) If the unbiased expectations theory of the term structure of interest rates holds, what is the oneyear interest rate expected one year from now, E(_{2}r_{1})? (LG4)  812   Unbiased Expectations Theory The Wall Street Journal reports that the rate on fouryear Treasury securities is 5.60 percent and the rate on fiveyear Treasury securities is 6.15 percent. According to the unbiased expectations hypotheses, what does the market expect the oneyear Treasury rate to be four years from today, E(_{5}r_{1})? (LG5)  813   Liquidity Premium Hypothesis The Wall Street Journal reports that the rate on threeyear Treasury securities is 5.25 percent and the rate on fouryear Treasury securities is 5.50 percent. The oneyear interest rate expected in three years is E(_{4}r_{1}), is 6.10 percent. According to the liquidity premium hypotheses, what is the liquidity premium on the fouryear Treasury security, L_{4}? (LG5)  814   Liquidity Premium Hypothesis Suppose we observe the following rates: (K) If the liquidity premium theory of the term structure of interest rates holds, what is the liquidity premium for year 2, L_{2}? (LG5) (K)  815   Forecasting Interest Rates You note the following yield curve in The Wall Street Journal. According to the unbiased expectations hypothesis, what is the oneyear forward rate for the period beginning one year from today, _{2}f_{1}? (LG6)  816   Forecasting Interest Rates On May 23, 20XX, the existing or current (spot) oneyear, twoyear, threeyear, and fouryear zerocoupon Treasury security rates were as follows: (K) Using the unbiased expectations theory, calculate the oneyear forward rates on zerocoupon Treasury bonds for years 2, 3, and 4 as of May 23, 20XX. (LG6) 
ADVANCED PROBLEMS 817   Determinants of Interest Rates for Individual Securities The Wall Street Journal reports that the current rate on 10year Treasury bonds is 7.25 percent, on 20year Treasury bonds is 7.85 percent, and on a 20year corporate bond is 8.75 percent. Assume that the maturity risk premium is zero. If the default risk premium and liquidity risk premium on a 10year corporate bond are the same as that on the 20year corporate bond, calculate the current rate on a 10year corporate bond. (LG4)  818   Determinants of Interest Rates for Individual Securities The Wall Street Journal reports that the current rate on fiveyear Treasury bonds is 6.85 percent and on 10year Treasury bonds is 7.35 percent. Assume that the maturity risk premium is zero. Calculate the expected rate on a fiveyear Treasury bond purchased four years from today, E(_{5}r_{5}). (LG4)  819   Unbiased Expectations Theory Suppose we observe the threeyear Treasury security rate (_{1}R_{3}) to be 8 percent, the expected oneyear rate next year—E(_{2}r_{1})—to be 4 percent, and the expected oneyear rate the following year—E(_{3}r_{1})—to be 6 percent. If the unbiased expectations theory of the term structure of interest rates holds, what is the oneyear Treasury security rate, _{1}R_{1}? (LG5) 
p. 203 820   Unbiased Expectations Theory The Wall Street Journal reports that the rate on threeyear Treasury securities is 5.60 percent and the rate on fiveyear Treasury securities is 6.15 percent. According to the unbiased expectations hypothesis, what does the market expect the twoyear Treasury rate to be two years from today, E(_{3}r_{2})? (LG5)  821   Forecasting Interest Rates Assume the current interest rate on a oneyear Treasury bond (_{1}R_{1}) is 4.50 percent, the current rate on a twoyear Treasury bond (_{1}R_{2}) is 5.25 percent, and the current rate on a threeyear Treasury bond (_{1}R_{3}) is 6.50 percent. If the unbiased expectations theory of the term structure of interest rates is correct, what is the oneyear interest rate expected on Treasury bills during year 3, _{3}f_{1}? (LG6)  822   Forecasting Interest Rates A recent edition of The Wall Street Journal reported interest rates of 2.25 percent, 2.60 percent, 2.98 percent, and 3.25 percent for threeyear, fouryear, fiveyear, and sixyear Treasury security yields, respectively. According to the unbiased expectation theory of the term structure of interest rates, what are the expected oneyear rates for years 4, 5, and 6? (LG6) 
