# Financial Institution & Markets Expectations Theory & Bonds Assignment

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Assuming that the expectations theory is the correct theory of the term structure, calculate the interest rates

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1. Assuming that the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years for the following series of one-year interest rates over the next five years. a. 5%, 7%, 7%, 7%, 7% b. 5%, 4%, 4%, 4%, 4% 2. Government economists have forecasted one-year T-bill rates for the following five years as follows: Year 1-year rate 1 4.25% 2 5.15% 3 5.50% 4 6.25% 5 7.10% You have liquidity premium 0.25% for the next two years and 0.50% thereafter. Would you be willing to purchase a 4-year T-bond at a 5.75% interest rate? 3. What is the yield on a \$1,000,000 municipal bond with a coupon rate of 8%, paying interest annually, versus the yield of a \$1,000,000 corporate bond with a coupon rate of 10% paying interest annually? Assume that you are in the 25% tax bracket. Which investment would you prefer. 4. Debt issued by Southeastern Corporation currently yields 12%. A municipal bond of equal risk currently yields 8%. At what marginal tax rate would an investor be indifferent between these two bonds? 5. 1-year T-bill rates are expected to steadily increase by 150 basis points per year over the next 6 years. Determine the required interest rate on a 3-year T-bond and a 6-year T-bond if the current 1-year interest rate is 7.5%. Assume that the Pure Expectations Hypothesis for interest rates holds. 6. The one-year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%, 9%, 10.5%, 13%, 14.5%, 16%, 17.5%. Using the pure expectations theory, what will be the interest rates on a 3year bond, 6-year bond, and 9-year bond? 7. Using the information from the previous question, now assume that the investor prefers holding short-term bonds. A liquidity premium of 10 basis points is required for each year of a bond’s maturity. What will be the interest rates on a 3-year bond, 6-year bond, and 9-year bond? 8. Which bond would produce a greater return if the pure expectations theory was to hold true, a 2-year bond with an interest rate of 15% or two 1-year bonds with sequential interest payment of 13% and 17%? 9. One-year T-bill rates over the next 4 years are expected to be 3%, 4%, 5%, & 5.5%. If 4-year Tbonds are yielding 4.5%, what is the liquidity premium on this bond? 10. If the interest rates on one- to five-year bonds are currently 4%, 5%, 6%, 7%, and 8% and the term premiums for one- to five year bonds are 0%, 0.25%, 0.30%, 0.40%, and 0.50%, predict what the one-year interest rate will be two years from now.
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1. Assuming that the expectations theory is the correct theory of the term structure,
calculate the interest rates in the term structure for maturities of one to five years for the
following series of one-year interest rates over the next five years.

a. 5%, 7%, 7%, 7%, 7%
The yield to maturity for a 1 year bond would be 5%, 5.9953% for a 2 year bond,
6.3291% for a three-year bond, 6.4965% for a four year bond and 6.5970% for a
5-year bond

b. 5%, 4%, 4%, 4%, 4%
The yield to maturity would be 5% for a one-year bond, 4.5% for a two-year bond, 4%
for a three-year bond, 4% for a four-year bond, and 4.2% for a five-year bond.

2. Government economists have forecasted one-year T-bill rates for the following five
years as follows:

Year

1-year rate

1

4.25%

2

5.15%

3

5.50%

4

6.25%

5

7.10%

You have liquidity premium 0.25% for the next two years and 0.50% th...

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