Chapter 15 - The Term Structure of Interest RatesCHAPTER 15: THE TERM STRUCTURE OF INTEREST RATESPROBLEM SETS.1.In general, the forward rate can be viewed as the sum of the markets expectation of the future short rate plus a potential risk (or liquidity) premium. According to the expectations theory of the term structure of interest rates, the liquidity premium is zero so that the forward rate is equal to the markets expectation of the future short rate. Therefore, the markets expectation of future short rates (i.e., forward rates) can be derived from the yield curve, and there is no risk premium for longer maturities.The liquidity preference theory, on the other hand, specifies that the liquidity premium is positive so that the forward rate is greater than the markets expectation of the future short rate. This could result in an upward sloping term structure even if the market does not anticipate an increase in interest rates. The liquidity preference theory is based on the assumption that the financial markets are dominated by short-term investors who demand a premium in order to be induced to invest in long maturity securities.2.True. Under the expectations hypothesis, there are no risk premia built into bond prices. The only reason for long-term yields to exceed short-term yields is an expectation of higher short-term rates in the future.3.Uncertain. Expectations of lower inflation will usually lead to lower nominal interest rates. Nevertheless, if the liquidity premium is sufficiently great, long-term yields may exceed short-term yields despite expectations of falling short rates.4. The liquidity theory holds that investors demand a premium to compensate them for interest rate exposure and the premium increases with maturity. Add this premium to a flat curve and the result is an upward sloping yield curve.5. The pure expectations theory, also referred to as the unbiased expectations theory, purports that forward rates are solely a function of expected future spot rates. Under the pure expectations theory, a yield curve that is upward (downward) sloping, means that short-term rates are expected to rise (fall). A flat yield curve implies that the market expects short-term rates to remain constant.6. The yield curve slopes upward because short-term rates are lower than long-term rates. Since market rates are determined by supply and demand, it follows that investors (demand side) expect rates to be higher in the future than in the near-term.7.MaturityPriceYTMForward Rate1$943.406.00%2$898.475.50%(1.0552/1.06) 1 = 5.0%3$847.625.67%(1.05673/1.0552) 1 = 6.0%4$792.166.00%(1.064/1.05673) 1 = 7.0%8.The expected price path of the 4-year zero coupon bond is shown below. (Note that we discount the face value by the appropriate sequence of forward rates implied by this years yield curve.)Beginning of YearExpected PriceExpected Rate of Return1$792.16($839.69/$792.16) 1 = 6.00%2($881.68/$839.69) 1 = 5.00%3($934.58/$881.68) 1 = 6.00%4($1,000.00/$934.58) 1 = 7.00%9.If expectations theory holds, then the forward rate equals the short rate, and the one-year interest rate three years from now would be 10.a.A 3-year zero coupon bond with face value $100 will sell today at a yield of 6% and a price of:$100/1.063 =$83.96Next year, the bond will have a two-year maturity, and therefore a yield of 6% (from next years forecasted yield curve). The price will be $89, resulting in a holding period return of 6%.b.The forward rates based on todays yield curve are as follows:YearForward Rate2(1.052/1.04) 1 = 6.01%3(1.063/1.052) 1 = 8.03%Using the forward rates, the forecast for the yield curve next year is:MaturityYTM16.01%2(1.0601 1.0803)1/2 1 = 7.02%The market forecast is for a higher YTM on 2-year bonds than your forecast. Thus, the market predicts a lower price and higher rate of return.11.a.b.The yield to maturity is the solution for y in the following equation:Using a financial calculator, enter n = 2; FV = 100; PMT = 9; PV = 101.86; Compute i YTM = 7.958%c.The forward rate for next year, derived from the zero-coupon yield curve, is the solution for f 2 in the following equation: f 2 = 0.0901 = 9.01%.Therefore, using an expected rate for next year of r2 = 9.01%, we find that the forecast bond price is:d.If the liquidity premium is 1% then the forecast interest rate is:E(r2) = f2 liquidity premium = 9.01% 1.00% = 8.01%The forecast of the bond price is:12.a.The current bond price is:($85 0.94340) + ($85 0.87352) + ($1,085 0.81637) = $1,040.20This price implies a yield to maturity of 6.97%, as shown by the following:$85 Annuity factor (6.97%, 3) + $1,000 PV factor (6.97%, 3) = $1,040.17b.If one year from now