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# Nominal Interest Rates and Yield Curves

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Nominal interest rates and yield curves A recent study of inflationary expectations
has revealed that the consensus among economic forecasters yields the following average annual rates of inflation expected over the periods noted.
(Note: Assume that the risk that future interest rate movements will affect
longer maturities more than shorter maturities is zero; that is, assume that there
is no maturity risk.)

Period 3 months Average annual rate of inflation 5%
Period 2 years Average annual rate of inflation 6%
Period 5 years Average annual rate of inflation 8%
Period 10 years Average annual rate of inflation 8.5%
Period 20 years Average annual rate of inflation 9%

a. If the real rate of interest is currently 2.5%, find the nominal rate of interest on
each of the following U.S. Treasury issues: 20-year bond, 3-month bill, 2-year
note, and 5-year bond.
b. If the real rate of interest suddenly dropped to 2% without any change in
inflationary expectations, what effect, if any, would it have on your answers in
part a? Explain.
c. Using your findings in part a, draw a yield curve for U.S. Treasury securities.
Describe the general shape and expectations reflected by the curve.
d. What would a follower of the liquidity preference theory say about how the
preferences of lenders and borrowers tend to affect the shape of the yield
curve drawn in part c? Illustrate that effect by placing on your graph a
dotted line that approximates the yield curve without the effect of liquidity
preference.
e. What would a follower of the market segmentation theory say about the supply
and demand for long-term loans versus the supply and demand for short-term
loans given the yield curve constructed for part c of this problem?

#### Solution Summary

This solution shows step-by-step calculations to determine yield on treasury securities, real rates of interest, and yield curves.

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## If one expects the inflation premium to be 2%, the default risk premium to be 1%

1) If one expects the inflation premium to be 2%, the default risk premium to be 1%, and the real interest rate to be 4%, what interest rate would you expect to observe in the market place under the simplest form of market rates?
a) 4% b) 7 % c) 2% d) 1%

2) What is the real rate of interest if the nominal rate of interest is 15%, the inflation premium is 3%, the default is 3%, and the maturity risk premium is 3%, and the liquidity premium is 2%
a) 3% b) 4% c) 5% d) none of the above.

3) When investors expect ______ inflation rates, they will require ______
nominal interest rates so that a real rate of return will remain after the inflation.
a) higher, higher. b) higher, lower. c) lower higher d) none of the above.

4) Assume that these current yields exist: long term government securities yield 9%, 5 year treasury securities yield 8.5%, and 1 year treasury bills yield 8%. What type of yield curve is depicted?
a) downward sloping b) flat or level c) upward sloping d) u shaped

5) What yield curve shape is depicted if intermediate term tresury securities yield 10%, short term treasuries yield 10.5%, and long term treasuries yield 9.5% ?
a) downward sloping b) flat or level c) upward sloping d) u shaped.

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