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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
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?

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Solution Summary

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

Solution provided by:
  • MBA, Indian Institute of Finance
  • Bsc, Madras University
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