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Interest Rate on an auto loan

The president of a company is in the process of setting rates on 1 year CDs and on 4 year, fixed rate automobile loans. The automobile loans will be financed primarily by issuing 1 year CDs. The yield curve is presently upward sloping, suggesting that these fixed rate loans should be priced carefully. Based on the following information and expectation theory, what rate should the bank charge on the 4 year loan? Assume liquidity premium is equal to zero.

Treasury Securities
Maturity (year) Observed annual yield
1 4.50%
2 5.25%
3 5.75%
4 6.5%

Administrative markup = 1.5% per year

Risk premiums required for holding auto loans

Year 1 2%
Year 2 2.5%
Year 3 3%
Year 4 3.5%

Solution Preview

The answer is in the attached Excel file

The president of a company is in the process of setting rates on 1 year CDs and on 4 year, fixed rate automobile loans. The automobile loans will be financed primarily by issuing 1 year CDs. The yield curve is presently upward sloping, suggesting that these fixed rate loans should be priced carefully. Based on the following information and expectation theory, ...

Solution Summary

The expert calculates the rate the bank should charge on the 4 year automobile loan.

$2.19