# Interest Rate Determination/The Yield Curve

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1) Morgan Motors has three-year bonds that currently yield 8.25%. The real risk-free rate (r*) is 2.50% and is expected to remain constant. Inflation is expected to be 3.0% per year for each of the next four years and 4.50% thereafter. The maturity risk premium (MRP) is determined from the formula: O.1(t - 1)%, where t is the security's maturity. The default risk and liquidity premiums on all of Morgan's bonds are equal. What is the yield on a six-year bond issued by Morgan Motors? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average.

8.97%

9.05%

8.69%

9.31%

9.13%

2) A Treasury yield curve is plotted below in the graph:

Would you describe this yield curve as being normal, inverted, or humped?

Normal

Humped

Inverted

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Morgan Motors has three-year bonds that currently yield 8.25%. The real risk-free rate (r*) is 2.50% and is expected to remain constant. Inflation is expected to be 3.0% per year for each of the next four years and 4.50% thereafter. The maturity risk premium (MRP) is determined from the formula: O.l(t - 1)%, where t is the security's maturity. The default risk and liquidity premiums on all of Morgan's bonds are equal. What is the yield on a six-year bond issued by Morgan Motors? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average.

8.97%

9.05%

8.69%

9.31%

9.13%

Answer: 9.05%

The determinants of interest rates are:

k = k* + IP + DRP + LP + MRP

For a 3 year ...

#### Solution Summary

Answers questions relating to the interest rate determination and the yield curve.