Interest rate determination

Integrated Case 6-21: Morton Handley & Company

Interest rate determination. Maria Juarez is a professional tennis player, and your firm managers her money. She has asked you to give her information about what determines the level of various interest rates. Your boss has prepared some questions for you to consider.

a. What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?
b. What is the real risk-free rate of interest (r*) and the nominal risk-free rate? How are these two rates measured?
c. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included in determining the interest rate on 1) short-term U.S. Treasury securities, 2) Long-term U.S. Treasury security, 3) short-term corporate securities, and 4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed.
d. What is the term structure of interest rates? What is a yield curve?
e. Suppose most investors expect the inflation rate to be 5% next year, 6% the following year, and 8% thereafter. The real risk-free rate is 3%. The maturity risk premium is zero for bonds that mature in 1 year or less and 0.1% for 2-year bonds; then the MRP increases by 0.1% per year thereafter for 20years, after which it is stable. What is the interest rate on 1-, 10-, and 20-year Treasury bonds? Draw a yield with these data. What factors can explain why this constructed yield curve is upward-sloping?
f. At any giving time, how would the yield curve facing a AAA-rated company compare with the yield curve for U.S. Treasury securities? At any giving time, how would the yield curve facing a BB-rated company compare with the yield curve for U.S. Treasury securities? Draw a graph to illustrate your answer.
g. What is the pure expectations theory? What does the pure expectations theory imply about the term structure of interest rates?
h. Suppose you observe the following term structure for treasury securities:
Maturity Yield
1 year 6.0%
2 year 6.2%
3 year 6.4%
4 year 6.5%
5 year 6.5%

Assume that the pure expectations theory of the term structure is correct. (The implies that you can use the yield curve provided to "back out" the market's expectations about future interest rates.) what does the market expect will be the interest rate on 1-year securities 1 year from now? What does the market expect will be the interest rate on 3 year securities 2 years from now?