What is the pure expectations theory

Reference no: EM13296189

Maria Juarez is a professional tennis player, and your firm manages her money. She has asked you to give her information about what determines the level of various interest rate. 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 rate, in the economy?

b) What is the real risk-free rate of interst (r*)and the nominal risk-free rate (r RF)? How are these two rates measured?

c) Define the term inflation premium(IP), default risk premium (DRP), liquidity premium (LP),and the maturity risk premium(MRP). Which of premium is included in determining the interst rate on (1)Short term U.S Treasury securities, (2)Long term U.S Treasury securities, (3)short term corporate securities, (4) long term coporate securities? Explain how the premiums would vary over time and among the different securities listed.

d) What is the term structure of interest rate? What is the 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 primium is zero for bonds that mature in 1 year or less and 0.1% for 2 years bonds; then the MRP increases by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest on 1-,10-, and 20-year treasury bonds? Draw a yield curve with these data. What factor can explain why this constructed yield curve is upward-sloping?

f) At any give time, how would the yield curve facing a AAA rated company compare with the yield curve for U.S Treasury securities? At any given 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 illustrat your answer.

g) What is the pure expectations theory? What does the pure expectation theory imply about the term structure of interest rate?

Reference no: EM13296189

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