Low Interest Rates Encourage Investment and Stimulate Consumer Spending
What is the price paid to borrow debt capital called?
What are the two items whose sum is the cost of equity?
What four fundamental factors affect the cost of money?
What role do interest rates play in allocating capital to different
potential borrowers?
What happens to market-clearing, or equilibrium, interest rates in a
capital market when the demand for funds declines? What happens
when expected inflation increases or decreases?
How does the price of capital tend to change during a boom or a
recession?
How does risk affect interest rates?
If inflation during the last 12 months was 2 percent and the interest
rate during that period was 5 percent, what was the real rate of
interest?
If inflation is expected to average 4 percent during the next
year and the real rate is 3 percent, what should the current rate of
interest be? (3%; 7%)
Write out an equation for the nominal interest rate on any security.
Distinguish between the real risk-free rate of interest, r, and the
nominal, or quoted, risk-free rate of interest, r RF.
How do investors deal with inflation when they determine interest
rates in the financial markets?
Does the interest rate on a T-bond include a default risk premium?
Explain.
Distinguish between liquid and illiquid assets, and list some assets
that are liquid and some that are illiquid.
Briefly explain the following statement: “Although long-term bonds
are heavily exposed to interest rate risk, short-term T-bills are heavily exposed to reinvestment rate risk. The maturity risk premium reflects the net effects of these two opposing forces.”
Assume that the real risk-free rate is r 2% and the average
expected inflation rate is 3 percent for each future year. The DRP
and LP for Bond X are each 1 percent, and the applicable MRP is
2 percent.
What is Bond X’s interest rate? Is Bond X (1) a Treasury
bond or a corporate bond and (2) more likely to have a 3-month or a
20-year maturity? (9 percent, corporate, 20-year)
What is a yield curve, and what information would you need to
draw this curve?
Distinguish among the shapes of a “normal” yield curve, an
“abnormal” curve, and a “humped” curve.
If the interest rates on 1-, 5-, 10-, and 30-year bonds are 4, 5, 6, and
7 percent, respectively, how would you describe the yield curve? If
the rates were reversed, how would you describe it
How do maturity risk premiums affect the yield curve?
If the inflation rate is expected to increase, would this increase or
decrease the slope of the yield curve?
If the inflation rate is expected to remain constant at the current level
in the future, would the yield curve slope up, down, or be horizon-
tal? Consider all factors that affect the yield curve, not just inflation
What key assumption underlies the pure expectations theory?
Assuming that the pure expectations theory is correct, how are
expected short-term rates used to calculate expected long-term
rates?
According to the pure expectations theory, what would happen if
long-term rates were not an average of expected short-term rates?
Most evidence suggests that a positive maturity risk premium exists.
How would this affect your calculations when determining interest
rates?
Assume the interest rate on a one-year T-bond is currently 7 percent
and the rate on a two-year bond is 9 percent. If the maturity risk
premium is zero, what is a reasonable forecast of the rate on a one-
year bond next year?
What would the forecast be if the maturity risk
premium on the two-year bond were 0.5 percent and it was zero for
the one-year bond? (11.04 percent; 10.02 percent
Other than inflationary expectations, name some additional factors
that influence interest rates, and explain the effects of each.
What is country risk?
What is exchange rate risk?
On what two factors does the return on a foreign investment depend?
If short-term interest rates are lower than long-term rates, why
might a borrower still choose to finance with long-term debt?
Explain the following statement: “The optimal financial policy
depends in an important way on the nature of the firm’s assets.”