Chapter 6

Question 1

r* can be defined as the ____1_______.
When analyzing interest rates, this is the lowest possible rate to which we add various __2___ to compensate lenders for various risks.

Answer 1

1. real, risk free rate of return

2. Risk Premiums

Question 2

There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. These are:

Answer 2

1. IP
2. DRP
3. LP
4. MRP

Question 3

There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. One These is “IP” what it stands for and what it compensates for

Answer 3

stands for:
Inflation
Premium

compensates for:
Inflation, reduction in purchasing
power

Question 4

There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. One These is “DRP” what it stands for and what it compensates for

Answer 4

stands for:
Default risk
premium

compensates for:
The risk that the borrower may not
be able to make interest payments
or repay the bond principal

Question 5

There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. One These is “LP” what it stands for and what it compensates for

Answer 5

stands for:
Liquidity
Premium

compensates for:
The risk that you may not be able
to dispose of a bond when you
need to.

Question 6

There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. One These is “MRP” what it stands for and what it compensates for

Answer 6

stands for:
Maturity Risk
Premium

compensates for:
The risk that, during a bond’s
term, market interest rates might
rise, and thus the value of your
bond decline.

Question 7

whats the formula for the make-up of market interest rates on bonds:

Corp Bond yield
Quoted interest rate =

Answer 7

r = (r* + IP) + DRP + LP + MRP

Question 8

When the term ‘risk-free rate’ is used, it normally refers to ___ + ___, and is labeled Rrf.

Answer 8

( r* + IP ) = Real, risk free rate of return + Inflation premium

Question 9

which premiums apply to U.S. Treasury Bond yield

Answer 9

r* + IP + MRP, so

Real Risk Free Rate of Return
             \+
Inflation Premium 
             \+
Maturity Risk Premium

Question 10

which premiums DO NOT apply to U.S. Treasury Bond yield

Answer 10

DRP & LP, so

Default Risk Premium
&
Liquidity Premium

Question 11

What is the normal slope of a Yield Curve, and why?

Answer 11

Upward Sloping due to risks such as DRP, LP, and MRP.

Question 12

Why might a Yield Curve be inverted?

Answer 12

If inflation rates are expected to decrease in the future.

Question 13

How would you compare the Yield Curve for Corporate Bonds to a Yield Curve for a U.S. Treasury Bonds (all else the same)? What differences should exist?

Answer 13

The Yield Curve for Corporate Bonds would lie above the Yield Curve for Treasuries. This would imply
higher interest rates, which compensate for higher risks

Question 14

Which of the Risk Premiums has the largest impact on the slope of (any) Yield Curve, and why?

Answer 14

Expected inflation (Inflation Premium)