Question: 1. (Yield curve) Discuss the shape of the yield curve based on the following:
a. Find any yield curve in the Internet.
b. Discuss three theories that explain the term structure of interest rate
2. (Unbiased expectations theory) Currently you have $50,000 that you would like to invest for 2 years and are considering buying a government security maturing in 1 year that pays 3% annually. If you do this, you will also have to purchase another 1-year security at the end of the first year. The alternative is to invest in a government security that matures in 2 years; currently, 2-year government securities are paying 3.5% annually. If you invest your money for 1 year and then after 1 year reinvest it for another year, what rate will you have to earn in order to make the two alternatives equal?
This Mini Case is available in MyFinanceLab. You have been assigned to work as an assistant to the chief financial officer (CFO) of Carat Designs, Inc. As one of your assignments, you have been asked to estimate the nominal interest rate for a new issue of a bond. The final format you should provide to the CFO is that of the equation in the following table. Some agreed-upon procedures related to generating estimates for key variables are as follows:
a. The current 3-month Treasury bill rate is 3% and the inflation rate is 2%.
b. The 30-year Treasury bond rate is 5% and the 30-year corporate bond rate is 7%.
c. The liquidity-risk premium will be greater than zero, however, because the secondary market for the firm's bonds is more uncertain. It is estimated at 5 basis points. Estimate the nominal interest rate and provide a short explanation for every step in the equation for your discussion with the CFO.
