Exam 7: Inflation and Deflation, Yield Curves, and Duration: Impact on Interest Rates and Asset Prices

According to the money-substitutes hypothesis, if interest rates rise above "normal" levels, investors will come to expect an eventual decline in the level of interest rates and capital gains on the bonds they hold and, therefore, will settle for lower liquidity premiums.

Synchron Corporation borrows long term-capital at an interest rate of 8.5 percent under the expectation that the annual inflation rate over the life of this borrowing was likely to be 5 percent. However, shortly after the loan contract was signed, the actual inflation rate climbed to 5.5 percent and is expected to remain at that level until Synchron's loan reaches maturity. Other factors held constant, what is likely to happen to the market value per share of Synchron's common stock? Please explain your reasoning.

The view that the nominal interest-rate need not be affected by inflation, but the real rate will be affected by inflation is known as the:

Price of the bond at a14% yield to maturity = 941.73 So the percentage change in the price of the bond is: ($941.73 - $914.35)/$914.35 = 2.99% Duration = $3083.98/$914.35 = 3.37 years. Present value of the bond at a 14% yield to maturity: Period Expected Cash Flows from Security Present value of expected Cash Flows (at 15 \% Rate of Discount) 1 120 105.26 2 120 92.34 3 120 81.00 4 120 71.05 4 1,000 592.08 Calculate the value of duration for a 4-year, $1,000 par value U.S. Government bond purchased today at a yield to maturity of 15%. The bond's coupon rate is 12 percent and it pays interest once a year at year's end. Now suppose the market interest rate on comparable securities falls to 14 percent. What percentage change in this bond's price will result?

An investor buys a U.S. Treasury bond whose current yield to maturity as reported in the daily newspaper is 10 percent. The investor is subject to a 33 percent federal income tax rate on any new income received. His real after-tax return from this bond is 2 percent. What is the expected inflation rate in the financial marketplace?

According to the Harrod-Keynes Effect, the real rate will be unaffected by inflation.

For the bond described in Problem 7, calculate the percentage change in this bond's price if interest rates on comparable securities in the market decline to 9 percent. What percentage change will occur if interest rates jump to 11 percent?

According to the Fisher effect if the real interest rate is currently 3 percent and the nominal rate is 8 percent, what rate of inflation is the financial marketplace predicting? Explain the reasoning behind your answer. If the nominal rate rises to 11 percent and following the assumptions of the Fisher effect, what would you conclude about the expected inflation rate? The real rate?

The Harrod-Keynes effect argues that :

Explain the meaning and importance of the concept of duration.

The 10 - year Treasury bond rate is currently trading at 6.08 percent, while the one-year bond rate carries a yield to maturity of 5.35 percent. What is the current yield spread between these instruments? What is this yield spread forecasting for the economy in the period ahead? Please explain.

Explain how inflation affects interest rates. What is the Fisher effect? What does it assume?

What uses does the yield curve have? Why is each possible use of potential value to borrowers and lenders of funds?

What is inflation? Why is it important?

What are TIPS? What advantages do they offer investors? Any disadvantages?

Explain how the following connect inflation to changes in interest rates:

Explain the meaning of the phrase term structure of interest rates. What is a yield curve? What assumptions are necessary to construct a yield curve?

What are the limitations of duration and the portfolio immunization technique?

What conclusions can you draw from recent research regarding the determinants of the yield curve? Which theory of the yield curve discussed in this chapter appears to be most supported by recent research studies?

According to the Harrod-Keynes effect a rise in the expected rate of inflation will increase an investor's real return from holding bonds.