6-21: A. 1. Production opportunities: the investment opportunities in the productive cashgenerating assets. 2.

Time preferences for consumption: the preferences for current consumption, as opposed to future consumption. 3. Risk: from a financial markets contexts the chance that a financial investment will provide a negative return. 4. Inflation: the amount by which prices increase over-time. B. 1. The risk-free rate of interest is the rate of interest that would exist on default free US treasury securities, if no inflation were expected. The nominal-risk-free rate of interest is the rate of interest on security that is free of all interest. The risk-free rate is proxied by the T-bill rate (short-term risk free rate), T-bond rate (long-term risk free rate). The riskfree rate includes an inflation premium. The risk-free rate of interest is measured, by the rate of return on indexed treasury bonds. The nominal-risk free rate includes inflation premium equal to the average expected inflation rate over the remaining life of the security. C. 1. The inflation premium: Is the premium equal to the expected inflation that the investors add to the real risk free rate of the return. The inflation premiums are the actual interest rate on a short-term default free US Treasury bill. 2. Default risk premium: The difference between the interest rate on a US Treasury bond and a coporate bond of equal maturity and marketability. Default risk premium is the difference between the quoted interest rate on a T-bond and that on a corporate bond with similar maturity and liquidity. This applies to both a short term and a long term corporate security and US Treasury security. 3. Liquidity premium: A premium added the equilibrium interest rate on a security if that security cannot be converted to cash on short notice and at close to its fair market value. This applies to both a short term corporate security and a short term US Treasury security. 4. Maturity risk premium: Is the premium that reflects interest rate risk. The bonds from any organization from the US Government to US Airlines have more interest rate risk, the longer the maturity of the bond. The maturity risk premium refers to both a long term US Treasury security and a long term corporate security.

D. 1. The term structure of interest rates describes the relationship between long and short term rates, bond yield and maturities. 2. A yield curve is a graph showing the relationship between bond yields and maturities. E. 1.
21.11%

19.11%

Interest rate

8 % One year Ten years Twenty years

Years to Maturity

T-bond yields=r*t +IPt + MRPt 1yr = 3%+5%+0% =8% 10yr =3%+8%+8.11%=19.11% 20yr =3%+8%+9.11%=21.11%

2. The yield curve is an upward curve, because inflation is expected to be higher in the future, because there is a positive maturity risk premium. F. 1. The BB rated company will have a higher yield curve than a US Treasury security yield curve. An AAA rated company, will have a higher yield curve than a US Treasury security yield curve. The reason for the higher yield curve is the increased default risk premium.
BB AAA

US Treasury Security

G. 1. The pure expectations theory states, that the shape of the yield curve, depends on investors expectations about future interest rates. 2. The pure expectations theory implies that the term structure of interest rates helps to decide whether investors should buy long or short term bonds and whether lenders should lend long term or short term debt. Both lenders and bowers need to understand, how long term and short term rates relate to one another and what causes the shift in their rate levels.

H. 1. (1.06)(1+X) = (1.598)1 1.06X/1.06 =(1.598)1 1.06/1.06 X= 5.98% interest rate on a 1 year security 1 year from now.

2.

.64 - .62 = .02 (1.064)(1=X) =(1.064)2 1.064X/1.064 = ((1.02)2 1.064/1.064 X=4.04% interest rate on a 3 year security 2 years from now.

References: Fundamentals of Financial Management Package, Brigham, Eugene F., Houston, Joel F., Copyright 2009, 12th. edition, South-Western Publishing Co.