Introduction to Finance

 15. 
(LO 8.3)
Describe the process of advance refunding of the federal 
debt.
 16. 
(LO 8.4)
What is the term structure of interest rates, and how is it 
expressed?
 17. 
(LO 8.4)
Identify and describe the three basic theories used to 
explain the term structure of interest rates.
 18. 
(LO 8.5)
Describe the process by which infl ation took place his-
torically before modern times.
 19. 
(LO 8.5)
Discuss the early periods of infl ation based on the issue 
of paper money.
 20. 
(LO 8.5)
What was the basis for infl ation during World Wars I 
and II?
 21. 
(LO 8.5)
Discuss the causes of the major periods of infl ation in 
American history.
 22. 
(LO 8.5)
Explain the process by which price changes may be ini-
tiated by a general change in costs.
 23. 
(LO 8.5) 
How can a change in the money supply lead to a change 
in the price level?
 24. 
(LO 8.5)
What is meant by the speculative type of infl ation?
 25. 
(LO 8.6)
What is meant by default risk and a default risk 
premium? 
 26. 
(LO 8.6)
How can a default risk premium change over time?

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216
C H A PT E R 8 Interest Rates
Exercises
1. 
Go to the Federal Reserve Bank of St. Louis website at http://www.
stlouisfed.org, and fi nd interest rates on U.S. Treasury securities and 
on corporate bonds with diff erent bond ratings.
a. 
Prepare a yield curve or term structure of interest rates.
b. 
Identify existing default risk premiums between long-term 
Treasury bonds and corporate bonds.
2. 
As an economist for a major bank, you are asked to explain a sub-
stantial increase in the price level when neither the money supply nor 
the velocity of money has increased. How can this occur?
3. 
As an advisor to the U.S. Treasury, you have been asked to com-
ment on a proposal for easing the burden of interest on the national 
debt. This proposal calls for the elimination of federal taxes on interest 
received from Treasury debt obligations. Comment on the proposal.
4. 
As one of several advisors to the secretary of the U.S. Treasury, 
you have been asked to submit a memo in connection with the aver-
age maturity of the securities of the federal government. The basic 
premise is that the average maturity is far too short. As a result, 
issues of debt are coming due with great frequency and need constant 
reissue. On the other hand, the economy shows signs of weakness. 
It is considered unwise to issue long-term obligations and absorb 
investment funds that might otherwise be invested in employment-
producing construction and other private-sector support. Based on 
these conditions, what course of action do you recommend to the 
secretary of the U.S. Treasury?
5. 
Assume a condition in which the economy is strong, with rela-
tively high employment. For one reason or another, the money supply 
is increasing at a high rate, with little evidence of money creation 
slowing down. Assuming the money supply continues to increase, 
describe the evolving eff ect on price levels.
6. 
Assume you are employed as an investment advisor. You are work-
ing with a retired individual who depends on her income from her 
investments to meet her day-to-day expenditures. She would like to 
fi nd a way of increasing the current income from her investments. A 
new high-yield or junk bond issue has come to your attention. If you 
sell these high-yield bonds to a client, you will earn a higher-than-
average fee. You wonder whether this would be a win-win investment 
for your retired client, who is seeking higher current income, and for 
you, who would benefi t in terms of increased fees. What would you 
do? 
Problems
1. 
Assume investors expect a 2.0 percent real rate of return over the 
next year. If infl ation is expected to be 0.5 percent, what is the expec-
ted market interest rate for a one-year U.S. Treasury security?
2. 
A one-year U.S. Treasury security has a market interest rate of 2.25 
percent. If the expected real rate of interest is 1.5 percent, what is the 
expected annual infl ation rate?
3. 
A 20-year U.S. Treasury bond has a 3.50 percent interest rate, 
while a same maturity corporate bond has a 5.25 percent interest rate. 
Real interest rates and infl ation rate expectations would be the same 
for the two bonds. If a default risk premium of 1.50 percentage points 
is estimated for the corporate bond, determine the liquidity premium 
for the corporate bond. 
4. 
A 30-year U.S. Treasury bond has a 4.0 percent interest rate. In 
contrast, a 10-year Treasury note has an interest rate of 3.7 percent. 
If infl ation is expected to average 1.5 percentage points over both the 
next 10 years and 30 years, determine the maturity risk premium for 
the thirty-year bond over the 10-year note.
5. 
A 30-year U.S. Treasury bond has a 4.0 percent interest rate. In 
contrast, a 10-year Treasury note has an interest rate of 2.5 percent. 
A maturity risk premium is estimated to be 0.2 percentage points for 
the longer maturity bond. Investors expect infl ation to average 1.5 
percentage points over the next 10 years.