1) Assume that an investor is risk-neutral (i.e. assume that the investor always chooses the investment with the higher expected rate of return even if it is riskier). If the yield on 1-year marketable CD’s is 6% while the yield on 2-year marketable CD’s is 7% and this investor purchased the 1year T-bill, what must (s)he expect to happen to short term interest rates over the coming year?
2) In question # 1 above, what is the expected interest rate level one year from now that would equalize the expected rate of return on one year and two year CD’s if both were held for one year?
3) If the Fed lowers short term interest rates by 1/2% but investors believe this is just a temporary reduction which will only last a few months, and therefore their expectations of future short term interest rates remain unchanged, what will happen to the yield on 10 year Treasury bonds?
4) If at a point in time long term interest rates were below short term interest rates, what would this indicate about investors expectations of future short term interest rates? Explain your answer in a few sentences.
5) If investors thought that a reduction in the Fed’s Federal Funds market interest rate target would cause inflation rates to increase in the future, what would happen to the shape of the treasury yield curve? Draw a diagram to illustrate your answer.
6) If interest rates and required yields at all maturities unexpectedly fell by .5% in a month, would a portfolio of long term securities perform differently than a portfolio of short term securities? explain your answer and relate it to the concept of interest rate risk.
7) Bond rating agencies such as Moody’s publish rankings of the credit quality of corporate borrowers. AAA rated corporations have the lowest level of default risk followed by AA and A the Baa, etc. Under what circumstances would the spreads between yields on bonds issued by ‘B’ rated corporations and yields on AA rated corporate bonds widen noticeably?
8) Suppose 1 year Treasury-bills were currently yielding 5.5%. Also suppose that a bank estimated that a particular loan applicant had a 30% chance of defaulting on a one year loan and that in the event of default the bank would recover only 25% of its scheduled payment of principle (estimated net proceeds of the sale of collateral). What interest rate would the bank have to charge to earn an expected rate of return on its loan equal to the T-bill rate?
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