ECON 3030 UVA Exam #1

Liquidity premium theory

the theory that the interest rate on a long-term bond will equal an average of the short-term interest rates expected to occur over the life of the long-term bond, plus a positive term (liquidity) premium

If 1-year interest rates for the next three years are expected to be 3, 2.5, and 4.25, and assuming a liquidity risk premium of 0.2% for a 1 year bond, 0.5% for a 2 year bond, and 1% for a 3 year bond, then what is the interest rate on a three bond according to the liquidity premium theory?

Take average of expected interest: [(3+2.5+4.25)/3] = 3.25. Add in three year risk premium of 1.0% to get 4.25%.

Consider a two year investment of $100. Expected inflation is 3%. What Would the purchasing power of this $100 principal be after two years?

Multiply 100 by (1 + Πe) raised to the number of years of investment: 100*(1.03)^2 = 106.09

Axis of the yield curve

YTM and nominal interest rate (i)

Consider a bond with the following properties: Face = $1,000, C = 7%, i = 5%, n = 5. What is the price of the bond under risk structure if there is a risk premium of .7?

Find PMT by multiplying $1000 by 7%, then multiply the product by .7: PMT = 49. Adjust FV by multiplying by .5: FV = $700. New bond price = $760.61

Bond prices and interest rates are ___________ related

inversely

Consider a 6 bond investment. Interest rates rise from 5% to 7%. What is the approximate percent change of the bond?

Duration formula: %Δ ~ -Duration * [Δi/(1+initial i)]: %Δ ~ -11.43%

Stock return

D/P(t) + [(P(t+1) - P(t))/P(t)]

Expected inflation and the yield curve are

correlated

How are the Expectations Hypothesis and the Liquidity Premium Theory related?

The latter is calculated identically to the former, with the exception that the latter adds in an associated risk premium for the year being calculated