Term Structure of Interest
Rates
Chapter
Seven
Problem Set
1. You observe that one year Government of Canada bonds are
currently yielding 4.5%. Two year Government of Canada
bonds are yielding 5.25%. What is the market predicting for
the yield on one year bonds, one year from today? (6%)
2. The spot yield on two year bonds is 5.25%. The spot yield on
5 year bonds is 6.50%. What is the market predicting for the
yield on 3 year bonds, two years from today? (7.34%)
3. You are an investor seeking to maximize your investment
returns. You have observed the information shown in
Question 2. Your personal belief is that the three year rate,
two years from today, will be 6.50%. Should you invest in one
five year bond or a series of two short bonds? Why? (5
years)
2
4. Using the information in Question 3, calculate the dollar difference
in the two scenarios, assuming you have $100,000 to invest for a
five year period. (2 short bonds - $133,811.37; 1 long bond $137,008.67)
5. The term structure of interest rates is sloping downward (referred to
as an inverted yield curve). What is the market predicting for future
short interest rates? What theory do we use to support this?
(Down – Unbiased expectations theory)
6. The nominal interest rate is currently 6%. If the market is expecting
inflation of 4%, what is the real interest rate (use both an
approximation and the exact method for calculating the real rate).
(Approximation – 2%; Exact – 1.92%)
7. You want to purchase a ten year, $100,000 Government of Canada
bond carrying a 6% coupon, paid semi-annually. If your required
yield is 5%, how much would you pay for the bond? ($107,794.58)
3
8. You are planning for retirement. One component of
your retirement planning strategy is to purchase strip
bonds that mature each year during retirement. If you
want one $100,000 bond to mature each year during
retirement, what would you have to pay today, assuming
you can purchase a strip bond with a YTM of 6% that
matures exactly 30 years from now? ($17,411.01)
9. A six year, $1,000 face value bond with a 4% coupon is
currently selling in the market for $942. What is the
YTM for this bond? (5.15%)
10. Decompose the YTM for the bond in Question 9 into its
two components of coupon (current) yield and the
capital gain or loss. (Coupon yield – 4.2463%; Capital
gain – 0.9018%)
4