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Interest and Real Rate

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P6–1 Interest rate fundamentals: The real rate of return Carl Foster, a trainee at an Investment banking firm, is trying to get an idea of what real rate of return investors Are expecting in today’s marketplace. He has looked up the rate paid on 3-month U.S. Treasury bills and found it to be 5.5%. He has decided to use the rate of change In the Consumer Price Index as a proxy for the inflationary expectations of Investors. That annualized rate now stands at 3%. On the basis of the information That Carl has collected, what estimate can he make of the real rate of return?

P6–2 Real rate of interest To estimate the real rate of interest, the economics division of Mountain Banks—a major bank holding company—has gathered the …show more content…

If the real rate of interest is currently 2.5%, find the nominal rate of interest on each of the following U.S. Treasury issues: 20-year bond, 3-month bill, 2-year note, and 5-year bond.

b. If the real rate of interest suddenly dropped to 2% without any change in inflationary expectations, what effect, if any, would this have on your answers in part a? Explain.

c. Using your findings in part a, draw a yield curve for U.S. Treasury securities.
Describe the general shape and expectations reflected by the curve.

d. What would a follower of the liquidity preference theory say about how the preferences of lenders and borrowers tend to affect the shape of the yield curve drawn in part c? Illustrate that effect by placing on your graph a dotted line that approximates the yield curve without the effect of liquidity preference.

e. What would a follower of the market segmentation theory say about the supply and demand for long-term loans versus the supply and demand for short-term loans given the yield curve constructed for part c of this problem?

P6–6 Nominal and real rates and yield curves A firm wishing to evaluate interest rate behavior has gathered

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