THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 170

138

PA R T I I

Financial Markets

*8. What are the financial implications of a firm with a
high default risk?

Predicting the Future
9. Predict what will happen to interest rates on a corporation s bonds if the federal government guarantees today that it will pay creditors if the corporation
goes bankrupt in the future. What will happen to the
interest rates on Canada bonds?

11. Predict what would happen to yield spreads in
response to the following macroeconomic events:
recession, high inflation, and stock market increase.
*12. If the yield curve suddenly becomes steeper, how
would you revise your predictions of interest rates
in the future?
13. If expectations of future short-term interest rates
suddenly fall, what would happen to the slope of
the yield curve?

*10. Predict what would happen to the risk premiums on
corporate bonds if brokerage commissions were
lowered in the corporate bond market.

Q U A N T I TAT I V E P R O B L E M S
*1. Assuming that the expectations theory is the correct
theory of the term structure, calculate the interest

rates in the term structure for maturities of one to
five years, and plot the resulting yield curves for the
following series of one-year interest rates over the
next five years:
(a) 5%, 7%, 7%, 7%, 7%
(b) 5%, 4%, 4%, 4%, 4%
How would your yield curves change if people preferred shorter-term bonds to longer-term bonds?
2. Assuming that the expectations theory is the correct
theory of the term structure, calculate the interest
rates in the term structure for maturities of one to
five years, and plot the resulting yield curves for the
following path of one-year interest rates over the
next five years:
(a) 5%, 6%, 7%, 6%, 5%
(b) 5%, 4%, 3%, 4%, 5%
How would your yield curves change if people preferred shorter-term bonds to longer-term bonds?
*3. Rates on one-year T-bills over the next four years
are expected to be 3%, 4%, 5%, and 5.5%. If fouryear Canada bonds are yielding 4.5%, what is the
liquidity premium on this bond?
4. Suppose that you are forecasting one-year T-bill
rates as follows:
Year

1-year rate (%)

1

4.25

2

5.15

3

5.50

4

6.25

5

7.10

You have a liquidity premium of 0.25% for the next
year and 0.50% thereafter. Would you be willing to
purchase a four-year Canada bond at a 5.75% interest rate?

CANSIM Questions
5. Get the monthly data from 1978 to 2006 on the
three-month T-bill rate (CANSIM series V122531), the
interest rate on long-term corporate bonds (series
V122518), and the interest rate on long-term Canada
bonds (series V122544) from the Textbook
Resources area of the MyEconLab.
a. Present a time series plot of these interest rate
series and comment on their long-run movements.
b. Calculate the mean and standard deviation as
well as the maximum and minimum values for

each series over the sample period.
c. Which were the worst and best years in terms of
interest rates?
6. Get the monthly data from 1978 to 2006 on longterm Canada bonds (CANSIM series V122544), the
interest rate on long-term provincial bonds (series
V122517), and the interest rate on long-term corporate bonds (series V122518) from the Textbook
Resources area of the MyEconLab.
a. Present a time series plot of these interest rates
and comment on their long-term movements.
b. Which series exhibit the strongest correlations?
The weakest? Do the correlation patterns you
identified here manifest in the graphical representation of the series?
c. Compare the contemporaneous correlations over
the whole period with those in the 1960s, 1970s,
1980s, 1990s, and 2000s.
d. Calculate the corporate-Canada spread and the
corporate-provincials spread and plot these
series.
e. Continuing from (d), comment on the time paths
of the risk premiums.