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Why might you expect interest rate movements of various industrialized countries to be more highly correlated in recent years than in earlier years? #2 Assessing Interest Rate Differentials among Countries. In some countries where there is high inflation, the annual interest rate is more than 50 percent, while in other countries such as the U.S. and many European countries, the annual interest rates are typically less than 10 percent. Do you think such a large interest rate differential is primarily attributed to the difference in the risk-free rates or to the difference in the credit risk premiums between countries? Explain. #3 After-tax Yield. You need to choose between investing in a one-year municipal bond with a 7 percent yield and a one-year corporate bond with an 11 percent yield. If your marginal federal income tax rate is 30 percent and no other differences exist between these two securities, which one would you invest in? #4 Deriving Current Interest Rates. Assume that interest rates for one-year securities are expected to be 2 percent today, 4 percent one year from now and 6 percent two years from now. Using only the pure expectations theory, what are the current interest rates on two-year and three-year securities? #5 POINT/COUNTER-POINT: Should a Yield Curve Influence a Borrower's Preferred Maturity of a Loan? POINT: Yes. If there is an upward-sloping yield curve, a borrower should pursue a short-term loan to capitalize on the lower annualized rate charged for a short-term period. The borrower can obtain a series of short-term loans rather than one loan to match the desired maturity. COUNTER-POINT: No. The borrower will face uncertainty regarding the interest rate charged on subsequent loans that are needed. An upward-sloping yield curve would suggest that interest rates will rise in the future, which will cause the cost of borrowing to increase. Overall, the cost of borrowing may be higher when using a series of loans than when matching the debt maturity to the time period in which funds are needed.
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