Inflation affects purchasing power of money and therefore has a major effect on interest rates. Therefore if inflation rate is expected to be 1% during the next year this is added to the risk free interest rate (say 3.5%) and so the Treasury bill rate will be: rT-bill = rRF = r* + IP = 3.5% + 1% = 4.5% The inflation rate is the main factor which determines the shape of the treasury yield curve. If the inflation rate is expected to increase, then the treasury yield curve will slope upwards; which is normal. On the other hand, if the inflation rate is expected to decrease, then this will cause the treasury yield curve to slope downwards. Another factor affecting the Treasury bill rate is interest rate risk. When interest rates rises the prices of treasury bonds decline sharply and since this is a regular occurrence all long term bonds including treasury bonds have an element of interest rate risk. A maturity risk premium (say 2.5%) is therefore added to the risk free rate resulting in the following formula for calculating the Treasury bill rate. rT-bill = rRF = r* + IP + MRP. = 3.5% + 1% + 2.5 = 7% This premium increases with the time to maturity. Therefore, the longer the period the higher maturity risk premium. ...

This information tells me that interest rates are subject to various economic conditions that will cause it to rise or fall and that the trend does not have to be continuous as it would appear from the examples seen. This yield curve has a dip and a hump indicating that the interest rates on one year maturities are higher than interest rates on 5 year maturities. The interest rates on medium term maturities rises constantly between year 6 and year 20 and then falls resulting in interest rates on some long term maturities being much lower than the interest rates on some in the medium term. Part 2 Yield to Maturity The yield to maturity is the annualized discount rate that equates the future coupon and payments to the future coupon and principal payments to the initial proceeds received from the bond offering (Madura 2006, p157). Consider Wal-Mart bond which matures on July 2015 with coupon rate of 2.25% which is paid semi-annually. The value of a bond (Vb) is found using the following formula. Vb = 1000 = [$11.25/(1 + rd/2)1] + [$11.25/(1 + rd/2)2] + [$11.25/(1 + rd/2)3] + [$11.25/(1 + rd/2)4] + [$11.25/(1 + rd/2)5] + [$11.25/(1 + rd/2)6] + [$11.25/(1 + rd/2)7] + [$11.25/(1 + rd/2)8] + [$11.25/(1 + rd/2)9] + [$11.25/(1 + rd/2)10] + [$1,0001/(1 + rd/2)10] The PV table can be used to find the figures for each of the ten six-monthly period: where $11.25 is the half yearly coupon rate. The time to maturity is five years and so Wal-Mart 2.25% Corporate Bond Time Periods Interest Payment Maturity Payment Total cash Flow PV Factor (1.125%) PV of Cash Flow $ $ $ $'000 0 1000 1 1000 Par Value of Bond 1 11.25 11.25 0.9889 11.1251 2 11.25 11.25 0.9779 11.0014 3 11.25 11.25 0.967 10.8788 4 11.25 11.25
...Show more