Question

Q1:  we discussed the interest rate theory of economist Irving Fisher. An important concept advanced by Fisher was that of “Real” interest rates as opposed to “Nominal” interest rates. How did Fisher define the difference between “Real” rates and “Nominal” rates?

Q2:  Let’s say that a certain corporate bond is selling on the New York Bond Exchange at a price that produces an expected return of 6.2%. Applying the logic of the Fisher Model as explained in class, you estimate that this 6.2% rate represents the combined effect of a 0.5% Time Value of Money (TV), a 2.0% required return to compensate for expected price inflation (Ia), and a 3.7% premium for various sources of Risk (RP). Use the formula derived in class to estimate the Real expected rate of return on this bond in accordance with Fisher’s theory. [4.12%]

Q3:  discussed the Term Structure of Interest Rates, expressed graphically in what is known as the “Yield Curve”. Normally the X axis of the Yield Curve is the Term to Maturity (TTM) of the bond, while the required return (Yield) is presented on the Y axis. The Yield Curve itself is usually exclusively determined by Treasury issues. The general shape of the Yield Curve is not always the same, it changes from one point in time to another. This curve is normally upward sloping, reflected higher required returns for bonds with longer terms to maturity (TTM). Why is it that this situation is Normal? That is to say, Why is it normally the case that returns on bonds with shorter TTMs are lower than they are for those with longer TTMs? (Hint: We did some bond pricing mathematics in class to explain this phenomenon)

Q4: we discussed the Term Structure of Interest Rates, expressed graphically in what is known as the “Yield Curve”. Normally the X axis of the Yield Curve is the Term to Maturity (TTM) of the bond, while the required return (Yield) is presented on the Y axis. The Yield Curve itself is usually exclusively determined by Treasury issues. The general shape of the Yield Curve is not always the same, it changes from one point in time to another. The curve may be upward sloping, or downward sloping. One of these shapes is often described as “Normal”, while the other is described as “Inverted”. One of these two shapes is generally considered to signal a heightened danger of a coming recession. Which of these two curves is the one that signals danger to the economy?

Q5:  we discussed the Term Structure of Interest Rates, expressed graphically in what is known as the “Yield Curve”. Analysts don’t want to keep reporting the entire curve in order to understand its general shape, and to track the changes in it. As a result, they take short cuts by reporting a set of popular Rate Spreads. One of these Spreads is the “10 Year – 3 month Spread”. How is this Spread defined?

Q6:  we discussed the Term Structure of Interest Rates, expressed graphically in what is known as the “Yield Curve”. Analysts don’t want to keep reporting the entire curve in order to understand its general shape, and to track the changes in it. As a result, they take short cuts by reporting a set of popular Rate Spreads. One of these Spreads is the “10 Year – 3 month Spread”. This Spread compares rates in two different Segments of the bond market. What are these two segments?

Answer 1

1. Irving Fisher said that the Interest rate which we observe in Everyday life is only nominal in Nature as it does not capture the Purchasing power of money. With time, the Purchasing power of money generally decreases because of Rise in prices of Goods and Services (Inflation). So, the purchasing power of Money goes down with time. The Real Rate of Return takes into account the decreased purchasing power of money and hence is a better Indicator of Interest rate.

To understand this effect , let us consider a scenario when the inflation rate is 4% and the Nominal Interest rate is 6%. Goods costing $100 today will be costing $104 after a year due to inflation, whereas $100 invested after a year at 6% will amount to $106 after a year. So the real gain is ( $106-$104) over $104 ie. 2/104 = 1.923%

If we put it in a formula, it reads

(1+ inflation rate) * (1+ real interest rate) = 1+ nominal interest rate