Department of Management Sciences

COMSATS Lahore

QUIZ 1

Class: BBA 8th Semester Course Code: MGT 433 Course Title: Financial Institutions
Date: 10-10-2017 Instructor: Dr. Ammar Abid

Question 1

The one-year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%, 9%, 10.5%, 13%,
14.5%, 16%, and 17.5%. Using the expectations theory, what will be the interest rates on a three-
year bond, six-year bond, and nine-year bond? (Marks 2)

Question 2

If the interest rates on one- to five-year bonds are currently 4%, 5%, 6%, 7%, and 8%, and the
term premiums for one- to five-year bonds are 0%, 0.25%, 0.35%, 0.40%, and 0.50%, predict
what the one-year interest rate will be two years from now. (Marks 3)

Solution
Question 1
Interest rate on 3 year bond = 3+4.5+6/3 = 4.5%
Interest rate on 6 year bond = 3+4.5+6+7.5+9+10.5/6 = 6.75%
Interest rate on 9 year bond = 3+4.5+6+7.5+9+10.5+13+14.5+16/9 = 9.33%
Question 2
The expected one-year interest rate two years from now is ite 2 [(1 i3t k3t)3/(1 i2t k2t)2] 1

[(1 0.06 0.0035)3/(1 0.05 0.0025)2] 1 0.075 7.5%.

 Assignment 1

Suppose you are working at Allied Bank as credit officer. Your job is to find the minimum
interest rate that your bank will charge from the most credit-worthy customer. This rate is
assumed to be sufficient to cover the cost of funds and the banks profit. The basis for your
minimum interest rate calculations should be the most recent five years. Pakistan investment
bonds (PIB) i.e. bonds issued by the government of Pakistan. Allied Bank normally charges four
percentage points more than the expected interest rate on PIB with five years of maturity.
Moreover, Allied Bank has known over the period of time the liquidity premium in case of credit
worthy customers is 1.5%.
Given the above, you are required to find answer to the following questions:

A. Obtain information on government securities (most recent T-bills and PIBs) of various
maturities, plot maturities of these securities against their yields and draw a yield curve and then
interpret the shape of the yield curve using:
1. The Pure Expectations Theory
2. The Market Segmentation Theory
3. The Liquidity Premium Theory
4. Which theory do you think best describes the curve?

B. Given the above information, use the pure expectations theory to calculate and predict interest
rates as follows:
1. If the one-year interest rate is expected to be the same as the yield curve over the
next three years, what interest rate is expected on a two-year bond one year from
now?
2. What interest rate is expected on a three-year bond one year from now?
3. What relationship do you find between interest rates and maturity?
4. If investors attach liquidity premiums of 0.5%, 0.75% and 0.85% to the one-, two-
and three- year bonds:
1. What would be the interest rate on a two-year security?
2. What would be the interest rate on a three-year security?