Financial Markets

Write out an equation for the nominal interest rate on any security. Distinguish between the real risk-free rate of interest, r*, and the nominal, or quoted, risk-free rate of interest, r RF.

How do investors deal with inflation when they determine interest

rates in the financial markets?

Does the interest rate on a T-bond include a default risk premium?

Explain.

Distinguish between liquid and illiquid assets, and list some assets

that are liquid and some that are illiquid.

Briefly explain the following statement: “Although long-term bonds

are heavily exposed to interest rate risk, short-term T-bills are heavily exposed to reinvestment rate risk. The maturity risk premium reflects the net effects of these two opposing forces.” Assume that the real risk-free rate is r* 2% and the average

expected inflation rate is 3 percent for each future year. The DRP

and LP for Bond X are each 1 percent, and the applicable MRP is

2 percent. What is Bond X’s interest rate? Is Bond X (1) a Treasury

bond or a corporate bond and (2) more likely to have a 3-month or a

20-year maturity?