Question 4

a) Why are many bonds callable? What is the disadvantage to the investor of a callable

bond? What does the investor receive in exchange for a bond being callable? How are bond

valuation calculations affected if bonds are callable?

[18 marks]

b) Under the liquidity preference theory, if the inflation is expected to be falling over the next

few years, the long-term interest rates will be higher than short-term rates.

True/false/uncertain? Why?

[7 marks]

c) The table shows yields to maturity of zero-coupon Treasury securities.

Term to Maturity (Years) Yield to Maturity (%)

13.50

2 4.50

3 5.00

45.50

5 6.00

Calculate the forward 1-year rate of interest for year 3.

[8 marks]