FIN435 Chapter 6 — Study Guide + Practice (Interest Rates & Yield Curve)

Study guide + interactive practice: True/False with instant feedback, multiple-choice calculations with full solutions, and new exam-style short problems with revealable answers.

1) What to expect on Exam questions (Chapter 6)

You should be able to do three things quickly:

Explain the story (SOFR → Fed → short rates → 2Y/10Y → yield curve → spreads).
Interpret the yield curve (normal / flat / inverted) and what it signals.
Compute rates using the component model and expectations theory (implied future/forward rates).

Study rule: If you can (i) define the components, (ii) read a yield curve, and (iii) do 5–6 calculations cleanly, you are prepared.

2) Must-know concepts and vocabulary

A. Benchmarks and market language

SOFR: secured overnight financing rate (repo-based), a key modern short-rate benchmark.
2-year Treasury (2Y): policy/expectations-heavy; often moves with expected Fed path.
10-year Treasury (10Y): longer-run expectations + term premium; anchor for long borrowing rates.
2s10s spread = 10Y − 2Y: negative = inverted curve.

B. Term structure / yield curve

Yield curve: relationship between maturity and yield (Treasuries).
Normal (upward sloping): long rates > short rates.
Flat / humped: mixed expectations/term premium.
Inverted (downward sloping): short rates > long rates; often linked to expected rate cuts and slower growth.

C. Yield component model (the “add-ons”)

Know these components and what changes them:

Component	Meaning (plain English)
r*	Real risk-free rate (real return for delaying consumption).
IP	Inflation premium (compensation for expected inflation).
MRP	Maturity risk premium / term premium (interest-rate risk grows with maturity).
DRP	Default risk premium (chance borrower does not repay).
LP	Liquidity premium (harder to sell quickly → higher required yield).

Key formula (required return):

r = r* + IP + MRP + DRP + LP

Shortcut: Corporate yield − Treasury yield (same maturity) ≈ DRP + LP (roughly).

3) Core theories you must explain

A. Fisher relationship (nominal vs real)

Approximation: nominal rate ≈ real rate + expected inflation.

Exam move: given a Treasury rate and expected inflation, solve for r* (or vice versa).

B. Expectations theory (pure expectations)

Big idea: a longer yield can be interpreted (roughly) as an average of expected future short yields (use compounding on exams).

C. Why the curve inverts

Inversion often means markets price future rate cuts (and/or weaker growth). Term premium matters in reality—still, the expectations-theory logic is your exam foundation.

4) How to practice (fast and effective)

Memorize the five components (r*, IP, MRP, DRP, LP) + what makes each larger/smaller.
Practice 10–15 short calculations until you can do them without confusion.
Practice reading yield curve shape → economic story in 2–3 sentences.
Do the practice sets below. Then check the feedback/solutions.

FIN435 • Chapter 6 — Interest Rates & the Yield Curve