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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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INTEREST RATE DETERMINATION AND YIELD CURVES

a. What effect would each of the following events likely have on the level of nominal interest rates?

  1. 1. Households dramatically increase their savings rate.
  2. 2. Corporations increase their demand for funds following an increase in investment opportunities.
  3. 3. The government runs a larger-than-expected budget deficit.
  4. 4. There is an increase in expected inflation.

b. Suppose you are considering two possible investment opportunities: a 12-year Treasury bond and a 7-year, A-rated corporate bond. The current real risk-free rate is 4%; and inflation is expected to be 2% for the next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP = 0 02(t − 1)%. The liquidity premium (LP) for the corporate bond is estimated to be 0.3%. You may determine the default risk premium (DRP), given the company’s bond rating, from the table below. Remember to subtract the bond’s LP from the corporate spread given in the table to arrive at the bond’s DRP. What yield would you predict for each of these two investments?

  Rate Corporate Bond Yield Spread = DRP + LP
U.S. Treasury 0.83% ----
AAA corporate 0.93 0.10%
AA corporate 1.29 0.46
A corporate 1.67 0.84

c. Given the following Treasury bond yield information, construct a graph of the yield curve.

Maturity Yield
1 year 5.37%
2 years 5.47
3 years 5.65
4 years 5.71
5 years 5.64
10 years 5.75
20 years 6.33
30 years 5.94

d. Based on the information about the corporate bond provided in part b, calculate yields and then construct a new yield curve graph that shows both the Treasury and the corporate bonds.

e. Which part of the yield curve (the left side or right side) is likely to be most volatile over time?

f. Using the Treasury yield information in part c, calculate the following rates using geometric averages:

  1. 1. The 1-year rate 1 year from now
  2. 2. The 5-year rate 5 years from now
  3. 3. The 10-year rate 10 years from now
  4. 4. The 10-year rate 20 years from now

a. (1)

Summary Introduction

To identify: The effect of given events on the nominal interest rate.

Nominal Rate:

An interest rate which is agreed and paid such as the borrower is ready to pay and the lender is ready to receive the money is known as the nominal interest rate.

Explanation
  • The increase ininterest rate of savings account of the households resultsto increase the demand for the funds.
  • To offer the good returns to household...

(2)

Summary Introduction

To identify: The effect of given events on the nominal interest rate.

Nominal Rate:

An interest rate which is agreed and paid such as the borrower is ready to pay and the lender is ready to receive the money is known as the nominal interest rate.

3.

Summary Introduction

To identify: The effect of given events on the nominal interest rate.

Nominal Rate:

An interest rate which is agreed and paid such as the borrower is ready to pay and the lender is ready to receive the money is known as the nominal interest rate.

4.

Summary Introduction

To identify: The effect of given events on the nominal interest rate.

Nominal Rate:

An interest rate which is agreed and paid such as the borrower is ready to pay and the lender is ready to receive the money is known as the nominal interest rate.

b.

Summary Introduction

To compute: The expected yield for 12-year Treasury bond and 7-year A-rated corporate bond.

Yield:

Yield is the percentage of the securities at which the return is provided by the company to its investors. Yield can be there in the form of dividend and interest.

c.

Summary Introduction

To prepare: A yield curve chart for given information.

Yield Curve:

The graphical representation of the expected return, provided by the company to its investors during the years is known as the yield curve.

d.

Summary Introduction

To draw: The yield curve chart.

e.

Summary Introduction

To identify: The side of a yield curve which would be more volatile.

f. (1)

Summary Introduction

To identify: The rates for the following statements.

2.

Summary Introduction

To identify: The rates for the following statements.

3.

Summary Introduction

To identify: The rates for the following statements.

4.

Summary Introduction

To identify: The rates for the following statements.

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