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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

INTEREST RATE DETERMINATION Maria Juarez is a professional tennis player, and your firm manages her money. She has asked you to give her information about what determines the level of various interest rates.

Your boss has prepared some questions for you to consider.

  1. a. What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?
  2. b. What is the real risk-free rate of interest (r″) and the nominal risk-free rate (rRF)? How are these two rates measured?
  3. c. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included in determining the interest rate on (1) short-term U.S. Treasury securities, (2) long-term U.S. Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed.
  4. d. What is the term structure of interest rates? What is a yield curve?
  5. e. Suppose most investors expect the inflation rate to be 5% next year, 6% the following year, and 8% thereafter. The real risk-free rate is 3%. The maturity risk premium is zero for bonds that mature in 1 year or less and 0.1% for 2-year bonds; then the MRP increases by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest rate on 1-, 10-, and 20-year Treasury bonds? Draw a yield curve with these data. What factors can explain why this constructed yield curve is upward sloping?
  6. f. At any given time, how would the yield curve facing a AAA-rated company compare with the yield curve for U.S. Treasury securities? At any given time, how would the yield curve facing a BB-rated company compare with the yield curve for U.S. Treasury securities? Draw a graph to illustrate your answer.
  7. g. What is the pure expectations theory? What does the pure expectations theory imply about the term structure of interest rates?
  8. h. Suppose you observe the following term structure for Treasury securities:
Maturity Yield
1 year 6.0%
2 years 6.2
3 years 6.4
4 years 6.5
5 years 6.5

Assume that the pure expectations theory of the term structure is correct. (This implies that you can use the yield curve provided to “back out” the market’s expectations about future interest rates.) What does the market expect will be the interest rate on 1-year securities 1 year from now? What does the market expect will be the interest rate on 3-year securities 2 years from now? Calculate these yields using geometric averages.

  1. i. Describe how macroeconomic factors affect the level of interest rates. How do these factors explain why interest rates have been lower in recent years?

a.

Summary Introduction

To identify: The factors which affect the cost of money or general level interest rate.

Interest Rate:

A rate at which a borrower is ready to pay and the depositor is ready to receive the money is known as the interest rate.

Explanation
  • Production opportunities for a company are the main factor, which affects the cost of money as it leads to the higher production.
  • The consumption of the product by the customer in the duration of a period, affect the cost of money.
  • The concept of higher risk lead to higher return and lower risk leads to lower return mainly affects the interest rate...

b.

Summary Introduction

To explain: The real risk-free rate and nominal risk-free rate and their measurement.

c.

Summary Introduction

To explain: The inflation premium, default risk premium, liquidity premium and maturity risk premium.

Interest Rate:

A rate at which a borrower is ready to pay and the depositor is ready to receive the money is known as the interest rate.

d.

Summary Introduction

To explain: The term structure of interest rate and the yield curve.

Yield:

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

e.

Summary Introduction

To identify: The interest rate of securities: 1-year, 10-year, and 20-year Treasury bond and draw a curve to identify whether it is upward-sloping or not.

f.

Summary Introduction

To explain: The performance of U.S. Treasury securities, AAA-rated securities, and BB-rated securities.

g.

Summary Introduction

To describe: The pure expectation theory and its implication in the regards of the term structure.

h.

Summary Introduction

To identify: The interest rate on 1-year securities after 1 year and interest rate on 3-year securities after 2 years from now with the use of the geometric average method.

i.

Summary Introduction

To explain: The effect of macroeconomic factors on interest rate and the reason of securities have the low-interestrate.

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