The Financial Markets and Interest Issues - Financial Management |, Exams of Financial Management

Download The Financial Markets and Interest Issues - Financial Management | and more Exams Financial Management in PDF only on Docsity! Chapter 2 + The Financtal Markets and Interest Rates Study Problems QoL, (Calentating the defuedt-risk prentivan) At present, 10-year’ Lteasury honds are yielding 4% while 4 10-year corporate bond was yielding 6.8%. If the liquidity premium on the corporate bond was 0.496, what is the corporate hond’s defauiterisk premium? 2-2, (Real interest rates: finnnclal analyst's method) The CFO of your firm has asked you for an ap- proximate answer to this question: What was the increase in real purchasing power associated with both 3-month ‘Iieasucy bills and 30-year Treasury honds? Assume chat the current 3-month Trea- sury bill rate is 4.34 percent, the 30-year Treasury bond rate is 7.33 percent, and the inflation rate is 2.78 percent. Also, the chief financial officer wants a short explanation should the 3-month real rate fir cut to be fess than the 30-year real rate. 2-3. (Inflation snd interest rates) What would you expect the nominal rate of interest to he if the real rate is + percent and the expected inflation rate is 7 percent? 2-4, (inflation and interest rates) Assume the expected inflation rate to be 4 percent, Jf the current real rate of interest is 6 percent, what ought the noruinal rate of interest be? 2-5. (Calculating the maturity premium) At present, the real risk-free cate of interest is 2%, while in- flation is expected to he 2% for the next two years. Ifa 2-year Treasury note yickls 4.5%, what is the maturity premium for this 2-year ‘Lreasury note? 2-6. (Teva structure of interest rates) You want to invest your savings of $20,000 in goverrunent se- cutities for the next 2 years. Currently, you can invest either in a security chat pays interest of 8 per- cent per year for the next 2 years or in a security that matures in 1 year but pays only 6 percent interest. If you make the latter choice, you would then reinvest your savings at the end of the first year for another year. a, Why inight you choose to make the investment in the 1-year security thar pays an interest rate of only 6 percent, as apposcil to investing in the 2-year security paying 8 percent? Pro- vide numerical support far your answer. Which theory of term structure have you sup- ported in your answer? b. Assume your required ratc of return on the second-year investment is 11 percent; other- wise, you will choose to go with the 2-year security, What rationale could you offer for your preference? Mini Case ‘On the first day of your summer internship, you've been assigned to work with the Chief Financial Officer (CFO) of SanBlas Jewels Inc. Not knowing how well trained you are, the CFO has decided to test your understanding of interest rates. Specifically, she asked you to provide a reasonable os- timate of the nominal interest rate for a new issue of Aag-rated bonds to be offered by Saniilas Jew- els Inc. The final format-that the chief financial officer of SanBlas Jewely has requested is duat of equation (2-1) in the text, Your assignment alsa requires that you consult the data in Table 2-2. Some agreed-upon procedures related to generating estimates for key variablesin equatian (2-1) fallow, a. The current 3-month ‘Treasury bill rate is 2.96 percent, the 30-year Treasury bond rate is 5.43 percent, the 30-year Aaa-rated corporate bond rate is 6.71 percent, and the inflation rate is 2.33 percent, ‘The real risk-free rate of interest is the difference hetween the calculated average yield on 3-month Trcasury bills and the inflation rate. c. The default-risk premium is estimated by the differcnce between tle average yield on Aaa~ rated bonds and 30-year Treasury bonds. ad. The maturity premium is estimated by the difference between the average yield on 30-year “Treasury bonds and 3-month Treasury bills. e, SanBlas Jewels’ bonds will be traded on the New York Bond Exchange, sa the liquidity pre- ium will be slight. It will be grcater than zeru, however, because the secondary snarket for the firny’s bonds is mare uncertain than that of some other jewel sellers, It is estimated at + basis points. A basis point is one one-hundredth of 1 percent. & Now place your output into the format of equation (2-1) su that the nominal interest rate can be es- timated and the size of each varishle can also be inspected for reasonableness and discussion with the CFO, Foundations of Finance: The Logic and Practice of Financial Maragoment, Seventh Edition, by Arthur 2. Keown, John D. Martin, and J. William Petty. Pubtished by Prentice Hall, Copyright @ 2015 by Pearson Education, Ine.