FINC412 Chapter Notes - Chapter 3: Reinvestment Risk

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copperelk215

8 Oct 2017

School

University of Delaware

Department

Finance

Course

FINC412

Professor

Infanti Martin

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Document Summary

I = risk free rate + default premium + liquidity premium + maturity. Risk free rate: rate the government borrows money at. Default premium: how likely you think it is that someone will not pay back the money they borrowed. Reinvestment risk: might not be able to get the same risk going forward. Pure expectance theory - interest rates are set based on where they think interest rates are going to go. Liquidity premium theory - investors prefer liquidity over non-liquidity. They"re giving up liquidity by lending to you which is where interest rates would come in.

Related Questions

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 rate. Your boss has prepared some questions for you to consider.

a) What are the four most fundamental factors that affect the cost of money, or the general level of interest rate, in the economy?

b) What is the real risk-free rate of interst (r*)and the nominal risk-free rate (r RF)? How are these two rates measured?

c) Define the term inflation premium(IP), default risk premium (DRP), liquidity premium (LP),and the maturity risk premium(MRP). Which of premium is included in determining the interst rate on (1)Short term U.S Treasury securities, (2)Long term U.S Treasury securities, (3)short term corporate securities, (4) long term coporate securities? Explain how the premiums would vary over time and among the different securities listed.

d) What is the term structure of interest rate? What is the yield curve?

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 primium is zero for bonds that mature in 1 year or less and 0.1% for 2 years bonds; then the MRP increases by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest on 1-,10-, and 20-year treasury bonds? Draw a yield curve with these data. What factor can explain why this constructed yield curve is upward-sloping?

f) At any give 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 illustrat your answer.

g) What is the pure expectations theory? What does the pure expectation theory imply about the term structure of interest rate?

Please show workout and aswer all questions, thank you

1) If you deposit money today in an account that pays 4.5% annual interest, how long will it take to double your money? Round your answer to two decimal places.

years

2) The real risk-free rate is 2.65%. Inflation is expected to be 3.2% this year, 4.1% next year, and then 2.5% thereafter. The maturity risk premium is estimated to be 0.05(t - 1)%, where t = number of years to maturity. What is the yield on a 7-year Treasury note? Round your answer to two decimal places.

3) An investment will pay $50 at the end of each of the next 3 years, $250 at the end of Year 4, $400 at the end of Year 5, and $550 at the end of Year 6.

a) If other investments of equal risk earn 9% annually, what is its present value? Round your answer to the nearest cent.

b)If other investments of equal risk earn 9% annually, what is its future value? Round your answer to the nearest cent.

4) A company's 5-year bonds are yielding 8.7% per year. Treasury bonds with the same maturity are yielding 5.9% per year, and the real risk-free rate (r*) is 2.65%. The average inflation premium is 2.85%, and the maturity risk premium is estimated to be 0.1(t - 1)%, where t = number of years to maturity. If the liquidity premium is 1.35%, what is the default risk premium on the corporate bonds? Round your answer to two decimal places.

5) Amortization schedule

Set up an amortization schedule for a $14,000 loan to be repaid in equal installments at the end of each of the next 3 years. The interest rate is 7% compounded annually. Round all answers to the nearest cent.

	Beginning		Remaining
Year	Balance	Payment	Balance
1	$	$	$
2	$	$	$
3	$	$	$

What percentage of the payment represents interest and what percentage represents principal for each of the 3 years? Round all answers to two decimal places.

	% Interest	% Principal
Year 1:	%?	?%
Year 2:	%?	?%
Year 3:	%?	? %

Why do these percentages change over time?

All:

Everyone today has to be concerned about being able to retire comfortably when they keep telling us that Social Security will be bankrupt in 2037, a mere 22 years from now, and that it is an entitlement, not something that we and our employers all paid into since we got our first job.

A retirement planner is attached to this message so you can estimate how much money you will need to save to be able to do the things most retirees want to do when they are no longer working.

Then provide your calculations to the class and make a statement as to what you think and if you can achieve it?

For Week 3, please turn in the answers to the following questions:

1. Define the following terms as they apply to bonds:

a. Face value

b. Maturity date

c. Coupon interest (including coupon interest rate)

d. Current yield

e. Yield to maturity (YTM)

f. Yield to call (YTC)

g. Call premium

2. What are âZero-couponâ bonds?

3. Suppose you see the following bond price quote in the newspaper:

McDonalds 5.7% 2039â¦â¦..122.733

What can you tell about this bond from reading the price quote?

4. (calculating the present value of a bond) If a corporate bond with a face value of $1,000 has 24 years to go until it matures, has a coupon interest rate of 5.7% and a yield to maturity (YTM) of 4.201%, what should be its price in the bond market (ie, PV)?

5. (calculating the current yield of a bond) If a corporate bond with a face value of $1,000 has 24 years to go until it matures, has a coupon interest rate of 5.7% and a market price of $1,223.92, what is its current yield?

6. (calculating the YTM of a bond) If a corporate bond with a face value of $1,000 has 24 years to go until it matures, has a coupon interest rate of 5.7% and a market price of $1,223.92, what is its yield to maturity (YTM)?

7. (calculating the YTC of a bond) Assume a callable corporate bond with a face value of $1,000, a coupon interest rate of 5.7%, a market price of $1,223.92, and a call premium of 6%. Assume also that the bond has 24 years to go until it matures, but it is callable after 14 years. What is the bondâs yield to call (YTC)?

8. (calculating the present value of a bond with semi-annual coupon interest payments) If a corporate bond with a face value of $1,000 has 24 years to go until it matures, has a coupon interest rate of 5.7%, paid semiannually, and has a yield to maturity (YTM) of 4.2%, what should be its price in the bond market (ie, PV)?

9. (calculating the YTM of a bond with semiannual interest payments) If a corporate bond with a face value of $1,000 has 24 years to go until it matures, has a coupon interest rate of 5.7%, paid semiannually, and has a market price of $1,223.92, what is its yield to maturity (YTM)?

10. Define the following terms as they apply to interest rates:

a. The real risk-free rate (r*)

b. The nominal risk-free rate (Rrf)

c. The inflation premium (IP)

d. The default risk premium (DRP)

e. The liquidity premium (LP)

f. The maturity risk premium (MRP)

11. Assume the real risk-free rate is 1%. Assume also that inflation is expected to be 1% in the coming year (year 1), 2% in the next year after that (year 2), and 3% in the year after that (year 3). Assume also that the default risk premium, the liquidity premium, and the maturity risk premium are 0%. Given these conditions, what would be the yield on three-year treasury bonds today?

12. Suppose the First Bank of St Louis was offering the following rates on certificates of deposit (CDs) this week:

Maturity Rate

3 month 1.50%

6 month 1.75%

1 year 2.00%

2 year 2.25%

3 year 2.50%

5 year 2.75%

10 year 3.00%

20 year 3.15%

a. Plot the above data on a yield curve. Label the graph and the axes appropriately.

b. Comment on the implications of this curve to you, as a potential investor in CDs.

End of assignment questions

(see answers to numerical problems on the next page)

Answers to numerical problems:

Question 4: $1,223.92

Question 5: 4.66%

Question 6: 4.2%

Question 7: 3.92%

Question 8: $1,225.44

Question 9: 4.21%

Question 11: 3.0%

FINC412 Chapter Notes - Chapter 3: Reinvestment Risk

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