Determinants of Interest Rate for Individual Securities You are
considering an investment in 30–year bonds issued by Borro Corporation. The bonds
have no special covenants. The Wall Street Journal reports that 1–year T–bills are
currently earning 2.50 percent. Your broker has determined the following information
about economic activity and Borro Corporation bonds:
Real interest rate = 1.00% Default risk premium = 1.25%
Liquidity risk premium = 0.75% Maturity risk premium = 0.50%
a. What is the inflation premium?
Expected (IP) = i – Real Interest Rate
b. What is the fair interest rate on Borro Corporation 30–year bonds?
ij* = inflation premium + Real interest rate + Default risk premium +
Liquidity risk premium + Maturity risk premium
Unbiased Expectations Theory Suppose that the current one–year rate (one–
year spot rate) and expected one–year T–bill rates over the following three years (i.e.,
years 2, 3, and 4, respectively) are as follows:
1R1=7%, E(2r1) =9%, E(3r1) =6.0% E(4r1)=4%
Using the unbiased expectations theory, calculate the current (long–term) rates for
one–, two–, three–, and four–year–maturity Treasury securities. Show your answers in
percentage form to 3 decimal places.
Note that:
Rate for a two year security
= [(1 + 1R1)(1 + E(2r1))]1/2 – 1
Rate for a three year security
= [(1 + 1R1)(1 + E(2r1))(1 + E(3r1))]1/3 – 1
Rate for a four year security
= [(1 + 1R1)(1 + E(2r1))(1 + E(3r1))(1 + E(4r1))]1/4 – 1
Liquidity Premium Hypothesis One–year Treasury bills currently earn 2.50
percent. You expected that one year from now, one–year Treasury bill rates will
increase to 2.75 percent. The liquidity premium on two–year securities is 0.15 percent.
If the liquidity theory is correct, what should the current rate be on two–year Treasury
securities?
1R2 =
[(1 + Real interest rate)(1 + Year 2 Rate + Liquidity risk premium)] 1/2 – 1
Zero Coupon Bond Price Calculate the price of a zero coupon bond (no interest
payments) that matures in 15 years if the market interest rate is 7.25 percent
(most bonds pay interest semi–annually, so unless specified, always use semi–
annual compounding).
Current Yield What’s the current yield of a 5.0 percent coupon corporate bond
quoted at a price of 80.00?
Yield = Payment/Price
Taxable Equivalent Yield What’s the equivalent taxable yield on a municipal
bond with a yield to maturity of 4.0 percent for an investor in the 20 percent
marginal tax bracket?
Equivalent taxable yield = Muni Yield/(1 – tax rate)
Compute Bond Price Compute the price of a 8.0 percent coupon bond with 15
years left to maturity and a market interest rate of 7.0 percent. (Assume
interest payments are semi–annual.) Is this a discount or premium bond?
Stock Index Performance. On Jan 4, 2019, the Dow Jones Industrial
Average opened at $22,686.22 and closed at $24,433.16. What
was the daily return that day, and what was the effective annual
rate return (in percent) of the stock market that day? ?
Buying Stock with a Market Order You would like to buy shares of
Widgets, Inc.The current ask and bid quotes are $8.625 and $8.375
respectively. You place a market buy–order for 500 shares that
executes at these quoted prices. How much money did it cost to buy
these shares?
Value a Constant Growth Stock Financial analysts forecast Safeco Corp.
(SAF) growth for the future to be 5 percent. Safeco’s recent dividend
was $3.00. What is the value of Safeco stock when the required return
is 14 percent?
Expected Return Ecolap Inc. (ECL) recently paid a $0.50dividend. The dividend
is expected to grow at a 12 percent rate. At a current stock price of $11.20,
what is the return shareholders are expecting?
Variable Growth A fast growing firm recently paid a dividend of $0.50 per share.
The dividend is expected to increase at a 20 percent rate for the next 3 years.
Afterwards, a more stable 10 percent growth rate can be assumed. If a 12
percent discount rate is appropriate for this stock, what is its value?
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