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MGT 326 HW1 1 1. The real risk-free rate of interest is 3%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity.

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Presentation on theme: "MGT 326 HW1 1 1. The real risk-free rate of interest is 3%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity."— Presentation transcript:

1 MGT 326 HW1 1 1. The real risk-free rate of interest is 3%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-yr and 3-yr U.S. Treasury bonds? (Hint: for U.S. Treasury bonds, DRP = LP = 0) Answer: 6%, 6.33% 2. The real risk-free rate is 3% and inflation is expected to be 3% for the next 2 years. A 2-yr U.S. Treasury bond yields 6.2%. What is the MRP on the 2-yr treasury? Answer: 0.2% 3. A U.S. Treasury bond that matures in 10 years has a yield of 6%. A 10-yr corporate bond has a yield of 8%. Assume the liquidity premium on the corporate bond is 0.5%. What is the default risk premium on the corporate bond? (Hint: since both bonds have the same maturity, they will have the same MRP) Answer: 1.5% 4. The real risk-free rate is 3%. Inflation is expected to be 3% this year, 4% next year and 3.5% thereafter. The MRP is estimated to be 0.05%(t – 1) where t is the number of years to maturity. What is the nominal interest rate on a 7-yr U.S. Treasury bond? Answer: 6.8% 5. You own a corporate bond that currently has a fair market value of $1023.68. If you sold this bond for $1,050.00, what would your rate of return be? (Note: face value ≠ fair market value; use profit/investment) Answer: 2.57% 6. You are considering purchasing one of the following securities: Security A: Sales Price = $10,300.00 Fair Market Value (FMV) = $10,192.56 Security B: Sales Price = $1,200.00 Fair Market Value (FMV) = $1,182.05 Which security is most fairly priced? [Hint: the most fairly priced security is the one that offers its seller the smallest rate of profit] Answer: ROR A = 1.05%, ROR B = 1.52%; Security A is most fairly priced

2 Homework 1 2 7. Yield Curves (Do this problem in Excel) Your task is to draw the bond yield curves for U.S. Treasuries, Microspongy Corp. and Diamond Jim’s Enterprises Inc. for maturities of 1 year to 30 years. Draw the yield curve for each entity onto one chart. The way to do this is to compute the cost of money (r = r*+IP+DRP+LP+MRP) for each maturity then construct a scatter plot (with connecting line) with maturities as the x-axis values and interest rates as the y-axis values for the U.S. Treasuries. You can then add onto that chart the Microspongy and Diamond Jim’s data series so that all three yield curves appear on the same chart. You must show the data you used to draw the yield curves Key Info: a. U.S. Treasuries 1) r*=1.0000% for each maturity, year 1 through year 30. 2) Expected inflation for the 1 st yr is 2.0000%, 2.5000% for the 2 nd year, 3.0000% the 3 rd year, 3.5000% the 4 th year and for every following year. 3) MRP for the first year is 0.2000% and increases by 0.2000% each year for the next 4 years until it reaches 1.0000% in year 5 and it will stay constant at 1.0000% thereafter. b. Microspongy Corp.: Same data as U.S. Treasuries above plus…. 1) DRP for the 1 st year is 0.0500% and increases by 0.0500% each year i.e. DRP 2 = DRP 1 + 0.0500% 2) LP for the 1 st year is 0.0500% and increases by 0.0500% each year i.e. LP 2 = LP 1 + 0.0500% c. Diamond Jim’s Enterprises Inc.: Same data as U.S. Treasuries above plus…. 1) DRP for the 1 st year is 0.1000% and increases by 0.1000% each year i.e. DRP 2 = DRP 1 + 0.1000% 2) LP for the 1 st year is 0.0500% and increases by 0.0500% each year i.e. LP 2 = LP 1 + 0.0500% Hints: Part a: I recommend you list all maturities form 1 to 30 vertically then list all the components horizontally (I have posted an Excel file entitled HW1 Yield Curves for you to use as a guide. It has my solution for the first 3 years for U.S. Treasuries and Microspongy). Fill in all the data you will need to complete the equation (r = r*+IP+DRP+LP+MRP) for the 1-year bond. Then do the same for the 2-year bond, noting that you should type in an equation for IP. Remember that IP is computed by averaging the inflation over the life of the bond. That’s what the equation in the IP cell does for you. Then all you have to do is click&drag cells downward to fill in the cells for the remaining maturities. To Parts b and c, all you have to do is copy & paste Part a and modify the IP, DRP and LP cells for the 2 year bond as stated above then click & drag.

3 This is what your final effort on Problem 3 should look like


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