Week 1 HW

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Feb 20, 2024

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Irene Cooper 1/7/2024 HW- Week 1 Chapter 2  Problems 1, 2, 18, 19 and 26 (pp 57-58) 1. A particular security’s equilibrium rate of return is 8 percent. For all securities, the inflation risk premium is 1.75 percent and the real risk-free rate is 3.5 percent. The security’s liquidity risk premium is 0.25 percent and maturity risk premium is 0.85 percent. The security has no special covenants. Calculate the security’s default risk premium. (LG 2-6) Default Risk Premium= Rate of Return - Inflation rate- real rate - Liquidity Risk- Majority Risk Rate of Return 8.00 % Inflation rate 1.75 % real rate 3.50 % Liquidity Risk 0.25 % Majority Risk 0.85 % Default Risk Premium 1.65 % 2. You are considering an investment in 30-year bonds issued by Moore Corporation. The bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 3.25 percent. Your broker has determined the following information about economic activity and Moore Corporation bonds: (LG 2-6) Real risk-free rate = 2.25% Default risk premium=1.15% Liquidity risk premium= 0.50% Maturity risk premium=1.75%

a. What is the inflation premium? Inflation Premium= Nominal Interest Rate - Real Risk-Free rate Nominal Interest Rate 3.25% Real Risk-Free Rate 2.25% Inflation Premium 1.00% b. What is the fair interest rate on Moore Corporation 30-year bonds? Fair Interest Rate= Real Risk-Free Rate + Default Risk Premium+ Liquidity Risk Premium+ Majority Risk Premium+ Inflation Premium Real Risk Free Rate 2.25% Inflation Premium 1.00% Default Risk Premium 1.15% Liquidity Risk Premium 0.50% Majority Risk Premium 1.75% Fair Interest Rate= 6.65% 18. You note the following yield curve in The Wall Street Journal. According to the unbiased expectations theory, what is the one-year forward rate for the period beginning two years from today, 3f1? (LG 2-8) Maturity Yield One Day 2.00% One Year 5.50 Two years 6.50 Three Years 9.00 Current 3 year 9.00% 0.09 Current 2 Year 6.50% 0.065 1.09 1.295029 1.07 1.134225 1.14177433 9 0.14177433 9

14.18% Formula in Excel Current 3 year 0.09 Current 2 Year 0.065 =1+B1 =A3^3 =1+B2 =A4^2 =B3/B4 =B5-1 =B6 19. On March 11, 20XX, the existing or current (spot) one-year, two-year, three-year, and four-year zero-coupon Treasury security rates were as follows: 1R1 4.75% 1R2 4.95% 1R3 5.25% 1R4 5.65% Using the unbiased expectations theory, calculate the one-year forward rates on zero-coupon Treasury bonds for years two, three, and four as of March 11, 20XX. (LG 2-8) Formulas in Excel 1R1 0.0475 =B1/1 1R2 0.0495 =B2/1 1- Year Forwards Rate for Year 2 1.0495 1.10145025 1.0475 1.051503819 0.05150381 9 5.15% 1- Year Forwards Rate for Year 3 1.0525 1.16591345 1.0495 1.10145025 1.05852575 1 0.058525751 5.85% 1- Year Forwards Rate for Year 4 1.0565 1.24588514 1.0525 1.165913453 1.06859144 3 0.068591443 6.86%

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1R3 0.0525 =B3/1 1R4 0.0565 =B4/1 1- Year Forwards Rate for Year 2 =1+C2 =B7^2 =1+C1 =C7/D7 =E7-1 =F7*1 1- Year Forwards Rate for Year 3 =1+C3 =B8^3 =1+C2 =D8^2 =C8/E8 =F8-1 =G8*1 1- Year Forwards Rate for Year 4 =1+C4 =B9^4 =1+C3 =D9^3 =C9/E9 =F9-1 =G9*1 26. Compute the future values of the following first assuming that payments are made on the last day of the period: