Elizabeth Patrick Assignment 2.2 - Chap.

6 Warm Up Exercises

MBA 504: Financial Management

E6-1. The risk-free rate on T-bills recently was 1.23%. If the real rate if interest is estimated to be 0.80%, what was the expected level of inflation? Ans. Rate of inflation = 1+rn = 1+ ri 1+rf =1 + 0.8 1 + 1.23 = 1.8 = 1 + ri 2.23 ri = -19.28% There is a decline in inflation. E6-2. The yields for Treasuries with differing maturities on a recent day were as shown in the table on page 253. a. Use the information to plot yield curve for this date. Ans. Graph = 1 + ri

yield2
6 5 4 3 2 1 0 maturity 0.25 0.5 2 3 5 10 30

yield2

Elizabeth Patrick

MBA 504: Financial Management

b. If the expectations hypothesis is true, approx. what rate of return do investors expect a 5 yr Treasury note to pay 5 yrs from now? Maturity 3 months 6 months 2 years 3 years 5 years 10 years 30 years 1.41% 1.71% 2.68 3.01 3.70 4.51 5.25 Yield

Ans. 1.3 % approx. should be the risk less return to be paid by a treasury bill for 5 years form now. 3.7 = eRT 3.7 = e5R From ex table 3.6693 = 1.3 Hence rate = 1.3% c. If the expectations hypothesis is true, approx. (ignoring compounding) what rate of return do investors expect a 1 year Treasury security to pay starting 2 years from now? Ans. According to the question the compounding is to be ignored so the rate = 2.68% d. Is it possible that even through the yield curve slopes up in this problem, investors do not expect rising interest rates? Explain. Ans. Yes it is possible as the yield curve in the given problem is showing an upward trend but the investor may not get a rising interest as the yield is the compounded and the rate of interest may be not increasing in real but only via compounding. E6-3. The yields for Treasuries with differing maturities, including estimate of the real rate of interest, on a recent day were as shown in the following table: Maturity 3 Mo. 6 Mo. Yield 1.41% 1.71 Real rate of Interest 0.80% 0.80

Elizabeth Patrick 2 yrs 3 yrs 5 yrs 10 yrs 30 yrs 2.68 3.01 3.07 4.51 5.25 0.80 0.80 0.80 0.80 0.80

MBA 504: Financial Management

Use the information in the preceding table to calculate the inflation expectation for each maturity. Ans. Maturity 3 months 6 months 2 years 3 years 5 years 10 years 30 years Inflation 33.89% -14.44% 10% 24.32% 25.44% 38.88% 46.67%

E6-4. Recently, the annual inflation rate measured by the Consumer Price Index Table (CPI) was forecast to be 3.3%. How could a T-Bill have had a negative real rate of return over the same period? How could it have has a zero real rate of return? What minimum rate of return must the T-bill have esarned to meet your requirement of a 2% real rate of return? Ans. Negative real rate can be earned by the treasury bill if it has negative inflation. Negative inflation will make the GDP high and the riskless return will decline or even it can be negative. If the inflation is highly negative a t-bill may have negative or zero return. Zero real rate of return can be when the rate of t-bill is equal to the rate of the market. CPI/real rate = risk free rate 3.3/2 = 1.65% E6-5. Calculate the risk premium for each of the following rating classes of long term securities, assuming that the yield to maturity (YTM) for comparable Treasuries is 4.51%. Rating Class AAA Nominal interest rate 5.12%

Elizabeth Patrick BBB B Ans. 5.78 7.82 Rating Class AAA BBB B risk premium 5.12-4.51=0.61 5.78-4.51=1.27 7.82-4.51=3.31

MBA 504: Financial Management