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.
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
[(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-
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
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?