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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?