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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

3.41% 1.Elizabeth Patrick MBA 504: Financial Management b. According to the question the compounding is to be ignored so the rate = 2. The yields for Treasuries with differing maturities. E6-3.01 3.68 3. 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 1.3 % approx. Yield 1. approx. If the expectations hypothesis is true. approx.3% c.71 Real rate of Interest 0.3 Hence rate = 1. 1.7 = e5R From ex table 3. Ans.80 . including estimate of the real rate of interest. investors do not expect rising interest rates? Explain. Is it possible that even through the yield curve slopes up in this problem. If the expectations hypothesis is true.41% 1. should be the risk less return to be paid by a treasury bill for 5 years form now.7 = eRT 3. on a recent day were as shown in the following table: Maturity 3 Mo.80% 0.25 Yield Ans.71% 2.6693 = 1.51 5.68% d. (ignoring compounding) what rate of return do investors expect a 1 – year Treasury security to pay starting 2 years from now? Ans.70 4. 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. 6 Mo.

Maturity 3 months 6 months 2 years 3 years 5 years 10 years 30 years Inflation 33.80 0.01 3.25 0. 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.3/2 = 1.44% 10% 24. Rating Class AAA Nominal interest rate 5.32% 25.3%.80 MBA 504: Financial Management Use the information in the preceding table to calculate the inflation expectation for each maturity. If the inflation is highly negative a t-bill may have negative or zero return.12% .68 3. Zero real rate of return can be when the rate of t-bill is equal to the rate of the market.88% 46.65% E6-5.67% E6-4. Ans.Elizabeth Patrick 2 yrs 3 yrs 5 yrs 10 yrs 30 yrs 2.80 0.51 5.51%.80 0. the annual inflation rate measured by the Consumer Price Index Table (CPI) was forecast to be 3. Recently.07 4.80 0. Negative inflation will make the GDP high and the riskless return will decline or even it can be negative.89% -14. Calculate the risk premium for each of the following rating classes of long term securities.44% 38. CPI/real rate = risk free rate 3. assuming that the yield to maturity (YTM) for comparable Treasuries is 4. Negative real rate can be earned by the treasury bill if it has negative inflation.

5.27 7.78-4.31 MBA 504: Financial Management .51=0.78 7.51=1.61 5.51=3.82 Rating Class AAA BBB B risk premium 5.82-4.12-4.Elizabeth Patrick BBB B Ans.

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