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You are on page 1of 7

Dustin Chambers

Fall 2014

Instructions: Please show all of your work. Turn-in one assignment per group,

and make sure to list the names of each student in your group. Tip: This

assignment can be solved very quickly using Microsoft Excel.

1.

Consider the following table which contains the current market prices

(as of January 1, 2008) for a series of discount bonds issued by Acme

Biotech, a startup biotechnology firm. The discount bonds all have the

same face value, $10,000, and range in maturity from one (1) to ten

(10) years. Using the Lucas rational expectations-based asset pricing

model, derive market traders expected discount rates for each of the

next ten years (i.e. for 2008 through 2017).

Years

(t)

1

2

3

4

5

6

7

8

9

10

1+iet =

Maturity

January 1, 2009

January 1, 2010

January 1, 2011

January 1, 2012

January 1, 2013

January 1, 2014

January 1, 2015

January 1, 2016

January 1, 2017

January 1, 2018

Price

9,569.38

9,113.69

8,597.82

8,149.60

7,761.52

7,409.57

7,124.58

6,817.78

6,493.13

6,125.59

YTM

4.50%

4.75%

5.16%

5.25%

5.20%

5.12%

4.96%

4.90%

4.92%

5.02%

104.50%

--109.73%

105.00%

116.31%

106.00%

122.71%

105.50%

128.84%

105.00%

134.96%

104.75%

140.36%

104.00%

146.68%

104.50%

154.01%

105.00%

163.25%

106.00%

Method 1

According to the Lucas Pricing Model, the price of any of these bonds is equal

to the face value ($10,000) divided by the product of the expected discount

factors. For example, consider the current price of the $10,000 discount bond

that matures in year 2 (Jan. 1, 2010):

= 9,113.69 =

10,000

!

!

(1 + !""#

) (1 + !"#"

)

We know that the market thinks that the appropriate discount rate for Acme

Biotech will be 4.5% in 2009 (because the bond expiring Jan. 1, 2009 has a

yield to maturity (YTM) of 4.5%). Plugging this into the price formula for the

two-year discount bond above:

iet

4.50%

5.00%

6.00%

5.50%

5.00%

4.75%

4.00%

4.50%

5.00%

6.00%

= 9,113.69 =

10,000

!

(1 + 0.045) (1 + !"#"

)

Which can be rearranged to solve for the unknown discount rate in 2010:

!

1 + !"#"

=

10,000

= 1.05

1 + 0.045 9,113.69

Continuing in this fashion, you can solve for all of the other discount rates.

However, there are two alternative techniques to solve this problem which are

much faster.

Method 2

Consider the pricing formula for bonds maturing in two consecutive years:

!!! =

! =

(1 +

!

!""#

)

10,000

!

!

(1 + !"#"

) (1 + !!!

)

(1 +

!

!"#"

) (1

10,000

(1 +

!

!""#

)

!

+ !!!

) (1 + !! )

!!!

!

10,000

!

!

(1 +

(1 + !"#"

) (1 + !!!

)

=

10,000

!

!

!

(1 + !""#

) (1 + !"#"

) (1 + !!!

) (1 + !! )

!

!""#

)

!!!

= (1 + !! )

!

To demonstrate this, consider the example above that solved for the 2010

discount rate. Taking the ratio of the price for 2009 (t-1) and 2010 (t) bonds:

!""# 9,569.38

=

= 1.05

!"#" 9113.69

Method 3

Finally, we can use each bonds average yield (i.e. the YTM) to find the yearspecific discount rates. To see this, we can re-write the pricing equations in a

slightly different fashion:

!!! =

10,000

(1 + !!! )!!!

! =

10,000

(1 + ! )!

So, taking the ratios of the prices gives us the third operational way to solve

the problem:

10,000

!!! (1 + !!! )!!!

(1 + ! )!

=

=

10,000

!

(1 + !!! )!!!

!

(1 + ! )

So, it must be the case that

1 + !! =

(1 + ! )!

(1 + !!! )!!!

2.

Now, suppose that you have been offered the right to purchase Acme

Biotechs royalties for a new diabetes drug over the next ten years,

with the following expected annual royalty payoffs (see below).

Determine the most you are willing to pay for this non-standard, 10year financial asset.

Years

(t)

1

2

3

4

5

6

7

8

9

10

Payment Date

January 1, 2009

January 1, 2010

January 1, 2011

January 1, 2012

January 1, 2013

January 1, 2014

January 1, 2015

January 1, 2016

January 1, 2017

January 1, 2018

Royalty

(millions)

10.00

15.00

20.00

30.00

40.00

50.00

50.00

40.00

30.00

30.00

Discount

Factor

104.50%

109.73%

116.31%

122.71%

128.84%

134.96%

140.36%

146.68%

154.01%

163.25%

Total >>

PV

(millions)

9.57

13.67

17.20

24.45

31.05

37.05

35.62

27.27

19.48

18.38

233.73

Using the discount factors from the previous table of Acmes bonds:

! = (1 + ! )!

We can appropriately discount the expected income streams from Acmes

new diabetes drug. Adding up these discounted streams gives us a fair

market price for the rights to these royalties ($233.73 million).

3.

Treasury yields, and investment grade (BAA) bond yields. Determine

the real risk-free rate of return, and the real risk premium on

investment grade bonds.

Year

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Real Returns (%)

BAA

US

Inflation Risk-Free

Risk

Corp.

Treasury

Premium

8.36

6.03

2.4

3.63

2.33

7.95

5.02

2.7

2.32

2.93

7.80

4.61

2.3

2.31

3.19

6.77

4.02

1.5

2.52

2.75

6.39

4.27

1.8

2.47

2.12

6.06

4.29

2.1

2.19

1.77

6.48

4.79

2.5

2.29

1.69

6.48

4.63

2.3

2.33

1.85

7.45

3.67

2.3

1.37

3.78

7.30

3.26

1.7

1.56

4.04

6.04

3.21

1.0

2.21

2.83

5.66

2.79

1.7

1.09

2.87

4.94

1.80

2.1

-0.30

3.14

5.10

2.35

1.8

0.55

2.75

The risk free real return (!" ) is equal to the difference between the risk

free nominal return (!" ) and the current rate of inflation ():

!" = !"

We use Treasury bond yields as a measure of the nominal, risk-free

return. So, for 2000, the risk-free real return is 3.63% (6.03% - 2.4%).

To calculate the risk premium, just subtract the nominal return on the

risk free asset (Treasuries) from the return of a risky asset (Corp.

Bonds). Therefore, in 2000, the risk premium is 2.33% (8.36% 6.03%).

4.

Suppose that Wall Street analysts anticipate that Coca-Cola will pay a

$5 annual dividend for the foreseeable future (i.e., forever). Assuming

that Wall Street analysts posses rational expectations, what should be

the price of a share of Coca-Cola if we assume that interest rates are

fixed at 5% (also assume that you will receive your first dividend

payment next year)? Hint: The value of a geometric series (

1

.

S = a 0 + a1 + a 2 + a 3 +L ) is equal to: S =

1 a

According to rational expectations theory:

5

5

5

P=

+

+

+!

2

1.05 1.05 1.053

5

from the above infinite sum:

1.05

0

1

2

"

%

%

5 "

1

1

5 $( 1 + ( 1 + ( 1 +

'

P=

$1+

+

+!

=

+

+

+!

*

*

*

'

$

'&

1.05 # 1.05 1.052

1.05

1.05

1.05

1.05

&

, )

, )

,

#)

"

%

"

%

"

%

$

'

$

'

$

'

5 $

1

1

' = 5 $

' = 5 $ 1 ' = 5 " 1.05 %

P=

$

'

1.05 $ ( 1 + ' 1.05 $ 1.05 ( 1 + ' 1.05 $ 0.05 ' 1.05 # 0.05 &

*

-'

-'

$1 *

$

$# 1.05 '&

# ) 1.05 , &

# 1.05 ) 1.05 , &

P = 100

Factoring out

5. Suppose that Wall Street analysts have a one-year consensus price target

(forecast) for Intel of $100 per share (i.e. they forecast that the price of

a share of stock will be $100 next year). Further, suppose that the

current price of Intel is $95.45 per share and that interest rates are

assumed to remain fixed at 10% for one year. What is next years

expected dividend amount?

Pt =

Dte+1 + Pt e+1

Dte+1 = Pt (1 + i ) Pt e+1 = 95.45 (1.1) 100

(1 + i )

Dte+1 = 5

6. Suppose that interest rates are fixed forever at the rate of 4%, and shares

of Acme Inc. are selling for $37.50. Assume Acmes dividend

payments are also fixed forever, and that the next dividend payment is

one year away.

a. Determine the annual dividend amount.

D

From question #1, we know that P = . Therefore,

i

D = P i = 37.50 0.04 = 1.50

b. Suppose that interest rates jump to 6%, determine Acmes new

stock price.

D 1.50

P= =

= 25

i 0.06

7. What is the lemons problem? What are its consequences? How can the

market and the government respond to this problem?

The lemons problem refers to the fact that asymmetric information in a

market leads to adverse selection. The lemons problem raises lending

costs because lenders are not able to distinguish between credit-worthy

and un-credit-worthy borrowers. Consequently, the average credit risk of

borrowers increase, which in-turn, causes lenders to issue fewer loans at

any given interest rate.

One market response to the problem is to engage in credit rationing,

whereby lenders force borrowers to aggressively compete for a small pool

of loanable funds (thus limiting credit to only the most qualified borrowers).

Moreover, lenders may impose more stringent collateral requirements.

Governments can help combat the lemons problem by requiring more

financial transparency (i.e. firms are required to disclose important

financial data to the general public).

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