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##### On the first page it mentions Wally,

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On the first page it mentions Wally, who when facing falling sales, sees a memo from his boss.;She is concerned about the declining operating margin from 14 percent to 10 percent. She has;asked Wally for yield curve data showing the stability of interest rates over the past few years;the stability of current prices, and inflation rates. She also wishes to evaluate whether Babes;should issue debt.;Towards the bottom of the page she states, I think we can currently issue 3-year bonds priced to;yield 6.4 percent, 5-year bonds priced to yield 7.3 percent, and 10-year bonds priced to yield 8.4;percent.;We are just reading through the case at this point. This is the information you need to forecast;interest rates.;See Table 1. Treasury securities are issued by the government, they are called Treasury;securities. There are 3 periods of information for August 1991, August 1992, and November;1992.;They have varying maturities, meaning they come due in 3 months, 6 months, etc. You notice;that yields (returns) rise with maturity, which is what you would expect. If you were tying your;money in an investment for a long period of time, your yield would be higher than it would be;for a short period of time.;Table 2 includes information about corporate bonds, see the section on Default risk premium.;Corporate bonds may default, if a firm issues debt, the firm may not pay the debt, the risk of;nonpayment is a percentage that is added to the return. Riskier bonds like C-rated bonds have;higher risk of default, or higher default risk than AAA bonds.;Using the data provided in Table 1, construct the yield curves for August 1991, August 1992, and;November 1992. Yes, T-bills are risk-free.;The yield curve is a graph of interest rates and time to maturity.;Draw a graph in Excel. Create a table of values first.;In the first column, list the maturities from Table 1.;Second column: list the yields for August 1992 Third column: list the yields for November;1992.;Insert Line Chart.;Highlight maturities 1 - 10 and the second and third columns to get the graph.;Answer;Answer: It is descriptive. Evaluate the change in shape of the yield curve using expectations and;market segmentation, write a paragraph.;We use 1-10 just because of ease of comparability, which does not exist for 30 years, from 1-10;as 3 months and 6 months are of a different duration than the annual maturities for years 1 - 10.;3. Calculate the one-year forward rates of interest implied by the November 1992 yield curve;over the period 1993-2002.;Answer: We need a starting point. Use 1993 as 3.8% 4.65 = 2 year rate = (3.8+x)/2.;According to the expectations theory, the 2 year rate = sum of the previous year's rate and the;year before that, or the 2 previous 1 year rates.;x = 5.5 %;This is for 1994.;Next, for 1995, you have a 3-year rate = 5.23 = (3.8+5.5+x)/3;x = 6.39 %;4. Using these 1 year forward rates, calculate the expected annual inflation rate in each of the;next 10 years, and use this rate to obtain the average rate of price appreciation over the 1993 to;2002 period. Assume expectations, knominal = kreal + expected inflation premium;Answer: expected inflation premium = knominal - kreal = 1993-1994 = 5.5-3.8 = 1.7%;5.5 were the first answer we computed, that is the nominal quoted interest rate.;The real rate, according to expectations, is the nominal rate for the year before, or 3.8%;for 1994-1995, 6.39 -5.5 = 0.89% is the expected inflation premium. knominal = 6.39 - kreal of;5.5.;5. Examine the information provided in Table 2. Do these data lead you to believe that the annual;inflation rate you calculated in Q 4 might be incorrect? Why or why not?;Answer: See Table 2, the second and third columns list maturity and liquidity risk premia which;were omitted from the strict expectations theory computation.;6. Using the data provided in Tables 1 and 2 prepare a revised estimate of (a) the one-year;forward interest rates implied by the November 1992 yield curve over the 1993-2002 period, and;the expected inflation rate in each of these years.;Answer: a-) Originally, we were using the expectations theory, now we are using liquidity;preference.;1993, one year forward rate = 3.8%;1994, 4.65 + 0.2 + 0, take the figure for 2 years from the last column of Table 1, add the maturity;risk premium and the liquidity risk premium;3 years, 1995, 5.23 +.3 +.1 = 5.63%.;b-)Find the inflation rates as the difference between the nominal rates (answers) to 6a.;We are using the liquidity preference theory, so inflation = sum of maturity and liquidity risk;premia.;Answer;1 year = 0%;2 years =.2 + 0 =.2;3 years,.3 +.1 =.4;7. How would the yield curve for an AAA rated firm, a B-rated firm, and a C-rated firm, differ;from the Treasury security yield curve you constructed in # 1?;Answer;You have to draw yield curves - 3 lines for the 3 types of bonds using the same procedure as;problem 1.;Year 1, nominal rate = T-bill rate + Maturity risk premium + liquidity risk premium + default risk;premium for an AAA bond;3.8 + 0 +0 +.9 = 4.7;3 years, 5.23 +.3 +.1 +.9;We are taking the lowest risk free rate on a Treasury security and adjusting it to the rate on an;AAA bond.;9. Can you use the information in the case to estimate Babes-N-Toyland's bond rating?;The yields on the second page. 3 year bonds priced to yield 6.4% per annum. 5-year bonds priced;to yield 7.3 percent per annum, 10 year bonds priced to yield 8.4 percent. Look at the yields on;the AAA. B, and C bonds and see if any bond has a maturity and yield similar to these figures.;That will be Babes's bond rating.;10.;AAA are the least risky and C the most risky.

Paper#23955 | Written in 18-Jul-2015

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