Financial Environment and Interest Rate and Inflation

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An Assignment of Business Finance Course Code: FIN -2101

Submitted To:
Md. Monzur Morshed Bhuiya Associate Professor Department of Finance Jagannath University, Dhaka.

Submitted By:
Md. Mazharul Islam. Group Representative of Finance Interface B.B.A, 3rd Batch (2nd Year, 1st Semester) Session: 2008-2009 Department of Finance Jagannath University, Dhaka.

Date of Submission: 25-10-2010

Department of Finance

Jagannath University

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Sl. No. Name 01. Md. Mazharul Islam. (Group Representative) 02. Khadizatuz Zohara. Roll No. 091541 091526 Department of Finance Jagannath University 2|Page

Table of Contents

Sl. No. 2-1 2-2 2-3 2-4 2-5 2-6 2-7 2-8 2-9 2-10 2-11

Contents Problems Yield Curves Yield Curves Inflation and Interest Rate Rate of Interest Real Risk-Free Rate, MRP and DRP Exam-Type Problems Expected Inflation Rate Expected Rate of Interest Expected Rate of Interest Interest Rate Interest Rate Expected Rate of Interest Ending Part Formula and Necessary Illustration for Calculation Summary of the Assignment

Page No. 5 6 7 9 10 12 13 14 14 15 16 17 18

Department of Finance

Jagannath University

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The Financial Environment: Interest Rates
Problems 2-1:
Suppose you and most other investors expect the rate of inflation to be 7 percent next year, to fall to 5 percent during the following year, and then to remain at a rate of 3 percent thereafter. Assume that the real risk-free rate, k*, is 2 percent and that maturity risk premium on treasury securities rise from zero on very short-term bonds ( those that mature in few days) by 0.2 percentage points for each year to maturity, up to a limit of 1.0 percentage point on five year or longer-term T-bonds. a. Calculate the interest rate on one, two, three, four, five, 10 and 20 year Treasury securities, and Plot the yield curve. b. Now suppose IBM, a highly rated company, had bonds with the same- maturities as the Treasury bonds. As an approximation, plot a yield curve for IBM on the same graph with the Treasury bond yield curve, (Hint: Think about the default risk premium on IBM’s long-term versus its short-term bonds.) c. Now plot the approximate yield curve of Long Island Lighting Company (LILCO), a risky nuclear utility.

Solution 2-1:
Requirement ‘a’: Expected Annual Inflation Rate 7% 5% 3% 3% 3% 3% 3% Real Risk-free Rate (k*) 2% 2% 2% 2% 2% 2% 2% Average Expected Inflation Rate or Inflation Premium (IP) ����1 = 7% 1 =7% ����2 = (7%+5%) ∕2 = 6% ����3 = (12%+3%) ∕3 = 5% ����4 = (15%+3%) ∕4 =4.5% ����5 =(18%+3%) ∕5 = 4.2% ����10 =(21%+3%×5) ∕10=3.6% ����20 =(36%+3%×10) ∕20=3.3%

Bond Type 1st year bond 2nd year bond 3rd year bond 4th year bond 5th year bond 10th year bond 20th year bond

Average Nominal Interest Rate ������ = k* + IP 9% 8% 7% 6.5% 6.2% 5.6% 5.3%

Bond Type 1st year bond 2nd year bond 3rd year bond 4th year bond 5th year bond 10th year bond 20th year bond

Maturity Risk Premium (MRP) 0.2% 0.2%+0.2% =0.4% 0.4%+0.2% =0.6% 0.6%+0.2% =0.8% 0.8%+0.2% =1.0% 1.0% 1.0%

Department of Finance

Jagannath University

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And Bond Type 1st year bond 2nd year bond 3rd year bond 4th year bond 5th year bond 10th year bond 20th year bond The yield Curve: ������ + ������ 9% + 0.2% 8% + 0.4% 7% + 0.6% 6.5% + 0.8% 6.2% + 1.0% 5.6% + 1.0% 5.3% + 1.0% Interest Rate (k) 9.2% 8.4% 7.6% 7.3% 7.2% 6.6% 6.3%

10.5 10.0 9.5 9.0 8.5 Yield (%) 8.0 7.5 7.0 6.5 6.0 5.5 5.0 0 2 4 6 8

Yield Curve

LILCO IBM T - Bonds - Bonds T

10

12

14

16

18

20

Yield of Maturity

Requirement ‘b’: The interest rate on the IBM bonds has the same components as the Treasury securities, except that the IBM bonds have default risk, so a default risk premium must be included. Therefore, �������� = ��* + IP + MRP + DRP For a strong company such as IBM, the default risk premium is virtually zero for short-term bonds. However, as time to maturity increases, the probability of default, although still small, is...
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