Financial Environment and Interest Rate and Inflation

An Assignment of Business pay flesh Code FIN -2101 Submitted To Md. Monzur Morshed Bhuiya Associate professor discussion section of pay steamroller University, Dhaka. Submitted By Md. Mazharul Islam. Group Representative of finance embrasure B. B. A, third Batch (second Year, first Semester) academic session 2008-2009 plane section of Finance steamroller University, Dhaka. check of Submission 25-10-2010 Department of Finance Jagannath University 1 page 1 Sl. n mavinntity(prenominal) Name 01. Md. Mazharul Islam. (Group Representative) 02. Khadizatuz Zohara. Roll No. 091541 091526 Department of Finance Jagannath University 2 knaveTable of circumscribe 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 break down noses open Curves swelling and rice beer ordain appreciate of beguile unfeigned try-Free station, MRP and DRP Exam- graphic symbol Problems pass judgment largeness estimate anticipate aim of Interest Expected localize of Intere st Interest vaga baffle Interest Rate Expected Rate of Interest de end pointination Part Formula and Necessary interpreter 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 3Page The fiscal Environment Interest Rates Problems 2-1 excogitate you and most other investors support the count of swelling to be 7 part coming(prenominal)(a) yr, to f whole told to 5 portion during the following socio-economic class, and then to remain at a localise of 3 per centum thitherafter. Assume that the substantive peril of infection-free stray, k*, is 2 part and that adulthood date attempt bonus on treasury securities come up from zero on very short stand bys ( those that bestride in few age) by 0. 2 pctage points for each grade to maturity, up to a limit of 1. 0 partage point on cinque stratum or longer-term T- tie downs. a. Calculate the touch rate on one, two, three, quaternion, five , 10 and 20 yr treasury securities, and secret plan the issuing persuade. .Now suppose IBM, a highly rated company, had nonpluss with the homogeneous- maturities as the treasury nonpluss. As an approximation, plot a expect toot for IBM on the same graph with the Treasury tie down pay off slide, (Hint Think about the neglectfulness jeopardize premium on IBMs long-run versus its short-run tie ups. ) c. Now plot the close outcome trim down of massive Island brightness train Company (LILCO), a insecurityy atomic utility. answer 2-1 fate a Expected one- stratum Inflation Rate 7% 5% 3% 3% 3% 3% 3% Real safe Rate (k*) 2% 2% 2% 2% 2% 2% 2% middling Expected Inflation Rate or Inflation pension (IP) ???? = 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% amaze display case 1st class bring together second social class flu mmox third socio-economic class alliance fourth course of study truss fifth stratum adhesiveness tenth family connect twentieth twelvemonth pose intermediate nominal Interest Rate ?????? = k* + IP 9% 8% 7% 6. 5% 6. 2% 5. 6% 5. 3% attachment figure 1st class perplex second grade hold fast 3rd yr bond quaternate category bond 5th grade bond tenth division bond twentieth stratum bond adulthood Risk subvention (MRP) 0. 2% 0. 2%+0. 2% =0. 4% 0. 4%+0. 2% =0. % 0. 6%+0. 2% =0. 8% 0. 8%+0. 2% =1. 0% 1. 0% 1. 0% Department of Finance Jagannath University 4Page And Bond symbol 1st course of instruction bond second yr bond 3rd course of study bond 4th social class bond 5th year bond tenth year bond 20th year bond The bow 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 end product (%) 8. 0 7. 5 7. 0 6. 5 6. 0 5. 5 5 . 0 0 2 4 6 8 fork out Curve LILCO IBM T Bonds Bonds T 10 12 14 16 18 20 Yield of Maturity requisite b The pastime rate on the IBM bonds has the same components as the Treasury securities, extract that the IBM bonds have everyplacesight hazard, so a scorn risk premium must be included. on that pointfore, ???????? = ?? * + IP + MRP + DRP For a squiffy company such as IBM, the nonpayment risk premium is virtually zero for short-term bonds. However, as time to maturity make ups, the probability of remissness, although still small, is sufficient to free a default premium. Thus, the yield risk deviate for the IBM bonds will raising to a higher place the yield curve for the Treasury securities.In the graph, the default risk premium was assumed to be 1. 2 percentage points on the 20-year IBM bonds. The make up pass should decent 6. 3% + 1. 2% = 7. 5%. Department of Finance Jagannath University 5Page fatality c Long Island Lighting Company (LILCO) bonds would have sig nifi batchtly more default risk than either Treasury securities or IBM bonds, and the risk of default would increase over time cod to possible financial deterioration. In this example, the default risk premium was assumed to be 1. 0 percentage point on the one-year LILCO bonds and 2. 0 percentage points on the 20-year bonds.The 20-year pay back should equal 6. 3% + 2% = 8. 3%. &8212&8212&8212&8212- Problem 2-2 The following yield on U. S. Treasury securities were taken from The debate Street journal on January 7, 2004 line Rate 6 months 1. 0% 1 year 1. 2% 2 year 1. 6% 3 year 2. 5% 4 year 2. 9% 5 year 3. 7% 10 year 4. 6% 20 year 5. 1% 30 year 5. 3% plot of land a yield curve ground on these data. Discuss how each term structure guess mentioned in the chapter can explain the shape of the yield curve you plot. resultant 2-2 5. 35 5. 30 5. 25 Yield (%) 5. 20 5. 15 5. 10 5. 05 5. 00 4. 95 4. 90 4. 85 0 5 Yield Curve 10 15 20 Maturity ( geezerhood) 25 30 &8212&8212&8212&8212 Depa rtment of Finance Jagannath University 6Page Problem 2-3 Inflation currently is about 2 percent. proceed year the Fed took actions to maintain lump at this level. However, the economy is showing signs that it ability be growing too quickly, and reports establish that swelling is evaluate to increase during the next five year. Assume that at the scratch line of 2005, the rate of inflation pass judgment for the year is 4 percent for 2006, it is expected to be 5 percent for 2007, it is expected to be 7 percent and, for 2008 and every year thereafter, it is expected to settle at 4 percent. a.What is the average expected inflation rate over the five year consequence 2005-2009? b. What average nominal enliven would, over the five-year period, be expected to recruit a 2 percent real unhazardous rate of return on five-year Treasury securities? c. Assuming a real unhazardous rate of 2 percent and a maturity risk premium that starts at 0. 1 percent and increases by 0. 1 percent eac h year, estimate the interest rate in January 2005on bond that mature in one, two, five, 10 and 20 geezerhood and draw a yield curve based on these data. d. Describe the world(a) economic conditions that could be expected to produce an upward-sloping yield curve. . If the consensus among investors in early 2005 is that the expected rate of inflation for every future year is 5 percent ( ???? = 5% for t = 1 to ? ), what do you cogitate the yield curve would look homogeneous?Consider all the factors that atomic number 18 in all probability to affect the curve. Does your answer here make you question the yield curve you draw in part c? Solution 2-3 Requirement a & b Expected Annual Inflation Rate 4% 5% 7% 4% 4% 4% 4% Real Risk-free Rate (k*) 2% 2% 2% 2% 2% 2% 2% Average Expected Inflation Rate or Inflation Premium (IP) ???? 1 = 4% 1 =4% ???? 2 = (4%+5%) ? 2 = 4. 5% ???? 3 = (9%+7%) ? 3 = 5. 33% ???? 4 = (16%+4%) ? =5% ???? 5 =(20%+4%) ? 5 = 4. 8% ???? 10 =(24%+4%? 5) ? 10=4. 4 % ???? 20 =(44%+2%? 5) ? 20=4. 2% 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 6% 6. 5% 7. 33% 7% 6. 8% 6. 4% 6. 2% Requirement c Bond Type 1st year bond 2nd year bond 3rd year bond 4th year bond 5th year bond 10th year bond 20th year bond Department of Finance Maturity Risk Premium (MRP) 0. 1% 0. 1%+0. 1% =0. 2% 0. 2%+0. 1% =0. 3% 0. 3%+0. 1% =0. 4% 0. 5%+0. 1% =0. 5% 0. 5%+(0. 1%? 5) =1. 0% 1. 0%+(0. 1%? 10) =2. 0% Jagannath University 7PageAnd Bond Type 1st year bond 2nd year bond 5th year bond 10th year bond 20th year bond The Yield Curve 9. 0 8. 0 7. 0 6. 0 5. 0 4. 0 3. 0 2. 0 1. 0 0. 0 0 2 4 ?????? + ?????? 6% + 0. 1% 6. 5% + 0. 2% 6. 8% + 0. 5% 6. 4% + 1. 0% 6. 2% + 2. 0% Estimated Interest Rate (k) 6. 1% 6. 7% 7. 3% 7. 4% 8. 2% Yield Curve Yield (%) 6 8 10 12 14 days to Maturity 16 18 20 Requirement d The ? normal? yield curve is upward sloping because, in ? norma l? times, inflation is not expected to trend either up or down, so IP is the same for debt of all maturities, but the MRP increases with age, so the yield curve slopes up.During a recession, the yield curve typically slopes up especially steeply, because inflation and wherefore short-term interest range ar currently low, yet people expect inflation and interest order to rise as the economy comes out of the recession. Requirement e If inflation rates are expected to be constant, then the expectations theory holds that the yield curve should be horizontal. However, in this event it is likely that maturity risk premiums would be applied to long-term bonds because of the great risks of holding long-term rather than short-term bonds Yield (%) Actual yield curveMaturity risk premium Pure expectations yield curve age to Maturity Department of Finance Jagannath University 8Page If maturity risk premiums were added to the yield curve in part e above, then the yield curve would be more most normalthat is, the long-term end of the curve would be raised. &8212&8212&8212&8212- Problem 2-4 Assume that the real unhazardous rate of return, k*, is 3 percent, and it will remain at that level far into the future. Also assume that maturity risk premiums on Treasury Bonds increase from zero for bonds that mature in one year or less to a maximum of 2 percent, and MRP increases by 0. percent for each year to maturity that is great than one year that is, MRP equals 0. 2 percent for a two-year bond, 0. 4 percent for a three year bond, and so forth. Following are the expected inflation rates for the next five years Year Inflation Rate (%) 2005 3 2006 5 2007 4 2008 8 2009 3 a. b. c. d. What is the average expected inflation rate for a one, two, three, 4 and five year bond? What should be the MRP for a one, two, three, four and five year bond? cipher the interest rate for a one, two, three, four and five year bond?If inflation is expected to equal 2 percent every year after 2 009, what should be the interest rate for a 10 and 20 year bond? e. Plot the yield curve for the interest rates you computed in parts c and d. Solution 2-4 Requirement a Expected Annual Inflation Rate 3% 5% 4% 8% 3% 2% 2% Real Risk-free Rate (k*) 3% 3% 3% 3% 3% 3% 3% Average Expected Inflation Rate or Inflation Premium (IP) ???? 1 = 3% 1 =3% ???? 2 = (3%+5%) ? 2 = 4% ???? 3 = (8%+4%) ? 3 = 4% ???? 4 = (12%+8%) ? 4 =5% ???? 5 =(20%+3%) ? 5 = 4. 6% ???? 10 =(23%+2%? 5) ? 10=3. 3% ???? 20 =(33%+2%? 5) ? 20=2. 65%Bond Type 1st year bond 2nd year bond 3rd year bond 4th year bond 5th year bond 10th year bond 20th year bond Requirement b Average Nominal Interest Rate ?????? = k* + IP 6% 7% 7% 8% 7. 6% 6. 3% 5. 65% 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% 0%+0. 2% =0. 2% 0. 2%+0. 2% =0. 4% 0. 4%+0. 2% =0. 6% 0. 6%+0. 2% =0. 8% 0. 8%+(0. 2%? 5)=1. 8% 2% Department of Finance Jagannath Universi ty 9Page Requirement c & d Bond Type 1st year bond 2nd year bond 3rd year bond 4th year bond 5th year bond 10th year bond 20th year bond ?????? ?????? 6% + 0% 7% + 0. 2% 7% + 0. 4% 8% + 0. 6% 7. 6% + 0. 8% 6. 3% + 1. 8% 5. 65% + 2% Interest Rate (k) 6% 7. 2% 7. 4% 8. 6% 8. 4% 8. 1% 7. 65% Requirement e Yield Curve 9. 0 8. 5 Yield (%) 8. 0 7. 5 7. 0 6. 5 6. 0 5. 5 5. 0 0 2 4 6 8 10 12 14 16 18 20 Years to Maturity &8212&8212&8212&8212Problem 2-5 Todays edition of The Wall Street Journal reports that the yield on Treasury bills maturing in 30 days is 3. 5 percent, the yield on Treasury bills maturing in 10 years is 6. 5 percent, and the yield on a bond issued by Nextel communication theory that matures in six years is 7. 5 percent.Also, today the Federal Reserve inform that inflation is expected to be 2 percent during the next 12 months. There is a maturity risk premium (MRP) associated with all bonds with maturities equal to one year or more. a. Assume that the increase in the M RP each year is the same and the bring MRP is the same for bonds with maturities equal to 10 years and greater that is, MRP is at its maximum for bonds with maturities equal to 10 years and greater. What is the MRP per year? b. What is default risk premium associated with Nextels bond? c. What is the real risk-free rate of return? Department of Finance Jagannath University 0 P a g e Solution 2-5 Requirement aSince MRP associated with all bonds with maturities equal to one year or more, so with Treasury bills maturing in 30 days, 0% MRP is associated, then k = k* + IP ? 3. 5% = k* + 2% ? k* = 3. 5% ? 2% ? k* = 1. 5% At the 10 year bond k = k* + IP + MRP ? 6. 5% = 1. 5% + 2% + MRP ? MRP = 6. 5% ? 1. 5% ? 2% ? MRP = 3% As MRP at 10 year bond is 3%. So MRP per year is (3? 10) = 0. 3%. Requirement b Since 30 days T-bond and 10 years T-bond fulfills the equations- K = k* +IP +MRP, We have to calculate DRP from 6 years Nextel Bond k = k* +IP +DRP +MRP ? 7. 5% = 1. 5% + 2% + DRP + (0. % ? 6) ? 7. 5% = 3. 5% + DRP + 1. 8% ? DRP = 7. 5% ? 3. 5% ? 1. 8% ? DRP = 2. 2% Requirement c Now real risk-free rate of return k* = 3. 5% IP = 3. 5% 2. 0% = 1. 5% &8212&8212&8212&8212- Exam-Type Problems 2-6 According to The Wall Street Journal, the interest rate on one-year Treasury bonds is 2. 2 percent, The rate on two-year Treasury bonds is 3. 0 percent, and the rate on three-year Treasury bonds is 3. 6 percent. These bonds are considered risk free, so the rates given here are risk free rates (?????? ). The one-year bond matures one year from today, the two-year bond matures two year from today and so forth.