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Chapter 3 ASSIGNMENT Structure of Interest Rates, Assignments of Banking and Finance

University of San Carlos (USC)Banking and Finance

Financial Markets and Basic Finance Chapter 3 Structure of Interest Rates ASSIGNMENT

Typology: Assignments

2023/2024

Available from 09/24/2024

jerianne-judith-lobaton
jerianne-judith-lobaton 🇵🇭

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Chapter 3 Assignment
1. Reasons debt securities have varying yields
Debt securities offer varying yields due to characteristics such as credit risk, liquidity, tax
status, and term to maturity.
For each of the following scenarios, determine which security will have a higher yield
and will be more popular to investors seeking a high return on their investment. Assume
that other than the differences in characteristics mentioned, the securities are identical.
Scenario 1
Security 1: A Treasury bond with a 5-year maturity that offers an annualized yield of 6
percent to maturity.
Security 2: A corporate bond with a 5-year maturity that offers an annualized yield of 11
percent to maturity.
Security 1
Security 2
Scenario 2
Security 1: A Treasury bond that has a very active secondary market.
Security 2: A debt security that has a long-term maturity and that does not have a very
active secondary market.
Security 1
Security 2
Scenario 3
Security 1: A taxable security that offers a before-tax yield of 6.5 percent, sold to an
investor with a marginal tax rate of 20 percent.
Security 2: A tax-exempt security with a yield of 6 percent.
Security 1
Security 2
Scenario 4
Security 1: A 10–year Treasury bond.
Security 2: A 30–year Treasury bond.
Security 1
Security 2
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Chapter 3 Assignment

1. Reasons debt securities have varying yields Debt securities offer varying yields due to characteristics such as credit risk, liquidity, tax status, and term to maturity. For each of the following scenarios, determine which security will have a higher yield and will be more popular to investors seeking a high return on their investment. Assume that other than the differences in characteristics mentioned, the securities are identical. Scenario 1 Security 1: A Treasury bond with a 5-year maturity that offers an annualized yield of 6 percent to maturity. Security 2: A corporate bond with a 5-year maturity that offers an annualized yield of 11 percent to maturity. Security 1 Security 2 Scenario 2 Security 1: A Treasury bond that has a very active secondary market. Security 2: A debt security that has a long-term maturity and that does not have a very active secondary market. Security 1 Security 2 Scenario 3 Security 1: A taxable security that offers a before-tax yield of 6.5 percent, sold to an investor with a marginal tax rate of 20 percent. Security 2: A tax-exempt security with a yield of 6 percent. Security 1 Security 2 Scenario 4 Security 1: A 10–year Treasury bond. Security 2: A 30–year Treasury bond. Security 1 Security 2

2. Yield modeling on a debt security Suppose Green Energy Corporation is planning to massively expand inventory and will issue 26-week commercial paper to obtain funding for the expansion. Prior to issuing the commercial paper, Green Energy Corporation must determine the yield that it must offer to successfully sell the debt securities. Upon further analysis of the key characteristics used to determine the appropriate yield of a security, Green Energy Corporation learns the following:

  1. The annualized yield on a risk-free 26-week Treasury bill is 9 percent.
  2. A 1 percent credit risk premium is needed to compensate investors for credit risk.
  3. A 0.5 percent liquidity premium is needed to compensate investors due to the low liquidity of the Treasury bills.
  4. A 0.2 percent tax adjustment is needed to compensate investors for a difference in tax status. What is the appropriate yield to be offered on the commercial paper? 9.70% 10.70% 15.40% 15.45% 3. Pure expectations theory: Two-year bonds Which of the following is consistent with the pure expectations theory of the yield curve? Check all that apply. An upward-sloping yield curve suggests that the market thinks interest rates are going to be lower in the future than they are today. A downward-sloping yield curve suggests that the market thinks interest rates in the future will be lower than they are today. A flat yield curve suggests that the market thinks interest rates in the future will be higher than they are today. An upward-sloping yield curve suggests that the market thinks interest rates are going to be higher in the future than they are today. Gilberto would like to invest a certain amount of money for two years and considers investing in a one-year bond that pays 6 percent and a two-year bond that pays 8 percent. Gilberto is considering the following investment strategies: Strategy A: In the first year, buy a one-year bond that pays 6 percent. Once that bond matures, buy another one-year bond that pays the forward rate.

The rate on the two-year bond purchased one year from now is 11.120 percent. The rate on the two-year bond purchased one year from now is 9.107 percent. The rate on the two-year bond purchased one year from now is 9.743 percent.

6. Liquidity premium theory Which of the following is consistent with the liquidity premium theory of the yield curve? Check all that apply. If liquidity influences the yield curve, the forward rate overestimates the market’s expectation of the future interest rate. If liquidity influences the yield curve, an upward-sloping yield curve suggests that the market thinks interest rates in the future will decrease. If liquidity influences the yield curve, an upward-sloping yield curve suggests that the market thinks interest rates in the future will increase. If liquidity influences the yield curve, a flat yield curve suggests that the market thinks interest rates in the future will remain the same. Bob would like to invest a certain amount of money for two years and considers investing in a one-year bond that pays 4 percent and a two-year bond that pays 8 percent. Bob is considering the following investment strategies: Strategy A: Buy a one-year bond that pays 4 percent and in year one, then buy another one-year bond that pays the forward rate in year two. Strategy B: Buy a two-year bond that pays 8 percent in year one and 8 percent year two. If the one-year bond purchased in year two pays 9 percent, and the liquidity premium on a two-year bond is 0.5 percent, Bob will choose (Choices: Strategy A or Strategy B ). Which of the following describes conditions under which Bob would be indifferent between Strategy A and Strategy B? The rate on the one-year bond purchased in year two is 11.089 percent. The rate on the one-year bond purchased in year two is 11.673 percent. The rate on the one-year bond purchased in year two is 12.023 percent. The rate on the one-year bond purchased in year two is 12.490 percent. 7. Segmented markets theory Which of the following are characteristics of the segmented markets theory? Check all that apply. The choice of long-term versus short-term maturities is determined by an investors’ needs, rather than by their expectation of future interest rates.

The segmented markets theory explains the yield curve’s shape but is not the sole explanation for the yield curve. Borrowers and savers do not have the flexibility to choose among various maturity markets. The choice of long-term versus short-term maturities is determined by a borrower’s expectation of future interest rates, rather than by their financial needs.