# Risk/Return, Yield Curve, Interest and Inflation Rates

4. Risk and return

Your uncle would like to restrict his interest rate risk and his default risk, but he would still like to invest in corporate bonds. Which of the possible bonds listed below best satisfies your uncle's criteria?

AAA bond with 10 years to maturity.

BBB perpetual bond.

BBB bond with 10 years to maturity.

AAA bond with 5 years to maturity.

BBB bond with 5 years to maturity.

5. Yield curve

If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond? The yield on the 10-year bond is less than the yield on a 1-year bond.

The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity premiums.

It is impossible to tell without knowing the coupon rates of the bonds.

The yields on the two bonds are equal.

It is impossible to tell without knowing the relative risks of the two bonds.

7. Interest rates

Assume interest rates on long-term government and corporate bonds were as follows:

T-bond = 7.72% A = 9.64%

AAA = 8.72% BBB = 10.18%

The differences in rates among these issues were caused primarily by:

Tax effects.

Default risk differences.

Maturity risk differences.

Inflation differences.

Answers b and d are correct.

10. Inflation rate

You are given the following data:

r* = real risk-free rate = 4%

Constant inflation premium = 7%

Maturity risk premium = 1%

Default risk premium for AAA bonds = 3%

Liquidity premium for long-term T-bonds = 2%

Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation is a constant. Given these conditions, the nominal risk-free rate for T-bills is _____, and the rate on long-term Treasury bonds is _____.

Hint: [rRF = r* + IP]

[r Nom = (r* + IP) + DRP + LP + MRP]

4%; 14%.

4%; 15%.

11%; 14%.

11%; 15%.

11%; 17%.

https://brainmass.com/business/bond-valuation/risk-return-yield-curve-interest-and-inflation-rates-111374

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4. Risk and return

Your uncle would like to restrict his interest rate risk and his default risk, but he would still like to invest in corporate bonds. Which of the possible bonds listed below best satisfies your uncle's criteria?

AAA bond with 10 years to maturity.

BBB perpetual bond.

BBB bond with 10 years to maturity.

AAA bond with 5 years to maturity.

BBB bond with 5 years to maturity.

Answer - AAA bond with 5 years to maturity.

AAA bonds will restrict the default risk and the interest rate risk is loess for bonds with less years to maturity.

5. Yield curve

If the yield curve is downward sloping, what is the yield to maturity on a 10-year ...

#### Solution Summary

The solution explains questions relating to Risk/Return, Yield Curve, Interest and Inflation Rates

Financial questions relating to Business Organization, Shareholders' wealth, Cash flow statement, financial ratios, time value of money, CAPM, Bonds, payback, NPV, IRR, IOS and MCC schedule, WACC, Leverage, EBIT-EPS approach, Cash Conversion cycle.

1) Explain the three principal forms of business organization. Outline their respective advantages and disadvantages. How do taxes, risk, scale, and ownership liquidity affect the selection of one of these three methods?

2) Compare the shareholder-wealth-maximization model with the corporate-wealth- maximization model. What is the proxy for shareholder wealth? How does the role of the shareholder conflict with that of other stakeholder? Who are some of the stakeholder and give examples of potential conflicts. Additionally, what is meant by the agency problem, why does it arise, and what may be done to address it?

3) Discuss the three components of a cash flow statement. What is another name for the statement of cash flows and why is the cash flow statement important? How is the statement of cash flows similar or different from a cash budget?

4) Outline the five classes of financial ratios (you do not need to give the formulas). What are the advantages and disadvantage to using ratio analysis? What do you need to be mindful of when doing ratio analysis? What is the DuPont ratio, what are its components, and why is it important?

5) Time value of money

a) What is the difference between compounding and discounting?

b) What are the five variables in a time value calculation?

c) What is the difference between an annuity and a mixed cash flow?

d) What is the difference between an ordinary annuity and an annuity due? Which has a greater future value and why?

e) Give examples where you may use time value in your own life.

6) How do you measure the return and total risk for a single asset? What is the difference between portfolio risk and stand alone risk? What is the difference between systematic risk and unique risk? What is the tradeoff between risk and return? How does risk change (absolutely and incrementally) as you randomly add assets to a portfolio? What effect does

the risk of a single asset and the correlation between assets in a portfolio have on portfolio risk?

7) What is the capital asset pricing model (CAPM); what does it show; why is it important: and how do you use it? What are some of the practical and theoretical limitations of the CAPM?

8) Describe and compare the zero-growth, constant-growth, and multi-stage dividend growth models for equity valuation. What assumptions must you make? How do changes in the growth rate and the cost of capital affect valuation?

11) Bonds

a) Using a bond price yield curve, discuss in detail the relationship between bond prices and the yield to maturity.

b) How do maturity and the size of the coupon affect the shape of the bond price yield curve? Explain. What does the shape of the bond price yield curve mean for interest rate risk?

c) Assuming no change in interest rates, what happens to the price of a bond as it approaches maturity? Show this graphically for a par, premium, and discount bond.

d) If you expect interest rates to rise (decline), what kind of bond should you buy? Why?

12) Compare and contrast the payback, NPV and IRR techniques for capital budgeting. What are their respective advantages and disadvantages of each? Will they ever give you different recommendations? If so, which would you prefer and why?

13) Draw and label an NPV profile? What does the profile show? How can you use it to assess an individual project or multiple projects? What factor(s) explains the shape of the NPV profile? What other curve does it resemble?

14) Explain the IOS and MCC schedules. What are they; how are they computed; and how can you use them? What is a break point? Use a graph to illustrate your work. Carefully label this graph.

15) Describe and discuss the following terms. Be sure to include where/why they are important and/or how you can use them.

a) Risk adjusted return

b) Annualized net present value

c) Scenario analysis

d) Sensitivity analysis

e) Capital rationing

16) Discuss the weighted average cost of capital: what is it, how do you compute it, why it is important, and what it does it mean for new projects. Is the weighted average cost of capital constant over time? Why or why not?

What are the different ways to determine the weights? Why do some firms use a hurdle rate that is higher than the WACC? What are the implications of using a higher hurdle rate to shareholder wealth maximization?

17) Define operating, financial and total leverage as well as the degree of operating, financial, and total leverage. How do you use them and why are they important? Is the degree of operating, financial, and total leverage constant? Explain why or why not. How do operating and financial leverage affect a company's target capital structure and earnings per share? How and why do businesses adjust for the tradeoff between financial and operating

leverage?

18) Conceptually and graphically discuss how you would determine the optimal capital structure for a specific firm. Include a discussion of the EBIT-EPS approach.

19) Describe the cash conversion cycle, its funding requirements, and the strategies for managing it.

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