# Intro to Finance

1. Consider the shape of the current Treasury Yield Curve.

a. What does the shape of the current curve tell us about the market's expectation of future interest rates? Explain using the liquidity premium theory and the expectation theory.

b. What factors might explain the market's expectations about the future interest rates? Explain using the loanable funds theory.

c. Suppose you are working for a mutual fund that is looking to invest in a new corporate bond issue. Given your answers to parts a and b, what features would you want to see included in the bond's indenture? What features would you want to see excluded?

2. Aspen Tech is considering undertaking a $69 million investment project with expected cash flows of $8.2 million per year for 15 years, beginning at the end of the first year. (Assume the first $8.2 million is received at the end of the first year, the second $8.2 million at the end of the second year, etc.) Aspen Tech plans to finance this project by selling bonds with a 15 year maturity and semi-annual coupon payments. Aspen Tech's required rate of return on its investment project is 2 percentage points above the coupon rate on its bonds.

a. Would you advise Aspen Tech to undertake the project if today's yield to maturity on comparable bonds is 7%? Explain.

b. If Aspen Tech does indeed undertake the project, what will Aspen Tech's expected rate of return on the project equal? (You will need excel to answer this question.) Please print the excel sheet to show your answer. Explain how you arrived at your answer.

c. If Aspen Tech wants to increase it expected rate of return on the project, What might you advise? Explain

3. True or false: Zero coupon bonds are always sold at a deep discount. Provide a numerical example to support your answer. ( Assume semi-annual coupon)

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#### Solution Preview

1. a) Treasury Yield Curve Rates. These rates are commonly referred to as "Constant Maturity Treasury" rates, or CMTs. Yields are interpolated by the Treasury from the daily yield curve. This curve, which relates the yield on a security to its time to maturity is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market. These market yields are calculated from composites of quotations obtained by the Federal Reserve Bank of New York. The yield values are read from the yield curve at fixed maturities, currently 1, 3 and 6 months and 1, 2, 3, 5, 7, 10 and 20 years. This method provides a yield for a 10 year maturity, for example, even if no outstanding security has exactly 10 years remaining to maturity.

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<br>The 'Pure Expectations Theory' is actually quite simple and straightforward. Simply put, the underlying assumption is that the forward rate is an unbiased estimator of what the expected futures spot price will be. It's what the future interest rate is expected to be. In the example I used in another paper in this section 'Calculating Forward Rates Of Interest Using Current Spot Rates' I worked out a forward rate to equal 8.1%. According to the Pure Expectations Theory, 8.1% is a reliable estimate of what the forward rate will be on a 3 year bond 2 years from now. The actual rate might be a little higher or a little lower. However, on average, 8.1% will be the prevailing rate.

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<br>The 'Liquidity Premium Theory' also deals with forward rates. However, this theory holds that the forward ...