Congratulations. You have been promoted to vice president and director of your m
ID: 2727345 • Letter: C
Question
Congratulations. You have been promoted to vice president and director of your mid-size firm’s pension fund management team located in Cincinnati, OH. Before you have even had the opportunity to settle into your new office, your senior vice president tapped you to take her place and present an investment seminar to "a group of investment decision-makers" comprised of government analysts from all over the tri-state area but that is the extent of the information you’ve been provided. After doing some quick research, you’ve identified that the specific target audience for this presentation is composed primarily of individuals with little or no professional investment experience who are attending this seminar to build their skills. In order to address the range of information these individuals need to know and the likely range of questions that may crop up, you’ll need to be able to: 5.Describe the type of returns one could one expect with a callable bond trading at a premium price and provide your rationale. Explain the significance of the designation "premium price." Discuss why or why not a callable bond trading at a premium price would be an appropriate investment for the target audience’s organizations. 6.Select an example scenario appropriate to the seminar’s target audience Write a general expression for the yield on a probable debt security (rd) and define these terms in regards to that hypothetical security: real risk-free rate of interest (r*), inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). 7.Define the nominal risk-free rate (rRF) and provide an example relevant to your target audience of a specific security that can be used as an estimate of rRF. 8.Describe interest rate risk and reinvestment rate risk and how these relate to the maturity risk premium. Based on reinvestment rate risk, provide an example on how a 1-year bond or a 10-year bond would be a better investment for a typical community as represented by those attending your seminar.
Explanation / Answer
5. There are basically two type of returns, which investors consider from a callable bond trading at premium price, "Yield to Call" and "Yield to Maturity". "Premium Price" in regards to callable bond simply means that the bond still has callble option active and the call price premium component has not expired. The call price is a pre-determined amount, which the issuer would pay, if it calls off the bond.
Callable bond trading at premium can be a good option for those, who want higher returns and are not skeptical with risk. The risk involved with a callble bond over and above non-callable bonds is the uncertainity of maturity period.
6. rd = r* + IP + DRP + LP + MRP.
r* is the real risk-free interest rate. It is the rate you see on a riskless security if there were no inflation.
The inflation premium (IP) is a premium added to the real risk-free rate of interest to compensate for expected inflation.
The default risk premium (DRP) is a premium based on the probability that the issuer will default on the loan, and it is measured by the difference between the interest rate on a U.S. treasury bond and a corporate bond of equal maturity and marketability.
A liquid asset is one that can be sold at a predictable price on short notice; a liquidity premium is added to the rate of interest on securities that are not liquid.
The maturity risk premium (MRP) is a premium which reflects interest rate risk; longer-term securities have more interest rate risk (the risk of capital loss due to rising interest rates) than do shorter-term securities, and the MRP is added to reflect this risk.
7. Nominal risk-free rate is the quoted interest rate on a risk-free security. This represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time and it doesn't account for inflation.
There is no truly riskless security, but the closest thing is a short-term U. S. Treasury bill (t-bill), which is free of most risks. The real risk-free rate, r*, is estimated by subtracting the expected rate of inflation from the rate on short-term treasury securities. It is generally assumed that r* is in the range of 1 to 4 percentage points. The t-bond rate is used as a proxy for the long-term risk-free rate. However, we know that all long-term bonds contain interest rate.
8. Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market. The sensitivity depends on two things, the bond's time to maturity, and the coupon rate of the bond.
Re-investment risk is the risk that future coupons from a bond will not be reinvested at the prevailing interest rate when the bond was initially purchased. Reinvestment risk is more likely when interest rates are declining. Reinvestment risk affects the yield-to-maturity of a bond, which is calculated on the premise that all future coupon payments will be reinvested at the interest rate in effect when the bond was first purchased. Zero coupon bonds are the only fixed-income instruments to have no reinvestment risk, since they have no interim coupon payments.
A 1-year bond will have lesser re-investment risk because of its shorter maturity period. Longer the maturity period, higher is the risk. So, those, who are more risk-averse, should opt for a bond with shorter maturity period and hence this is a suitable option for them, while a 10-year bond is a suitable option for those, who are ready to take extra risk and seek for higher returns.