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    FM 1 Assignment 6 Solution - 2019

    Uploaded by

    Amna Nasser
    This document contains solved examples and problems related to chapter 6 on financial management. [1] It provides examples of calculating bond yields based on different risk premium components such as inflation premium, maturity risk premium, liquidity premium, and default risk premium. [2] Several problems are presented at the end for calculating individual risk premium components and bond yields given relevant information. [3] Detailed calculations are shown for determining yields on various types of bonds ranging from 1 to 10 years, accounting for changing inflation and risk premium rates over time.

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    FM 1 Assignment 6 Solution - 2019

    Uploaded by

    Amna Nasser
    21 views3 pages
    This document contains solved examples and problems related to chapter 6 on financial management. [1] It provides examples of calculating bond yields based on different risk premium components such as inflation premium, maturity risk premium, liquidity premium, and default risk premium. [2] Several problems are presented at the end for calculating individual risk premium components and bond yields given relevant information. [3] Detailed calculations are shown for determining yields on various types of bonds ranging from 1 to 10 years, accounting for changing inflation and risk premium rates over time.

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    This document contains solved examples and problems related to chapter 6 on financial management. [1] It provides examples of calculating bond yields based on different risk premium components such as inflation premium, maturity risk premium, liquidity premium, and default risk premium. [2] Several problems are presented at the end for calculating individual risk premium components and bond yields given relevant information. [3] Detailed calculations are shown for determining yields on various types of bonds ranging from 1 to 10 years, accounting for changing inflation and risk premium rates over time.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    21 views3 pages

    FM 1 Assignment 6 Solution - 2019

    Uploaded by

    Amna Nasser
    This document contains solved examples and problems related to chapter 6 on financial management. [1] It provides examples of calculating bond yields based on different risk premium components such as inflation premium, maturity risk premium, liquidity premium, and default risk premium. [2] Several problems are presented at the end for calculating individual risk premium components and bond yields given relevant information. [3] Detailed calculations are shown for determining yields on various types of bonds ranging from 1 to 10 years, accounting for changing inflation and risk premium rates over time.

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    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 3

    Lahore School of Economics

    Financial Management I
    Chapter 6
    Assignment 6 Solution
    Class Examples

    Q1) r = r* + IP + MRP + LP + DRP


    r = 2% + 3% + 2% + 1% + 1%
    r = 9%

    Q2) T-bill rate = r* + IP


    5.5% = r* + 3.25%
    r* = 2.25%.

    Q3) r = r* + IP + DRP + LP + MRP.

    Since these are Treasury securities, DRP = LP = 0.

    rT2 = r* + IP2.
    IP2 = (2% + 4%)/2 = 3%.
    rT2 = 3% + 3% = 6%.

    rT3 = r* + IP3.
    IP3 = (2% + 4% + 4%)/3 = 3.33%.
    rT3 = 3% + 3.33% = 6.33%.

    Q4)
    a) Average inflation over 4 years = (2% +2% + 2% + 4%) / 4 = 2.5%

    b) T4 = rRF + MRP4
    = r* + IP4 + MRP4
    = 3 + 2.5 + (0.1)*3
    = 5.8%

    c) C4, BBB = r* + IP4 + MRP4 + DRP + LP


    = 3 + 2.5 + (0.1)*3 + 1.3 + 0.5
    = 7.6%

    d) T8 = r* + IP4 + MRP4
    = 3 + 3.25 + (0.1)*7
    = 6.95%

    IP8 = (2 + 2 + 2 + 4 + 4 + 4 + 4 + 4) / 8 = 3.25%

    e) C8, BBB = r* + IP8 + MRP8 + DRP + LP


    = 3 + 6.95 + (0.1)*7 + 1.3 + 0.5
    = 8.75%

    f) T9 = r* + IP9 + MRP9
    7.3 = 3 + IP9 + (0.1)*8
    IP9 = 3.5%

    IP9 = (2 + 2 + 2 + 4 + 4 + 4 + 4 + 4 + Inflation Year 9) / 9


    3.5 = (26 + Inflation Year 9) / 9
    31.5 = 26 + Inflation Year 9
    Inflation Year 9 = 5.5%

    Q5) MRP = 0.1%(5 – 1) = 0.4%.


    r = r* + IP + MRP + LP + DRP
    7.75% = 2.3% + 2.5% + 0.4% + 1.0% + DRP
    DRP = 1.55%

    Q6) a) Yield of 1-year security, 1 year from now:

     1.062  2   1.06   1  X 
     1.062 
    2

     1 X  
     1.06 
    1  X  1.064
    X  6.4%

    b) Yield of 1-year security, 2 years from now:

     1.063   1.062  1 X 


    3 2

     1.063
    3

     1 X  
     1.062 
    2

    1  X  1.065
    X  6.5%

    c) Yield of 2-year security, 1 year from now:

     1.063   1.06   1  X 
    3 2

     1.063 3
     1 X 
    2

     1.06 
     1  X   1.13317
    2

     1  X    1.13317  1/ 2
    X  6.45%

    Q7) Let X equal the yield on 2-year securities 4 years from now:
    (1.07)4(1 + X)2 = (1.075)6
    (1.3108)(1 + X)2 = 1.5433
    1/2
    1.5433
    1+X =
    ( 1.3108 )
    X = 8.5%.

    Problems for Assignment

    Q1) rT10 = 6%; rC10 = 8%; LP = 0.5%; DRP = ?

    r = r* + IP + DRP + LP + MRP.
    rT10 = 6% = r* + IP10 + MRP10; DRP = LP = 0.

    rC10 = 8% = r* + IP10 + DRP + 0.5% + MRP10.


    Because both bonds are 10-year bonds the inflation premium and maturity risk premium on both bonds are
    equal. The only difference between them is the liquidity and default risk premiums.
    rC10 = 8% = r* + IP10 + MRP10 + 0.5% + DRP. But we know from above that r* + IP10 + MRP10 = 6%

    rC10 = 8% = 6% + 0.5% + DRP


    1.5% = DRP.

    Q2) rT2 = r* + IP2 + MRP2 = 6.2%


    rT2 = 3% + 3% + MRP2 = 6.2%
    MRP2 = 0.2%.

    Q3) (1 + rT2)2 = (1.05)(1.06)


    (1 + rT2)2 = 1.113
    1 + rT2 = 1.055
    rT2 = 5.5%.

    Q4) r7 = r* + IP7 + MRP7 + DRP + LP.


    r* = 0.03.
    IP7 = [0.03 + 0.04 + (5)(0.035)]/7 = 0.035.
    MRP7 = 0.0005(t – 1) = 0.0005(6) = 0.003.
    DRP = 0. LP = 0.

    rT7 = 0.03 + 0.035 + 0.003 = 0.068 = 6.8%.

    Q5) rC8 = r* + IP8 + MRP8 + DRP8 + LP8


    8.3% = 2.5% + (2.8%  4 + 3.75%  4)/8 + 0.0% + DRP8 + 0.75%
    8.3% = 2.5% + 3.275% + 0.0% + DRP8 + 0.75%
    8.3% = 6.525% + DRP8
    DRP8 = 1.775%.

    Q6) Let X equal the yield on a 1-year bond 1 year from now:
    (1.07)(1 + X) = (1.09)2
    (1.07)(1 + X) = 1.1881
     1.1881 
     
    1 + X =  1.07 
    X = 11.04%

    Q7) (1.045)2 = (1.03)(1 + X)


    1.092/1.03 = 1 + X
    X = 6%.

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