Module 2: Critical Thinking

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Interest Rates and Time Value of Money (70 Points)

1.A security’s equilibrium rate of return is 7 percent. For all securities, the inflation risk premium is 1.65percent and the real interest rate is 3.25 percent. The security’s liquidity risk premium is .25 percent and maturity risk premium is .75 percent. The security has no special covenants. Calculate the security’s default risk premium.

2.You are considering an investment in 30-year bonds issued by Envision Corporation. The bonds have no special covenants. The Wall Street Journal reports that one-year T-bills are currently earning 3.25percent. Your broker has determined the following information about economic activity and Envision Corporation bonds:

Real interest rate is 2.20%

Default risk premium is 1.00%

Liquidity risk premium is 0.50%

Maturity risk premium is 1.75%

a. What is the inflation premium?

b. What is the fair interest rate on Moore Corporation 30-year bonds?

3.One-year Treasury bills currently earn 3.25 percent. You expect that one year from now, one-year Treasury bill rates will increase to 3.55 percent. If the unbiased expectations theory is correct, what should the current rate be on two-year Treasury securities?

4.Suppose we observe the following rates: 1R1= .10, 1R2= .16, and E (2r1) = .10. If the liquidity premium theory of the term structure of interest rates holds, what is the liquidity premium for year 2?

5.Assume you received $8,000 five years from today. Calculate the present value of the $8,000 if your investments pay

a. 6 percent compounded annually

b. 8 percent compounded annually

c. 10 percent compounded annually

d. 10 percent compounded semiannually

e. 10 percent compounded quarterly

Discuss your answer. Specifically, what do your answers to these questions tell you about the relation between present values and interest rates and between present values and the number of compounding periods per year?

6.Assume you received $8,000 today. Calculate the future value in five years of the $8,000 if your investments pay

a. 6 percent compounded annually

b. 8 percent compounded annually

c. 10 percent compounded annually

d. 10 percent compounded semiannually

e. 10 percent compounded quarterly

Discuss your answer. Specifically, what do your answers to these questions tell you about the relation between future values and interest rates and between future values and the number of compounding periods per year?

7.Assume you just retired and you have accumulated $900,000 in your retirement account. You opted to receive annual payment of $60,000 for the next 30 years. Determine the interest rate on this annuity.

Complete your 2-4 page response using Microsoft Word or Excel. For calculations, you must show work to receive credit. Your well-written response should be formatted according to CSU-Global Guide to Writing and APA Requirements, with any sources properly cited. Upload your completed work to the Module 2 folder.

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