18 Jun WHAT IS THE RISK PREMIUM SUGGESTED BY THE CURRENT PRICE OF THE STOCK?
The following Table shows current and expected one year yield for five years into the future. It also shows the current yields on various multiyear bonds. Use the data in the table to calculate the liquidity premium
According to the data given in the table, does the average market participant expect the inflation rate to change and in which direction?
Year Expected one year bond yield in % Current multi year Bond yield in %
1 2 2
2 3 3
3 4 5
4 6 6
5 7 8
Part B
If the yield curve were flat what would you expect to happen to the expected short term interest rate in the future?
Suppose that the yield curve rises over the next few years and then falls so that it looks like a dome. What is the bond market indicating about the future expected interest rates? What does the curve indicate about the future expected inflation rate?
Predict what would happen to the yield on corporate bonds if the federal government decides to guarantee that it will pay the creditors if any corporation goes bankrupt in the future? What would happen to the yield on the federal government bonds?
Exercise 2
This exercise consists of a certain number of independent questions. Attempt all of them
A stock that sells for $100 entitles you to a yearly dividend of $4. (D0 in the textbook) You estimate that the growth rate of dividends is about 2% per year. Suppose that the risk free yield on government bonds is 2%.
What is the risk premium suggested by the current price of the stock?
How your answer change if the price of the stock jumps to $150.
Is the following statement True, false or uncertain? Justify your answer.
“By abolishing limited liability of shareholders of joint stock companies, the corporation would be able to borrow more at higher bond prices”
What are the advantages of holding stock in a given company versus holding bonds issued by the same company?
Why is a booming stock market not always good for the economy?
Exercise 3: This exercise consists of two independent parts. Attempt both of them.
Michael has a $1000 cash savings that he wishes to invest in either company X shares or company Y shares. Each company has a $10000 capital project that will yield a random return with the following probability distribution:
Yearly Return on $10,000 capital in either company X or Y Probability
$2000 0.5
$600 0.5
The only difference between the two companies is the following:
Company X plans to raise the entire capital it needs by issuing shares
Company Y plans to raise half ( $5,000) of the same amount of capital through the sale of shares and the other half ($5000) by issuing and selling bonds that will pay a 10% coupon rate rain or shine. Bond owners have must be paid first their promised coupons.
Answer the following questions. Justify your answer
Derive the probability distribution of the returns on a $1000 investment in each company
Find the expected value and the standard deviation of the returns on the shares of each company
In which company would Michael choose to invest his $1000 under the following alternative assumptions:
He is a risk neutral asset holder
He is a risk averse. (more than one answer is possible)
A company shares pay an annual dividend of $10 this year (D0 in the textbook) and promises that its dividend will grow at a rate of 4% per year for the indefinite future. The risk-free interest rate is 3%. However, an asset holder requires a risk premium of 5%. The current price of the shares of this company is $200 a share. The asset holder has $20,000 free cash that he wishes to invest.
Should he invest in this company?
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