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Mini Case: 5 - 31
website, in whole or in part.
j. Define the real risk-free rate (r*). What security can be used as an estimate of
r*? What is the nominal risk-free rate (rRF)? What securities can be used as
estimates of rRF?
Answer: The real risk-free rate, r*, is the rate that a hypothetical riskless security pays each
security.
k. Describe a way to estimate the inflation premium (IP) for a T-Year bond.
Answer: Treasury Inflation-Protected Securities (TIPS) are indexed to inflation. The IP for a
particular length maturity can be approximated as the difference between the yield on
website, in whole or in part.
l. What is a bond spread and how is it related to the default risk premium? How
are bond ratings related to default risk? What factors affect a company’s bond
rating?
Bond ratings are based upon a company’s default risk. They are based on both
qualitative and quantitative factors, some of which are listed below.
1. Financial performance--determined by ratios such as the debt, TIE, FCC, and
E. Debt maturity
3. Other factors:
A. Earnings stability
B. Regulatory environment
C. Potential product liability
m. What is interest rate (or price) risk? Which bond has more interest rate risk, an
annual payment 1-year bond or a 10-year bond? Why?
Answer: Interest rate risk, which is often just called price risk, is the risk that a bond will lose
value as the result of an increase in interest rates. Earlier, we developed the following
15 956 749
A 5 percentage point increase in r causes the value of the 1-year bond to decline by
only 4.8 percent, but the 10-year bond declines in value by more than 38 percent.
Thus, the 10-year bond has more interest rate price risk.
4.4%
Mini Case: 5 - 34
n. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-
year bond or a 10-year bond?
Answer: Investment rate risk is defined as the risk that cash flows (interest plus principal
term bond.
o. How are interest rate risk and reinvestment rate risk related to the maturity risk
premium?
Mini Case: 5 - 35
website, in whole or in part.
p. What is the term structure of interest rates? What is a yield curve?
website, in whole or in part.
q. Briefly describe bankruptcy law. If this firm were to default on the bonds,
would the company be immediately liquidated? Would the bondholders be
assured of receiving all of their promised payments?
Answer: When a business becomes insolvent, it does not have enough cash to meet scheduled
terms of a potential reorganization. The reorganization plan may call for a
restructuring of the firm’s debt, in which case the interest rate may be reduced, the
term to maturity lengthened, or some of the debt may be exchanged for equity. The
point of the restructuring is to reduce the financial charges to a level that the firm’s
cash flows can support.
If the firm is deemed to be too far gone to be saved, it will be liquidated and the
priority of claims would be as follows:
too far gone to be saved, it would be liquidated.
