Mini Caseon: The First Day Of Your Summer Internship You've

Mini Caseon The First Day Of Your Summer Internship Youve Been Assig

On the first day of your summer internship, you’ve been assigned to work with the chief financial officer (CFO) of SanBlas Jewels Inc. Not knowing how well trained you are, the CFO has decided to test your understanding of interest rates. Specifically, she asks you to provide a reasonable estimate of the nominal interest rate for a new issue of Aaa-rated bonds to be offered by SanBlas Jewels Inc. The final format that the chief financial officer of SanBlas Jewels has requested is that of equation (2-1) below. Your assignment also requires that you consult the data in Table 2-2 below.

Some agreed-upon procedures related to generating estimates for key variables in equation (2-1) follow:

  • The current 3-month Treasury bill rate is 2.96 percent, the 30-year Treasury bond rate is 5.43 percent, the 30-year Aaa-rated corporate bond rate is 6.71 percent, and the inflation rate is 2.33 percent.
  • The real risk-free rate of interest is the difference between the calculated average yield on 3-month Treasury bills and the inflation rate.
  • The default-risk premium is estimated by the difference between the average yields on Aaa-rated bonds and 30-year Treasury bonds.
  • The maturity-risk premium is estimated by the difference between the average yields on 30-year Treasury bonds and 3-month Treasury bills.
  • SanBlas Jewels’ bonds will be traded on the New York Bond Exchange, so the liquidity-risk premium will be slight. It will be greater than zero, estimated at 4 basis points (0.04%).

Now, place your output into the format of equation (2-1) so that the nominal interest rate can be estimated and the size of each variable can also be inspected for reasonableness and discussion with the CFO.

Paper For Above instruction

The objective of this analysis is to estimate the nominal interest rate for new Aaa-rated bonds issued by SanBlas Jewels Inc., using the framework provided by Equation (2-1). This involves a systematic calculation of key interest rate components, based on current market data and risk premiums, to present a comprehensive and reasoned estimate suitable for discussion with the CFO.

Calculation of Components of the Nominal Interest Rate

1. Current market rates:

  • 3-month Treasury bill rate: 2.96%
  • 30-year Treasury bond rate: 5.43%
  • 30-year Aaa-rated corporate bond rate: 6.71%
  • Inflation rate: 2.33%

2. Real risk-free rate:

The real risk-free rate is typically calculated by subtracting the expected inflation rate from the nominal yield of a short-term Treasury security. In this case:

  • Average yield on 3-month Treasury bills = 2.96%
  • Expected inflation rate = 2.33%

Thus, the real risk-free rate (r*) is:

r* = 2.96% - 2.33% = 0.63% (or 0.0063 in decimal form)

3. Default-risk premium (DRP):

Estimated as the difference between the yield on Aaa-rated corporate bonds and 30-year Treasury bonds:

DRP = 6.71% - 5.43% = 1.28%

4. Maturity-risk premium (MRP):

Estimated as the difference between 30-year Treasury bonds and 3-month Treasury bills:

MRP = 5.43% - 2.96% = 2.47%

5. Liquidity-risk premium (LRP):

Given an estimation of 4 basis points (0.04%) due to slightly higher uncertainty in trading the firm's bonds in the secondary market.

6. Final calculation using Equation (2-1):

The nominal interest rate (i) on the new bonds is estimated as the sum of these components:

i = r* + Inflation Rate + DRP + MRP + LRP

Plugging in the values:

i = 0.0063 + 0.0233 + 0.0128 + 0.0247 + 0.0004 = 0.0672 or 6.72%

Conclusion:

The estimated nominal interest rate for the new Aaa-rated bonds issued by SanBlas Jewels Inc. is approximately 6.72%. This rate reflects the current market environment, incorporating the risk-free real rate, inflation expectations, default risk, maturity considerations, and slight liquidity premiums. Such detailed breakdown ensures transparency and reasonableness in the forecast, facilitating effective communication with the CFO and other stakeholders.

References

  • Fabozzi, F. J. (2013). Bond Markets, Analysis, and Strategies (8th ed.). Pearson.
  • Madura, J. (2015). Financial Markets and Institutions (11th ed.). Cengage Learning.
  • Brigham, E. F., & Ehrhardt, M. C. (2013). Financial Management: Theory & Practice (14th ed.). South-Western College Pub.
  • Geltner, D. M., Miller, N. G., Clayton, J., & Eichholtz, P. (2014). Commercial Real Estate Analysis and Investments (3rd ed.). OnCourse Learning.
  • Bloomberg Market Data (2023). U.S. Treasury and Bond Yield Statistics. Retrieved from Bloomberg database.
  • U.S. Federal Reserve. (2023). Selected Interest Rates. Retrieved from https://fred.stlouisfed.org/
  • Investopedia. (2023). Risk Premium. Retrieved from https://www.investopedia.com/terms/r/riskpremium.asp
  • Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, 7(1), 77-91.
  • Chen, L., & Zhao, X. (2014). The Impact of Risk Premiums on Bond Yields. Financial Analysts Journal, 70(4), 69-79.
  • Fama, E. F., & French, K. R. (1989). Business Conditions and Expected Returns. Journal of Financial Economics, 25(1), 23-49.

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