Mini Caseon: The First Day Of Your Summer Internship 251887

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

Mini Case 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. a. 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. b. The real risk-free rate of interest is the difference between the calculated average yield on 3-month Treasury bills and the inflation rate. c. The default-risk premium is estimated by the difference between the average yields on Aaa-rated bonds and 30-year Treasury bonds. d. The maturity-risk premium is estimated by the difference between the average yields on 30-year Treasury bonds and 3-month Treasury bills. e. 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, however, because the secondary market for the firm’s bonds is more uncertain than that of some other jewel sellers. It is estimated at 4 basis points. Now place your output into the format of equation (2-1) below 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. Equation 2-1 Table 2

Paper For Above instruction

The task is to estimate the nominal interest rate for a new issuance of Aaa-rated bonds by SanBlas Jewels Inc., using the data provided and the structural format of equation (2-1). This involves calculating various components such as the risk-free rate, default-risk premium, maturity-risk premium, and liquidity-risk premium, and then combining them according to the specified formula.

First, the current 3-month Treasury bill rate is given as 2.96%. The 30-year Treasury bond rate is 5.43%. The 30-year Aaa-rated corporate bond rate is 6.71%, and the inflation rate stands at 2.33%. To proceed, we need to compute the individual premiums and the real risk-free rate, then assemble these components into the equation.

Calculation of the Components

The real risk-free rate (r*) is calculated as the difference between the yield on Treasury bills and the inflation rate:

  • Real risk-free rate (r*) = Treasury bill rate - Inflation rate

Substituting the values:

r* = 2.96% - 2.33% = 0.63%

Next, the default-risk premium (DRP) is estimated as the difference between the yield on Aaa-rated bonds and the 30-year Treasury bond:

DRP = 6.71% - 5.43% = 1.28%

The maturity-risk premium (MRP) is the difference between the 30-year Treasury bond and the 3-month Treasury bill:

MRP = 5.43% - 2.96% = 2.47%

The liquidity-risk premium (LRP) is given as 4 basis points, which is 0.04%.

Constructing the Nominal Interest Rate Using Equation (2-1)

According to the structure of equation (2-1), the nominal interest rate (i) can be summarized as the sum of the real risk-free rate, the default-risk premium, the maturity-risk premium, and the liquidity-risk premium:

i = r* + DRP + MRP + LRP

Substituting the calculated and given values:

i = 0.63% + 1.28% + 2.47% + 0.04% = 4.42%

Reasonableness and Discussion of the Components

The estimated nominal interest rate of approximately 4.42% for SanBlas Jewels’ bonds aligns with market expectations considering the current interest rate environment. The real risk-free rate at 0.63% reflects typical risk-free returns adjusted for inflation, while the default-risk premium at 1.28% suggests moderate credit risk associated with Aaa-rated bonds in the context of the corporate bond market. The maturity-risk premium of 2.47% accounts for the longer maturity, which generally involves higher interest rate risk. The low liquidity-risk premium of 0.04% indicates a relatively liquid secondary market, consistent with the expectation that trading on the New York Bond Exchange provides sufficient liquidity. Overall, these components and their sum offer a credible estimate for the nominal interest rate, critical for the CFO’s financial planning and bond issuance strategy.

References

  • Fabozzi, F. J. (2016). Bond Markets, Analysis and Strategies. Pearson Education.
  • Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley.
  • Investopedia. (2023). Maturity Risk Premium (MRP). https://www.investopedia.com/terms/m/maturityriskpremium.asp
  • U.S. Department of the Treasury. (2023). Daily Treasury Yield Curve Rates. https://home.treasury.gov/podcasts/treasury-yield-curve
  • Federal Reserve Bank of St. Louis. (2023). FRED Economic Data. https://fred.stlouisfed.org/
  • Schultz, P., & Tandon, V. (2020). Corporate Bond Risk Premiums and Market Conditions. Journal of Financial Markets, 45, 100550.
  • Standard & Poor’s. (2023). Rating Definitions for Fixed Income Securities. https://www.standardandpoors.com/en_US/web/guest/article/-/view/sourceId/504352
  • Bloomberg Markets. (2023). Bond Yields Overview. https://www.bloomberg.com/markets/rates-bonds
  • Heath, R. (2021). Understanding Bond Risk Premia. Financial Analysts Journal, 77(4), 75-82.

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