Problem 6-11: Liquidity Premium Theory Based On Economists

Problem 6 11 Liquidity Premium Theory3based On Economists Forecasts

Problem 6-11 involves applying the Liquidity Premium Theory to determine the current long-term interest rates based on given short-term rates, expected future rates, and liquidity premiums. Additionally, it encompasses calculating the time to maturity for a bond issued by Ford, analyzing the adjustments in value of a Treasury Inflation-Protected Security (TIPS) with given CPI adjustments, and assessing the price change of a coupon bond in response to the predicted shift in yield to maturity (YTM). These exercises require understanding of yield curve construction, inflation-indexed securities, time to maturity calculations, and bond price sensitivity to interest rate changes.

Paper For Above instruction

Introduction

The application of the Liquidity Premium Theory (LPT) provides a framework for understanding the long-term interest rates' structure as a combination of expected future short-term rates and a liquidity premium that compensates investors for the increased risk associated with longer maturities. This theory implies that the current long-term rates can be deduced from expected future short-term rates and liquidity premiums, which reflect the added risks of holding longer-term securities. Furthermore, bond valuation, inflation-adjusted securities like TIPS, and interest rate movements are fundamental concepts in fixed-income analysis. This paper explores each component through detailed calculations grounded in financial theory to develop a comprehensive understanding of these topics.

Application of the Liquidity Premium Theory

Given the data on 1-year Treasury bill rates and the expected future short-term rates alongside the liquidity premiums, the current long-term rates are calculated by summing the expected one-year forward rates and the corresponding liquidity premiums, per the LPT formula:

For a maturity n, the long-term rate (L) is given by:

Ln = E(r1) + E(2r1) + ... + E(nr1) + Ln

where E(k r1) is the expected k-year forward rate, and Ln is the liquidity premium for the nth year.

Using the provided data:

  • Expected 1-year rate, R1 = 0.80%
  • Expected 2-year rate, E(2r1) = 1.95%
  • Liquidity premium for 2-year, L2 = 0.07%
  • Expected 3-year rate, E(3r1) = 2.05%
  • Liquidity premium for 3-year, L3 = 0.11%
  • Expected 4-year rate, E(4r1) = 2.35%
  • Liquidity premium for 4-year, L4 = 0.13%

The current long-term rates are computed by summing the expected future rates with the corresponding liquidity premiums. For example, the 2-year long-term rate (L2) is:

L2 = R1 + E(2r1) + L2 = 0.80% + 1.95% + 0.07% = 2.82%

Similarly, for 3-year and 4-year rates:

L3 = R1 + E(2r1) + E(3r1) + L3 = 0.80% + 1.95% + 2.05% + 0.11% = 4.91%

L4 = R1 + E(2r1) + E(3r1) + E(4r1) + L4 = 0.80% + 1.95% + 2.05% + 2.35% + 0.13% = 7.28%

Hence, the current long-term rates based on the liquidity premium theory are 2.82%, 4.91%, and 7.28% for two, three, and four-year horizons respectively.

Calculating Bond Time to Maturity

The bond issued by Ford matures on May 15, 2097, with today's date being November 16, 2002. To calculate the time remaining, we find the interval between these dates in days and convert it into years and months using a 365-day year convention.

From May 15, 2002, to November 16, 2002, we count backward and forward as follows:

  • Days remaining in 2002 from November 16 to May 15 of the next year (2003) are calculated accordingly. However, since we are moving backward from 2002, we determine the days from November 16, 2002, to May 15, 2003.
  • Counting days: November 16 to November 30: 15 days; December: 31 days; January to April: 120 days (assuming 30 days each); May 1–15: 15 days. Total days from November 16, 2002, to May 15, 2003: 15 + 31 + 120 + 15 = 181 days.

Next, from May 15, 2003, to May 15, 2097, is a period of 94 years exactly.

Given that the current date is November 16, 2002, the total time to maturity is:

94 years minus approximately 6 months (from May 15, 2003, back to November 16, 2002), resulting in roughly 94 years and 6 months.

Specifically, calculating the exact months: from November 16, 2002, to May 15, 2003, spans about 6 months. Thus, the total time to maturity is approximately:

93 years and 6 months.

Inflation-Adjusted Securities: TIPS Analysis

The principal of a Treasury Inflation-Protected Security (TIPS) adjusts with the Consumer Price Index (CPI). Given an original reference CPI of 185.1 and a current CPI of 210.4, the new par value can be calculated by:

Par value = Original principal × (Current CPI / Reference CPI)

Assuming the original par is $1,000, this becomes:

Par value = $1,000 × (210.4 / 185.1) ≈ $1,136.00

The interest payment on the TIPS is based on its real coupon rate (3.125%) multiplied by the adjusted principal:

Interest payment = 3.125% × $1,136.00 ≈ $35.50

Therefore, the current par value of the TIPS is approximately $1,136.00, and the current interest payment is approximately $35.50.

Bond Price Change with Interest Rate Shifts

For a bond with a coupon rate of 6.50%, ten years to maturity, priced at an 8.0% yield to maturity (YTM), and expected to experience a YTM of 7.0% in one year, the bond's current and expected prices are calculated using the present value of cash flows. The change in bond price is determined by the difference between the two prices.

Initial bond price (P0):

P0 = ∑ (Coupon payment / (1 + YTM)t) + Face value / (1 + YTM)n

Where:

  • Coupon payment = 6.50% of face value (assumed $1,000) = $65 annually
  • Number of years (n) = 10
  • YTM initially = 8.0% (0.08)

Calculations for initial price and expected price in one year involve discounting future cash flows at 8.0% and 7.0%, respectively, using the bond pricing formula.

Finally, the change in price is the difference in dollar terms: expected price after one year minus the current price. This calculation reflects how bond prices are inversely related to yield changes.

Conclusion

This comprehensive analysis demonstrates the interrelatedness of interest rate forecasts, inflation adjustments, and bond valuation. Using the Liquidity Premium Theory, we can construct a more accurate yield curve, which is essential for fixed-income investment decision-making. Additionally, understanding the CPI-linked adjustments of TIPS helps investors hedge inflation risk. Lastly, quantifying the sensitivity of bond prices to interest rate changes underscores the importance of duration and convexity in managing bond portfolio risks. These concepts collectively underpin effective bond investment strategies and risk management techniques.

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