Week 4 Activity: Returns And Bond Ratings Overview 762119

Week 4 Activity Returns And Bond Ratingsoverviewin This Activity

Week 4 Activity - Returns and Bond Ratings Overview In this activity, you will carry out calculations and research that help you understand how to evaluate the return and risk on investments. Instructions Answer these questions in a 1–2 page paper. 1. You have just won the Strayer Lottery jackpot of $11,000,000. You will be paid in 26 equal annual installments beginning immediately. If you had the money now, you could invest it in an account with a quoted annual interest rate of 9% with monthly compounding of interest. • Calculate the present value of the payments you will receive. Show your calculations using formulas in your paper or in an attached spreadsheet file. • Explain why there is a difference between the present value of the Strayer lottery jackpot and the future value of the 26 annual payments based on your calculations and the information provided. 2. Compare the information about risk and return indicated by different bond ratings. Support your answer with references to research. • Use various bond websites to locate one of each of the following bond ratings: AAA, BBB, CCC, and D. Research the differences between the bond ratings, the required interest rates, and the risk. List the websites used as sources for this research. • Identify the strengths and weaknesses of each rating.

Paper For Above instruction

Evaluating investment returns and understanding bond ratings are fundamental components of financial literacy and prudent decision-making. This paper addresses two key areas: the calculation of the present value of lottery payments and an analysis of bond ratings with their associated risks and returns.

Part 1: Present Value of the Strayer Lottery Jackpot

Suppose you win a lottery jackpot of $11,000,000, payable in 26 equal annual installments starting immediately. To determine the current worth of these installments, a present value calculation considering the time value of money is necessary. Assuming an annual interest rate of 9% compounded monthly, the first step involves converting the monthly compounded rate to an effective annual rate (EAR) to accurately reflect the investment's growth. The formula for the EAR is:

EAR = (1 + i/m)^m - 1

where i is the nominal annual interest rate (9%), and m is the number of compounding periods per year (12). Plugging in these numbers:

EAR = (1 + 0.09/12)^12 - 1 ≈ (1 + 0.0075)^12 - 1 ≈ 1.093807 - 1 ≈ 0.0938 or 9.38%

With the effective annual rate, the present value (PV) of the annuity can be calculated using the formula for an ordinary annuity, modified for immediate payments (annuity due):

PV = P × [ (1 - (1 + r)^-n) / r ] × (1 + r)

where P is the annual payment ($11,000,000 / 26 ≈ $423,076.92), r is the effective annual interest rate (9.38%), and n is the total number of payments (26). Using the formula:

PV ≈ 423,076.92 × [ (1 - (1 + 0.0938)^-26) / 0.0938 ] × (1 + 0.0938)

Calculating inside brackets:

(1 + 0.0938)^-26 ≈ 1.0938^-26 ≈ 0.1399

So,

PV ≈ 423,076.92 × [ (1 - 0.1399) / 0.0938 ] × 1.0938 ≈ 423,076.92 × 9.136 × 1.0938 ≈ approximately $4,227,000.

This value represents the current amount equivalent to the 26 future installments, considering the rate of interest and compounding effects. The discrepancy between this present value and the total payout ($11,000,000) illustrates the time value of money and the discounting effect, where future payments are worth less today.

Part 2: Bond Ratings and Risk-Return Analysis

Bond ratings are indicators of the creditworthiness and associated risk of a bond issuer, influencing the interest rate demanded by investors. Ratings from agencies like Standard & Poor's, Moody's, and Fitch range from high-grade, low-risk ratings (AAA) to very speculative or junk ratings (D).

AAA Bond: Rated by S&P and Fitch as of the highest quality with the lowest risk. These bonds typically have the lowest interest rates (around 2-3%) because default risk is minimal (Standard & Poor’s, 2023).

BBB Bond: This is the lowest rating within investment-grade bonds. While still considered relatively safe, it carries a higher risk of default than AAA bonds, demanding a higher interest rate (approximately 4-6%) (Moody's, 2022).

CCC Bond: Classified as highly speculative, these bonds carry significant risk of default. Interest rates are substantially higher to compensate investors for the elevated credit risk, often exceeding 10% (Fitch Ratings, 2023).

D Bond: Represents bonds in default or currently distressed. These bonds offer the highest yields but come with imminent risk of principal loss (Standard & Poor’s, 2023).

The strengths of AAA ratings include extreme reliability and minimal default risk, making them suitable for conservative investors. Conversely, the weakness lies in their lower yields, which may not compensate adequately for inflation or opportunity costs. On the other hand, D-rated bonds may offer high yields to compensate for their risk, but investors face the likelihood of default, potential loss of principal, and market liquidity issues.

In conclusion, bond ratings serve as vital signals for evaluating the risk-return profile of fixed-income securities. Investors must balance their risk tolerance with the potential for return, recognizing that higher yields usually entail higher risk, particularly with lower-rated bonds.

References

  • Fitch Ratings. (2023). Credit Ratings Definitions. Retrieved from https://www.fitchratings.com
  • Moody's Investors Service. (2022). Corporate Bond Ratings. Retrieved from https://www.moodys.com
  • Standard & Poor’s. (2023). Understanding Bond Ratings. Retrieved from https://www.spglobal.com
  • Standard & Poor’s. (2023). Guide to Bond Ratings. Retrieved from https://www.spglobal.com
  • Investopedia. (2022). Bond Rating Agencies and What They Do. Retrieved from https://www.investopedia.com
  • Investopedia. (2023). Present Value of Annuities. Retrieved from https://www.investopedia.com
  • Federal Reserve. (2020). Interest Rate Basics. Retrieved from https://www.federalreserve.gov
  • U.S. Securities and Exchange Commission. (2021). Understanding Bond Ratings and Credit Risks. Retrieved from https://www.sec.gov
  • Morningstar. (2022). Guide to Bond Ratings. Retrieved from https://www.morningstar.com
  • Corporate Finance Institute. (2021). Time Value of Money and Present Value Calculations. Retrieved from https://corporatefinanceinstitute.com

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