As the treasurer of a corporation, one of your jobs is to maintain investments in liquid securities such as Treasury securities and commercial paper. Your goal is to earn as high a return as possible but without taking much of a risk. a. The yield curve is currently upward sloping, such that 10-year Treasury bonds have an annualized yield 3 percentage points above the annualized yield of three-month T-bills. Should you consider using some of your funds to invest in 10-year Treasury securities? b. Assume that you have substantially more cash than you would possibly need for any liquidity problems. Your boss suggests that you consider investing the excess funds in some money market securities that have a higher return than short-term Treasury securities, such as negotiable certificates of deposit (NCDs). Even though NCDs are less liquid, this would not cause a problem if you have more funds than you need. Given the situation, what use of the excess funds would benefit the firm the most? c. Assume that commercial paper is currently offering an annualized yield of 1.5 percent, while Treasury securities are offering an annualized yield of 0.5 percent. Economic conditions have been stable, and you expect conditions to be very favorable over the next six months. Given this situation, would you prefer to hold T-bills or a diversified portfolio of commercial paper issued by various corporations? d. Assume that commercial paper typically offers a premium of 0.5 percent above the T-bill rate. Given that your firm typically maintains about $10 million in liquid funds, how much extra will you generate per year by investing in commercial paper versus T-bills? Is this extra return worth the risk that the commercial paper could default? Part 2. Forecasting Bond Returns As a portfolio manager for an insurance company, you are about to invest funds in one of three possible investments: (1) 10-year coupon bonds issued by the U.S. Treasury, (2) 20-year zerocoupon bonds issued by the Treasury, or (3) one-year Treasury securities. Each possible investment is perceived to have no risk of default. You plan to maintain this investment for a one-year period. The return of each investment over a one-year horizon would be about the same if interest rates do not change over the next year. However, you anticipate that the U.S. inflation rate will decline substantially over the next year, while most of the other portfolio managers in the United States expect inflation to increase slightly. a. If your expectations are correct, how will the return of each investment be affected over a one-year horizon? b. If your expectations are correct, which of the three investments should have the highest return over the one-year horizon? Why?FIN345 Financial Markets and Institutions Homework 2 c. Offer one reason why you might not select the investment that would have the highest expected return over the one-year investment horizon. Part 3. Bond Investment Dilemma As an investor, you plan to invest your funds in long-term bonds. You have $100,000 to invest. You may purchase highly rated municipal bonds at par with a coupon rate of 6 percent; you have a choice of a maturity of 10 years or 20 years. Alternatively, you could purchase highly rated corporate bonds at par with a coupon rate of 8 percent; these bonds also are offered with maturities of 10 years or 20 years. You expect that you will not need the funds for five years. At the end of the fifth year, you will definitely sell the bonds since you will need to make a large purchase at that time. a. What is the annual interest you would earn (before taxes) on the municipal bond? On the corporate bond? b. Assume that you are in the 20 percent tax bracket. If the level of credit risk and the liquidity for the municipal and corporate bonds are the same, would you invest in the municipal bond or the corporate bond? Why? c. Assume that you expect all yields paid on newly issued notes and bonds (regardless of maturity) to decrease by a total of 4 percentage points over the next two years, and to increase by a total of 2 percentage points over the following three years. Would you select the 10-year maturity or the 20-year maturity for the type of bond you plan to purchase? Why? Part 4. CMO Investment Dilemma. As a manager of a savings institution, you must decide whether to invest in collateralized mortgage obligations (CMOs). You can purchase interest-only (IO) or principal-only (PO) classes. You anticipate that economic conditions will weaken in the future and that government spending (and therefore government demand for funds) will decrease. a. Given your expectations, would IOs or POs be a better investment? b. Given the situation, is there any reason why you might not purchase the class of CMOs that you selected in the previous question? c. Your boss suggests that the value of CMOs at any point in time should be the present value of their future payments. He says that since a CMO represents mortgages, its valuation should be simple. Why is your boss wrong?FIN345 Financial Markets and Institutions Homework 2 Part 5. Investing in an IPO As a portfolio manager of a financial institution, you are invited to numerous road shows at which firms that are going public promote themselves, and the lead underwriter invites you to invest in the IPO. a. Select any recent IPO and based on the information available at the period before IPO prepare one-two page summary of all information, which is relevant to make decision on whether to invest or not in the IPO. b. Analyse the above information and make decision on whether to invest or not in the shares of this company. c. Is your decision supported by the developments in the stock price after the IPO? d. What is your assessment of the future prospects of your investment in this stock? Part 6. Problems 1. Assume an investor purchased a six-month T-bill with a $10,000 par value for $9,000 and sold it ninety days later for $9,100. What is the yield? 2. Newly issued three-month T-bills with a par value of $10,000 sold for $9,700. Compute the T-bill discount. 3. The Treasury is selling 91-day T-bills with a face value of $10,000 for $9,900. If the investor holds them until maturity, calculate the yield. 4. Assume the following information for an existing bond that provides annual coupon payments: Par value = $1,000 Coupon rate = 11% Maturity = 4 years Required rate of return by investors = 11% a. What is the present value of the bond? b. If the required rate of return by investors were 14 percent instead of 11 percent, what would be the present value of the bond? c. If the required rate of return by investors were 9 percent, what would be the present value of the bond? 5. Assume the following information for existing zero-coupon bonds: Par value = $100,000 Maturity = 3 years Required rate of return by investors = 12% How much should investors be willing to pay for these bonds?