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The slope of the yield curve is considered a leading economic indicator. A yield curve plots the relationship between the yield-to-maturity and the term to maturity of a bond (Bodie, Kane, & Marcus, 2013, p. 322). The curve presents the term structure of interest rates and, therefore, presents a view of the expected movement of interest rates. Such future views allow for economists and monetary authorities to predict the movements of the economy. Therefore, the yield curve is a leading indicator because it is indicative of an economic variable that changes before the actual cyclical change occurs.
Reference
Bodie, Z., Kane, A., & Marcus, A. J. (2013). Essentials of Investments. New York: McGraw-Hill/Irwin.
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Inflation and Interest Rates
Overview
Solve three problems addressing inflation and interest rates affecting the financial environment, including the real risk-free rate, expected interest rate, detailed risk premium, and ratio analysis.
By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria:
Competency 1: Maximize shareholder wealth.
Compute real risk-free rate of return based on data presented.
Determine yield on 2-year and 3-year Treasury securities.
Competency 2: Evaluate the financial health of the firm
Assess the default risk of a corporate bond.
Context
There are different determinants of market interest rates. Try to answer such questions as, “What determines the shape of the yield curve?” and “How is the yield curve used to estimate future interest rates?,” which are important considerations for financial managers.
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Resources
The following optional resources are provided to support you in completing the assessment or to provide a helpful context.
Brigham, E. F., & Houston, J. F. (2016). Fundamentals of financial management (14th ed.). Boston, MA: Cengage.
Assessment Instructions
For this assessment, complete Problems 1–3 on inflation and interest rates affecting financial environment. You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet. In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receive credit for your answer. Note the following:
You may need an HP 10B II business calculator.
You may use Word or Excel, but you will find Excel to be most helpful for creating spreadsheets.
If you choose to solve the problems algebraically, be sure to show your computations.
If you use a financial calculator, show your input values.
If you use an Excel spreadsheet, show your input values and formulas.
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Real Risk-Free Rate
Current 30-day T-bills are yielding 3.5 percent. Your accountant provided you with these interest rate premiums:
IP = 1.5%
LP = 0.6%
MRP = 1.8%
DFP = 2.15%
What is the real risk-free rate of return based on this data?
The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.
The so-called “real” risk-free rate can be calculated by subtracting the current inflation rate from the yield of the Treasury bond matching your investment duration.
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