Shortly after its recent bankruptcy, a new store of Macys (to be known as Macy Ways) is being formed. You have the opportunity to invest in “Macy Ways”. If you invest $200 today, you will receive a zero-coupon bond that will pay $1,000 (face value or principal) at the end of 20 years. To be adequately compensated for the risk of this bond, you know that you should expect a spread (relative to comparable Treasury securities of at least 765 basis points. We also know that that yield for a 90-day Treasury bill is 0.50%, the yield for a 5-year Treasury note is 1.00%, the yield for a 10-year Treasury bond is 1.95%, the yield for a 20-year Treasury bond is 2.35%, and the yield for a 30-year Treasury bond is 3.05%. Provide calculations to identify whether the “Macy Ways” bond appears to be a good investment. B. How much reinvestment rate risk does this bond have?
a]
Fair value of bond = $1,000 discounted at appropriate rate for 20 years
Appropriate rate = yield for a 20-year Treasury bond + spread = 2.35% + 7.65% = 10.00%
Fair value of bond = $1,000 / (1 + 10%)20 = $148.64
Cost of bond today is $200
The bond is overpriced as the cost is higher than its fair value
b]
The bond has no coupon payments because it is a zero-coupon bond
Hence, there is no risk that the coupon payments would have to be reinvested a lower rate
The reinvestment rate risk is zero
Shortly after its recent bankruptcy, a new store of Macys (to be known as Macy Ways)...
1. Alaa works for a pharmaceutical company that has developed a new drug. The patent on the drug will last 17 years. She expects that the drug’s profits will be $2 million in its first year and that this amount will grow at a rate of 5% per year for the next 17 years. Once the patent expires, other pharmaceutical companies will be able to produce the same drug and competition will likely drive profits to zero. What is the...