Answer the following questions.
1.) Focus on a governmental agency and how it impacts ethical compliance. Discuss the agencies purpose and what you believe it is doing to combat unethical business practices. If you were in charge of setting policy, what would you do differently?
2.) Discounted cash flow techniques are capital budgeting techniques that take into account both the time value of money and the estimated net cash flow from an investment. These techniques take into account the fact that cash flows that occur early in the life of an investment will be worth more than those that occur later. The primary discounted cash flow technique is called net present value. Describe this method. How is the NPV calculated and what is the decision rule?
3.) Read the “Global Economic Crisis” story on p. 215. Discuss what it means to have the treasury bond downgraded and what ripple effects happen because of it.
4.) Suppose you owned a portfolio consisting of $250,000 of U.S. government bonds with a maturity date of 30 years. Would your portfolio be riskless? What if your portfolio consisted of $250,000 of 30-day Treasury bills? Every 30 days your bills mature, and you reinvest the principle ($250,000) in a new batch of bills. Assume that you live on the investment income from your portfolio and that you want to maintain a constant standard of living. Is your portfolio truly riskless? Can you think of any asset that would be completely riskless? What security comes closest to being riskless? Explain.
The Global Economic Crisis
U.S. Treasury Bonds Downgraded!
The worsening recession that began at the end of 2007 led
increase, narrowly avoiding a partial government shut-
Congress to pass a huge economic stimulus package in
early 2009. The combination of the stimulus package and
down. However, the deficit r eduction package that
accompani ed the legislation was small, doing little to
the government’s bailouts of financial institutions caused
address the structural revenue and spending imbalance
the U.S. government to increase its borrowing substan-
the federal government faces going forward.
tially. The current (March 2012) level of public debt is $10.4
On August 5, 2011, the combination of a dysfunctional
trillion, about 68% of gross domestic product (GDP). The
political process apparently incapable of reliably perform-
Congressional Budget Office long-term projections show
ing basic financial housekeeping chores, and the lack of a
this percentage growing to 70% to 90%, depending on the
clear plan to address future deficits, raised enough questions about the U.S. government’s financial stability to
assumptions. Any way you look at it, this is a lot of money,
even by Washington standards!
With so much debt outstanding and enormous annual
deficits continuing, in mid-2011 Congress was faced with
induce Standard & Poor’s (S&P), the credit rating agency,
to downgrade U.S. public debt from AAA to AA+, effectively
removing it from its list of risk-free investments. Financial
the need to increase the amount of debtthe federal govern-
markets quickly responded to this dark assessment with the
ment is allowed to issue. Although Congress had increased
Dow Jones Industrial Average plunging some 13% over the
the debt ceiling 74 times previously, and 10 times since
next week. Moody’s and Fitch, the other two major rating
2001, partisan and heated debate seriously delayed
agencies, however, kept their rati ngs of U.S. public debt at
approval of the measure and brought the federal governmentto the brink of default on its obligations by August. At
their highest levels. With 2 out of3 agencies rating U.S. debt
at the highest level, is the yield on U.S. debt still a proxy for
the last minute, Congress approved a debt cei ling
the risk less rate? Only time will tell.
apart in early 2009. In other words, BAA investors didn’t require much extra return over
that of an AAA bond to induce them to take on that extra risk most years, but in 2009
they required a very large risk premium.
Not only do spreads vary with the rating of the security, they also usually increase as
maturity increases. This should make sense. If a bond matures soon, investors are able to
forecast the company’s performance fairly well. But if a bond has a long time until it
matures, investors have a difficult time forecasting the likelihood that the company will
fall into financial distress. This extra uncertainty creates additional risk, so investors
demand a higher required return.
SELF-TEST
Differentiate between mortgage bonds and debentures.
Name the major rating agencies, and list some factors that affect bond ratings.
What is a bond spread?
How do bond ratings affect the default risk premium?
A 10-year T-bond has a yield of 6%. A 10-year corporate bond with a rating of AA
has a yield of 7.5%. If the corporate bond has excellent liquidity, what is an estimate
of the corporate bond’s default risk premium? (1.5%)
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