Question

Directions: Answer the following questions on a separate document. Explain how you reached the answer or show your work if a mathematical calculation is needed, or both. Submit your assignment using the assignment link above.

A. 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. What is the present value of the payments you will receive?

B. In your own words and using various bond websites, please locate one of each of the following bond ratings: AAA, BBB, CCC, and D. Please describe the differences between the bond ratings. Identify the strengths and weaknesses of each rating.

Answer 1

A. Present value of an annuity due is given by:

A/i*(1+(1+r)-(n-1)+ A

Where,

A is the annual annuity

r is the interest rate p.a.

n is the number of years of annuity

In the given problem

A = 11,000,000/26 = 423076.9231

r = 9% p.a compounded monthly = 9.3807% p.a. compounded annually

n = 26 years

Hence, Present value of annuity = 4453793.243

B. Here are the examples of bonds with various ratings as given in the problem:

Explanation for each of the bond ratings are given below:

1. AAA: Bonds with AAA ratings are believed to be the one with the highest credit quality and thus, minimal credit risk. The spread on these bonds are also minimal as compared to treasuries.

2. BBB: This are junk bonds or high yielding bonds with significant amount of credit risk in them. Since they carry high credit risk, they have a higher yield and consequently higher spread as compared to the investment grade bonds

3. CCC: They are generally considered to be the lowest credit class and are typically in default with minimal chances of recovery of principal and interest.

4. D: Bonds rated D have defaulted and have little prospects of recovery of principal and interest.

Advantages:

1. Ratings by the credit rating agencies are relatively stable as they are based on long term outlook and factors.

2. If we go by the past trend, ratings transition across the rating classes have typically lower i.e. a bond rated A has rarely defaulted or vice-versa. Thus, they follow a robust methodology to arrive at the same.

3. These ratings have sub-ratings depending on the credit agency. For example, AA+ or AA- which lets the investor dive into deeper details.

Disadvantages:

1. Since the ratings are based on a relatively long term, there is a considerable lag in updating the market information.

2. They are long term ratings and hence, are not suitable for trading purposes. Traders generally rely on CDS or their own models to update the ratings given by the rating agencies.

3. Most of the rating agencies rate the issue and not the borrower or the company as a whole. The only bond that ever comes close to the issuer’s rating is on senior unsecured bonds.

4. There are various unlisted and private companies that are not rated by the agencies that create a lot of information asymmetry in the market

5. Obligations carrying the same rating cannot be judged to be completely identical in credit quality though they broadly are. This happens due to the fact that the rating classes are relatively lesser in number and are based on a range of scores arrived at using the methodology.

6. After the financial crisis, agencies have followed a rather conservative outlook. Hence, the ratings are based on rather bad scenarios into the future.