1.a. A public company is planning to raise 3.2 million dollars by using financial instruments for...

1.a. A public company is planning to raise 3.2 million dollars by using financial instruments for a seven-month project. Assume you work as a financial advisor, which instrument you would suggest the company to issue or purchase? Is the instrument you suggest a money market instrument or capital market instrument? Explain the reason(s).

b. Discuss at least two reasons (differences) why the instrument you suggested in part (a) may trade at a different yield to a 10-year treasury bond

2.What is the yield curve of interest rate? Briefly discuss two theories that explain the shape of the yield curve.

Expert Solution

1) a. We would go for money market instruments such as commercial papers, certificates of deposits, etc.
Money market instruments are used to raise money for a period of less than one year and since the project timeline is 7 months only whereas capital market instruments have maturity of more than one year
They are more liquid as compared to capital market instruments whereas capital market instruments are less liquid
Since the money market instruments are liquid and are for shorter periods (up to one year), the risk associated with it is low, and since the risk is low therefore the financial burden is low (for investment-grade companies) whereas capital market instruments are perceived to be riskier
Therefore we should go for money market instruments instead of capital market instruments

b) The money market instrument may trade at different yield because
i) Maturity
The maturity of the money market instrument is less than 1 year whereas the maturity of the 10-year bond is for 10 years and hence the yield would be different. Higher the maturity more will be the yield
ii) Riskiness
Treasury bonds are backed by the government and hence they are perceived to be riskless assets whereas the money market instrument is raised by the company (in our case). So, there will be some amount of risk associated and hence will result in differential pricing

2) In general, the yield curve of interest rate is upward sloping i.e. longer the maturity, higher will be the yield
The 2 theories explaining this phenomenon are
a) Pure Expectation Theory
According to this theory, the market participants have different views on inflation and interest rate for short term and long term. If the interest rate and inflation is expected to rise then the yield curve is normal (upward sloping) and vice versa
b) Liquidity Premium Theory
According to this theory, the investors prefer short term investment over long term investment because of higher interest rate risk. The short term investments are more liquid as compared to long term investments. In order to compensate for investing in long term investments, the longer-term yields are higher than shorter-term.

jeff jeffy answered 1 year ago

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