Babes-N-Toyland Case Study Case Study Samples

Answer

As per the case study, Babes-N-Toyland has been increasing with a positive and robust pace. In this particular part, it is required to construct the Yield Curve for August 1991, August 1992 and November 1992. The yield curve is as follows
The yield curve with higher maturities usually have lower yield as compared to the higher yield that can be found from the Yield to Maturity (YTM) figures of November 1992 as compared to YTM of August 1991 and August 1992.
There is a considerable change that can be found in the aforementioned yield curve due to their approaching towards the maturity (Bond & Brown, 2002). Expectation Theory and Market Segmentation theory are some of the important theories of Interest rate that stipulates that there is no necessary relationship found between the long and short term interest rates. Therefore, the Yield Curve will be shaped according to the supply and demand of the securities. The demand of the treasury securities have been decreased heavily in November 1992 due to which the Yield to Maturity (YTM) of the security decreased drastically for a maturity of 10 and 30 years. On the other hand, the YTM in August 1991 and August 1992 is somewhat similar.
The one year forward rates implied by November 1992 Yield Curve over the period from 1993 to 2002. The Forward rates are as follows
It is required to calculate the expected annual inflation rate for each of the ten years period. Both nominal and real interest should have been considered to compute the same. Expected Inflation Premium is basically a combination of Nominal and Real Interest Rates. The expected annual inflation rate for the next ten years is as follows
The information provided in the 2nd table has two important items included in it known as Maturity Risk Premia and Liquidity Risk Premia. The annual inflation rate data which has been computed in the aforementioned question is completely different than that of the table provided in table-2. Precisely, it can be said that the computation of annual inflation rate is incorrect, because most of the computed inflation rates from 1993 to 2003 comes in negative term, while the maturity as well as liquidity risk premia are in positive term, thus it is not backing the result which has been just calculated.

The Forward interest rate from 1993 to 2002 on the basis of table 1 and Table-2 is as follows

We are using the Liquidity Preference Theory, therefore expected inflation rate for these 10 years will be computed by adding the maturity risk premium and liquidity risk premium, and the computation is as follows

Yes the Yield Curve of Rated Treasuries are different than the 1 computed above, and the computation is as follows

It can be clearly seen that the gaps among the red and blue dotted lines which are representing yield curves among Nov-1992 and individual risky security is increasing according to the ratings of the treasury security.
Financial analysts prefer to construct the yield curve using the term structure of returns drawn from the Treasury Securities rather than Risky corporate Bonds because treasury securities are governmental issues securities and subject to absorb the yield of risk free securities (Parameswaran & Hegde, 2007). It is made usually on the basis of the prevailing interest rate of the country which is one of the most important aspects that can be used to assess the actual yield of security in a given time frame. Hence this particular method would be worthwhile than the other one.
If Babes-N-Toyland issue a 10-Year Corporate Bond to fund its expansion, and if the bond is priced to sell at par, then the semi-annual coupon rate that the company should give to their bond holders is
Coupon = Interest/2 / Price
= 8.4% / 2 / 8.4%
Coupon Rate = 0.5%

References

Bond, P., & Brown, P. (2002). Rating valuation. London: Estates Gazette.
Parameswaran, S., & Hegde, S. (2007). Futures markets. Singapore: John Wiley & Sons (Asia).