Inflation and Real Rates of Return - Essay Example

Inflation and real rates of return a.  b. 3.4% c.  d. Inflation is the rise in the general price level for goods and services in an economy over a given period of time. The effect of inflation is that it reduces the consumer’s purchasing power. One dollar now buys fewer amounts of goods and services. Nominal interest rate is the interest rate which does not take inflation into account hence giving an unrealistic number. Real interest rate is the rate that has been inflation adjusted. It removes the effects of inflation to reflect the real cost of funds to the borrower, and the real yield to the lender. Real interest rates can be positive as well as negative. A positive real interest rate indicates that the purchasing power of the individual is increasing while a negative interest rate shows that the purchasing power of the individual is decreasing if the individual invests at the nominal rate. From the calculations above, it can be understood that at the current level of inflation, if a person invests in 1-year Certificate of Deposits, he will end up with less purchasing power. It can be analysed in such a way that a higher inflation rate than the nominal interest rate means that the purchasing power is decreasing at a faster rate than the rate of return of the investment. 2. Duration (Bonds) a. Frederick Macaulay developed a method to measure the interest rate risk of a bond and called it Macaulay Duration. He felt that duration is a better “measure of the bond’s worth than its time to maturity because duration considers both the repayment of capital at maturity and the size and timing of coupon payments before maturity” (Macaulay Duration). Macaulay Duration is the weighted average term to maturity of the cash flows from a bond. The weight of each cash flow is determined by dividing the present value of the cash flow by the price (Macaulay Duration Definition). Duration measures a bond’s price sensitivity to interest rate changes. The valuation of a bond changes when the interest rate changes. So, it is important to know how the value of your bond portfolio will respond to interest rate changes. b.  V0 = $100 ?y = 100 basis points = 1% = 0.01 N=3 years PMT=$6 FV=$100 Calculating V-: I/Y= 5% V- = $102.723 Calculating V+: I/Y= 7% V+ = $97.376 c. Calculating V-: I/Y= 9% V- = $92.406 Calculating V+: I/Y= 11% V+ = $87.781 3. Price-Earnings Ratio a. False. The PE ratio is equal to the market price of the share divided by the earnings per share (EPS). If we are using the dividend discount model to estimate the share price, a higher beta would lead to a higher required rate of return. This would decrease the share price and as a result the PE ratio will decrease. b. True. The PE ratio tells us how much an investor is willing to pay for $1 of a company’s earnings. If the net income of a company is good then the investors will be willing to pay more for a dollar earned. The ROE is equal to the net income divided by the average shareholders’ equity. A higher net income means a higher ROE. c. False. If we are using the dividend discount model to estimate the share price, higher dividends will result in a higher share price. Higher share price will increase the PE ratio. When the plowback rate is higher the dividends will be lower. 4. Book Value a. The market to book value signifies how many times a company’s stock is operating per share compare to the company’s book value per share. The organization’s book value reflect historic costs, hence this ratio is significant in indicating the management’s success in adding value for its shareholders in case of the market value being higher than the book value. A high price to book value ratio means that shareholders expect the management of the company to create more value with the given level of assets. b. Common shareholders’ equity = (20,000 x 20) + 5,000,000 + 70,000 Common shareholders’ equity = $5,470,000 Book value per share = Common shareholders’ equity / Number of common shares outstanding Book value per share = 5,470,000 / 20,000 Book value per share = $273.5 5. Option Strategies Strategy A: Mary Jones will immediately receive an amount of $3,000 by writing call options. Risk is unlimited if price goes below $32. At a price of $32, Mary would end up with $35,000. Profit is limited to a maximum of $48,000. She should write call options only when she thinks that the price of the share will increase slightly or remain the same. An advantage of this strategy is that it generates income from the premium and also from any dividends without the writer selling the shares. Disadvantage of this strategy is that if the stock price falls then the loss can be substantial. Strategy B: This strategy is best if Mary Jones feels that the shares will be on a bearish side. The advantage of this strategy is that it has unlimited profit potential. Another advantage is that it limits the maximum loss a buyer has to suffer in case the share price falls. Following this strategy the put option buyer keeps all the dividends and the ownership rights of the shares. The only disadvantage with this strategy is that Mary Jones will not end up with $35,000 which she needs for her home if the stock price falls. If the price falls below $35 then she will end up with only $32,000. For her to end up with at least $35,000, the stock price shall not fall below $38. Strategy C: This strategy is best if Mary Jones is unsure (neutral opinion) about the future stock price. Mary Jones should write a call option with a strike price of $45 and sell it at $3 and buy a put option for $3 with a strike price of $40. This strategy will protect Mary Jones’ profit. Mary Jones will buy the put option with the money she receives by selling the call option. If the price of the share is above $45, she will be forced to sell the share at $45 and make $45,000. If the share price falls below $40, she will exercise the put option and make $40,000. This way she is indifferent between selling the shares now and keeping them longer. I would recommend strategy C. It is because it will protect the profits of Mary Jones. Following this strategy, Mary Jones will end up with enough money that she will be able to have a cash reserve even after making her down payment. Strategy A is not suitable because she is not in need for immediate liquidity, otherwise she can sell the shares right now for $40. With strategy B there is a hint of uncertainty involved whether how much money will be made. This strategy will not protect Mary from the value of the investment going below $35,000. Works Cited Durell, P. (n.d.). How to Use the P/E. Retrieved August 11, 2011, from The Motley Fool: http://www.fool.com/investing/value/2005/08/19/how-to-use-the-pe.aspx Fabozzi, F. J. (2010). Introduction to the Measurement of Interest Rate Risk. In Equity and Fixed Income - CFA Program Cirriculum Volume 5 (pp. 532-544). Pearson Custom Publishing. Macaulay Duration. (n.d.). Retrieved August 4, 2011, from Your Dictionary: http://invest.yourdictionary.com/macaulay-duration Macaulay Duration Definition. (n.d.). Retrieved August 10, 2011, from Investopedia: http://www.investopedia.com/terms/m/macaulayduration.asp#axzz1Ubu9Nk85 The Options Industry Council. (n.d.). Retrieved August 12, 2011, from The Options Industry Council: http://www.888options.com/default.jsp -----------------------------------Please leave a positive feedback-------------------------------------- Read More