Question

1. “Since firms do not raise money in the secondary market, the secondary market provides no benefit to the financial system.” Identify whether or not this statement is accurate AND EXPLAIN WHY. Note that you will not receive credit for part A without the explanation.

2. You know that the Yield-to-Maturity (interest rate) on a particular bond is 6.28%. You estimate that expected inflation over the life of the bond is expected to average 2.78%. The default risk premium for this bond is 2.20%. The maturity risk premium for this bond is 0.2%. The liquidity risk premium for this bond is 0.2%. There are no special characteristic premiums. Based on this, calculate the real rate of interest.

Answer 1

1)

This statement is not accurate.

Secondary market ensures liquidity in the market. The buyers in the primary market can sell in the secondary market and this ensures liquidity and ensures price discovery to happen. This creates the necessary supply demand dynamics to play out and ensures that companies can raise money in the primary market and there will be takers for the securities in the primary market since they can sell the same in secondary market.

2)

Yield-to-Maturity (interest rate) on a particular bond is 6.28%

expected inflation over the life of the bond is expected to average 2.78%.

Real interest rate = 6.28% - 2.78% = 3.50%