Stocks and Bonds 1a) the Research Proposal

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In both cases, the bonds that were the most severely affected by the interest rate shocks were the longer-term maturities.

A g) Even Treasury bonds are risky, because short-term fluctuations in the interest rate can impact the value of the cash flows that they are to receive. The main difference between corporate bonds and Treasury bonds is that the latter are guaranteed by the government. Thus, they are considered risk free, in the sense that there is no default risk, only market risk. Corporate bonds, however, contain default risk. Therefore, it is important for the issuers of corporate bonds to understand that they must add in a risk premium to account for the default risk. The degree of default risk will be measured by bond rating agencies and that will determine the risk premium that the corporation must pay in order to raise funds in the bond market.

2. The three components of stock prices according to the dividend growth model are the current dividend, the expected growth rate of dividends, and the discount rate for future cash flows. The current dividend is generally known, except for companies that do not pay one. The expected growth rate can be extrapolated either from past dividend growth rates or the company's overall growth rate compared to its plowback rate. The discount rate is generally calculated as the cost of equity.

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There are several practical issues with regards to the use of the dividend growth model in order to determine the price of the stock. One is that the growth of the value of the company's equity may not be related to the growth rate of the dividend. Past dividend growth rates do not necessarily imply future dividend growth rates. Also, some firms do not yet pay a dividend. In this situation, the dividend growth model must infer some estimate of the time and amount of a future dividend. Lastly, the cost of equity (discount rate) is also subject to change over time. Each of the three variables, therefore, is subject to estimates and fluctuations. This makes the dividend discount model a relatively impractical means of estimating a company's stock price, in all but the most stable of companies.

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