John Smith, an investment adviser, meets with Lydia Carter to discuss her pending retirement and potential changes to her investment portfolio. Domestic economic activity has been weakening recently, and Smiths outlook is that equity market values will be lower during the next year. He would like Carter to consider reducing her equity exposure in favor of adding more fixed- income securities to the portfolio. Government yields have remained low for an extended period, and Smith suggests considering investment- grade corporate bonds to provide additional yield above government debt issues. In light of recent poor employment figures and two consecutive quarters of negative GDP growth, the consensus forecast among economists is that the central bank, at its next meeting this month, will take actions that will lead to lower interest rates. Smith and Carter review par, spot, and one- year forward rates (Exhibit 1) and four fixed- rate investment- grade bonds issued by Alpha Corporation which are being considered for investment (Exhibit 2). Exhibit 1 Par, Spot, and One- Year Forward Rates (annual coupon payments) Maturity (Years) Par Rate (%) Spot Rate (%) One- Year Forward (%) 1 1.0000 1.0000 1.0000 2 1.2000 1.2012 1.4028 3 1.2500 1.2515 1.3522Exhibit 2 Selected Fixed- Rate Bonds of Alpha Corporation Bond Annual Coupon Type of Bond Bond 1 1.5500% Straight bond Bond 2 1.5500% Convertible bond: currently trading out of the money Bond 3 1.5500% Putable bond: putable at par one year and two years from now Bond 4 1.5500% Callable bond: callable at par without any lockout periods Note: All bonds in Exhibit 2 have remaining maturities of exactly three years. Carter tells Smith that the local news media have been reporting that housing starts, exports, and demand for consumer credit are all relatively strong, even in light of other poor macroeconomic indicators. Smith explains that the divergence in economic data leads him to believe that volatility in interest rates will increase. Smith also states that he recently read a report issued by Brown and Company forecasting that the yield curve could invert within the next six months. Smith develops a binomial interest rate tree with a 15% interest rate volatility assumption to assess the value of Alpha Corporations bonds. Exhibit 3 presents the interest rate tree. Exhibit 3 Binomial Interest Rate Tree for Alpha Corporation 15% Interest Rate Volatility Year 0 1.0000% Year 1 1.6121% 1.1943% Year 2 1.7862% 1.3233% 0.9803% Carter asks Smith about the possibility of analyzing bonds that have lower credit ratings than the investment- grade Alpha bonds. Smith discusses four other corporate bonds with Carter. Exhibit 4 presents selected data on the four bonds. Exhibit 4 Selected Information on Fixed- Rate Bonds for Beta, Gamma, Delta, and Rho Corporations Bond Issuer Bond Features Credit Rating Bond 5 Beta Corporation Coupon 1.70% Callable in Year 2 OAS of 45 bps B Bond 6 Gamma Corporation Coupon 1.70% Callable in Year 2 OAS of 65 bps BBond 7 Delta Corporation Coupon 1.70% Callable in Year 2 OAS of 85 bps B Bond 8 Rho Corporation Coupon 1.70% Callable in Year 2 OAS of 105 bps CCC