INV3702 Assignment 2 (DETAILED ANSWERS) Semester 2 2024 - DISTINCTION GUARANTEED

INV3702 Assignment 2 (DETAILED ANSWERS) Semester 2 2024 - DISTINCTION GUARANTEED - DISTINCTION GUARANTEED - DISTINCTION GUARANTEED Answers, guidelines, workings and references ... Question 1 You observe the following sovereign bonds. Time to maturity Coupon Yield to maturity Bond A 1 year 6% 2.342% Bond B 1 year 0% 2.350% Bond C 2 years 6% 2.496% Bond D 2 years 0% 2.500% Bond E 3 years 6% 2.711% Bond F 3 years 0% 2.725% Determine whether Bond C is overvalued, undervalued or fairly valued. All coupons are paid annually. (3) Question 2 A trader observes the following bonds and compares each bond’s yield to maturity to the yield on bonds which are similar. If the trader expects the bond yields to return to the yield of the peer group, which bond should the trader buy and why? (3) Current yield to maturity Average yield of other, similar bonds Bond A 8.0% 8.0% Bond B 8.5% 8.0% Bond C 8.5% 9.0% Question 3 Ms Koko is a bond portfolio manager who supports the segmented markets theory of the term structure of interest rates. Her bond portfolio has a market value of R20 million and a Macaulay duration of 12 years. She is making adjustments to her portfolio in response to her clients expressing a reduced appetite for risk. Her objective is to reduce the portfolio's Macaulay duration to 6 years. She plans to do this by selling a portion of the portfolio and investing the proceeds in bonds which meet her criteria . The bonds she plans to sell have an average Macaulay duration of 12 years. Ms Koko has Bond Y and Bond Z available for purchase; both bonds meet her selection criteria. Bond Y is a 10% semiannual-coupon bond trading at par with 5 years to maturity and Bond Z is a zero-coupon bond with 4 years to maturity. Determine the actions that Ms Koko needs to take to achieve her objective. (4) 2 Question 4 An analyst collects the following financial information to assess the credit quality of Company Y and Company Z, relative to each other and their industry average. Company Y Company Z Industry average Earnings before interest and tax 1 400 000 Funds from operations 000 Interest expense 000 Total debt Total capital Goodwill Present value of operating leases Net pension liability Calculate adjusted financial ratios for both companies and the industry, and evaluate the relative creditworthiness of Company Y and Company Z. (4) Question 5 Joe states that in a stable interest rate environment the price of a discount bond will increase and its yield to maturity will decrease as time passes. Explain why you agree or disagree. (3) Question 6 Consider the following treasury spot rate curve Time to maturity Spot Rate 1 year 3.000% 2 years 4.020% 3 years 5.069% Use a binomial interest rate tree with the following rates to value a three-year, 3% annual-pay option-free Treasury bond with a R100 par value. (3) One-Period Forward Rate in Year 0 1 2 3% 6.7883% 10.7383% 3.8800% 7.1981% 4.8250%