S.F.M.

by CA R AJIV SINGH

ANS - Valuation of Bonds

Exam Nov 03 May 04 Nov 05 Nov 01, 05 May 07 Nov 07 Nov 08 SFM/ MAFA SFM June 09 Nov 09 SFM/MAFA May 10 SFM
Ans 1.

Q. No.

Concept tested

year 1-4 4

CF 80 1000

DF at 15% 2.855 .572

PV 228.40 572

DF at 12% 3.037 .636

PV 242.96 636

1(b) The MV of 8% coupon bond yielding 8% is its face value that is Rs 1000. 1(c) The market value would be Rs 1000 if market rate of interest and coupon interest rate are 15%. Ex 2(1) NOV 03 Ans The CFs can be easily calculated. The only thing we have to decide is the discount rate. The market rate is the discount rate in normal case. In this case since investors are supposed to get 16% compounded return therefore the discount rate would be 16%. Year CF DF at 16% 1 9 .862 2 9 .743 3 9 .641 4 9 .552 5 10 .476 6 10 .410 7 10 .354 8 10 .305 9 14 .263 10 14+105 .227

Debenture price is Rs 71.33 Nov 12 study notes by: Rajiv Singh

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Ans: 2(2). Current price = 70 x CDF for 1 to 3 years at 8% + 1000 x DF for 3 year at 8% = 974.39 Price after one year = 70 x CDF at 8% for 1 to 2 years + 1000 x DF at 8% for 2 Price after 2 year = (70 + 1000) x DF at 8% for 1 year = 990.74 Ans 3. YTM = 50 + (1000 870) / 8 (1000 870) / 2
nd

rd

year = 982.15

= 7.08 (semi annual) i.e. 14.16 (annual) Since required rate of return of the investor is more than YTM therefore he will not opt for bond. Ans 4. YTM = 70 + (500 455) / 5 (500 455) / 2

= 16.54

With a 10% decline, the YTM should be 16.54 x .90 = 14.90% % change in bond price = New Price Existing Price Existing Price

Ans 5. 1 (a) Since Face value is equal to market price hence YTM for both A and B is equal to coupon rate. (b) Now value the bond by reducing YTM by 1% that is at 13%. [Solution using calculator may differ] A B Price 102.94 104.42 (c) % change in price = 2.94% 4.42% Comment: for a 1% change in YTM, the bond having longer maturity experiences more price change as compared to shorter maturity bond. (d) Now value at 15% Price of A = 97.17 % change = 2.83% Comment: The percentage price change in case of similar increase or decrease in YTM is not exactly equal for similar bond. Ans: 5(2) YTM Bond Value 8% 1000 6% 1084.25 10% 924.18 The abov e r esult s hows i nverse r elationship bet ween t he price of a bo nd a nd its Y TM. T he % c hange i s 8.425% when YTM moves from 8 to 6% and it is -7.582% when it moves from 8 to 10%. Ans: 5(3) Before tax YTM on taxable bond = 8% After tax YTM = 8% (1-.35) = 5.2% At 5.2% the investor would be inefficient. The YTM of tax free Bond (at indifference level) = 5.2% nd Price of tax free bond = 80 x 5.2% for 2 years + 1000 x DF @ 5.2% for 2 year. Ans 7. a. The cash flows are: 0 1 80 2 80 3 1080

The pricing is based on the principle (followed in practice) that each coupon payment should be discounted at separate & appropriate discount rate rather than one YTM. b Premium (Price > Par) c. The current spot market intt. rates for the bond's cash flows are all less than 8% (5,6 and 7%). The bond would only sell at par ($1000) if its coupons were somewhere between 5 and 7% since. Thus, the Nov 12 study notes by: Rajiv Singh

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opportunities being offered in the market over the life of the bond are less attractive than the bond. The bond's price must rise above par until they are equally attractive investments. Ans 8. Since semiannual market yield is to be worked out, the period would be doubled that is from 10 to 20 years. Price of zero coupon bond = maturity value x DF for 20th period at semiannual rate (Lets assume it is Y) Y= 312/1000=.312 Now refer DF table in 20th row and locate the discount rate for the figure .312 and it is 6%. Nominal YTM = 2 X 6% =12% 2 Effective annual YTM= (1.06) -1 = 12.36% 1,000/(1+ YTM/2) Ans 9. Bond 1: 699.07 = 40 (PVIFA YTM/2,40 )+ Bond is at a discount so you know that the coupon rate (8%) must be less than the discount rate. From trial and error, the YTM/2 = 6% so YTM = 12% Bond 2: 699.07 = = C/2 = C =
th 40

C/2 (PVIFA 6%,10 ) + C/2 (7.6301) + $19.11 $38.22

1,000/(1.06) 558.39

10

Ans: 10. (a) 463.20 = 1000 x DF for 10 year

th

i.e., DF = .46320

Refer DF table in the 10 year bond and locate the interest rate for the figure .46320. The answer is 8%. (b) Value of bond = 1000 x 1/ (1.12) = 624.60 Ans: 11. (a) Price = 12 x CDF at 8% for 1 to 8 years + 100 x DF for 8 years at 8% (b) Price = 12 x CDF at 14% for 1 to 8 years + 100 x DF for 8 years at 14%
th th 4

Ans 12.

Zero Coupon Bond 2018 Current price Revised price 100 x DF @6% for Case I: 100 x DF th th 15 year @7% for 15 year = 1000 x .4173 = 41.73 = 36.25 % decrease = 13% Case I: 100 x DF th @5% for 15 year = 48.10 % increase = 15.3%

12% Gift 2018 Current price Revised price 6 x CDF for 1 to 30 Case I: 6 x CDF for 1 periods @3% +100 x to 30 periods @3.5% DF for 30 period +100 x DF for 30 @3% period @3.5% = 158.80 = 145.98 % decrease = 8.1% Case II: 6 x CDF for 1 to 30 periods @2.5% +100 x DF for 30 period @2.5% = 173.25 % increase = 9%

Ans 13(3). (i) price = 11 x 2.361 + 100 x 6.93 = 95.27 (ii) YTM = 11 + (100 97.60) / 3 (100 + 97.60) / 2 = 11.94%

Ans 14. May 04

After tax coupon = 9 x (1-.30) = 6.3% After tax redemption price = 105 (15x.10) or Rs.103.5 After tax capital gain = 103.5-90 = Rs. 13.5 YTM = 6.3 + (13.5/5) or 9.00 = 9.30% (103.5+90)/2 96.75

Ans 15. YTC =

6.5 + (110 107) / 6 (110 + 107) / 2

= 12.28%

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Ans 17. Nov 08 Loan pricing for AA rated bond Step I: AAA + 2% = 364 T bill + 3% + 2% = 9% + 3% + 2 = 14% Step II: Price = 150 x CDF for 1 to 5 at 14% + 1000 x DF for 5 year at 14 = 1033.80 Step III: Since current price is less than intrinsic value hence the investor should by it. Step IV: C Y = 150 / 1025.86 = 14.62% Step V: YTM (approx) = 150 + (1000 - 1025.86) / 5 (1000 + 1025.86) / 2 = 14.3%
th th

Ans 18.

YTM =

95 + (1000 1165.75) / 28 (1165.75 + 1000) / 2

= 8.22%

Ans 20. This question is based on the concept of horizon analysis. In this analysis we estimate RY during the life of the bond. The value available to bond h older after 5 y ears would be computed first and then we will calculate RY for 5 years. A Coupon payment for first 5 years compounded at reinvestment rate of 5% plus PV of bond at 9% for 1 to 20 years. = 8 x compound factor for 1 to 5 years at 5% + [8 x CDF for 1 to 20 years at 9% + 100 x DF for 20 year at 9% ] = 44.208 + 90.832 = 135.04 RY over 5 years horizon
th

B Compounded value of 7.25 for 1 to 5 years at 5% + [7.25 x CDF for 1 to 10 years at 8% + 100 x DF for 10 year at 8% ] = 40.064 + 94.9475 = 135.0115
th

A 5 89 (1 + RY) = 135.04 RY = 8.7% Decision: select A as it has higher RY. Ans. 22. Dirty Price = Clean price + AI = 116 + 100 x 13% x 119/136*

B 5 90.5 (1 + RY) = 135.0115 RY = 8.33%

[* In practice the settlement date is always business day following the day of transaction. Hence, it would be 120 days and not 119 days] Ans: 23. Nov. 07 (a) The bonds were sold at par value on Jan 1, 00 therefore, the YTM equaled the coupon rate of 10% YTM equaled the coupon rate of 10%. (b) Step I: PV of bond at 1/7/08 = 50 + 50 x CDF for 1 to 15 periods at 6% + 100 x DF for 15 period at 6% = 903. Step II: PV of bond at 1/3/08 = 953 x .962 = 916 Step III: A I = 50 x 2/6 = 16 Basic value of bond = 916 16 = 900. Ans 24(1). (1)This qu estion is abo ut t esting s kill s et i n r etiring high cost bo nd (with c all pr ovision) w ith a simple but low cost bond. The decision would be based on comparing PV of incremental CFs under both the options. The decision regarding retirement of old bond will have following incremental CF . (i) Call premium will became payable due to early retirement (1140 1000) X 30000 = 4200000 Less: Tax saving on call premium @40% 1680000 Nov 12
th

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Net outflows (ii) (iii) New Flotation cost Tax saving from amortisation of new floatation cost 400000/25 X .4 = 6400 PV of Tax saving 6400 at 8% for 1 to 25 6400 X 10.675 (iv) Tax saving on old unamortized (a)Floatation cost 25/30 X 360000 X .4 (This benefit will arise immediately) (b) (v) Tax saving lost on floating cost an old (360000/30) X .4 / 10.675 Tax saving on unamortized a. (b) (vi) discount an old bond (this will arise immediately) 25/30 X ( 30 X 30000) X .4 Tax saving lost on old 300 lacs X 2% Less: Tax @ 40% Net saving on Intt per year PV of Intt saving = 360000 X 10.75 Add: Intt on old bond 300 lacs X 14% X 2/ 12 700000 Less: Tax saving @ 40% 280000 NPV *Ignoring time value factor for 2m Refunding of bond is recommended. Ans: 24(2) SFM June 09 900000/30 X .4 X 10.675 600000 240000 360000 p.a. 360000 Intt cost saving on old bond

2520000 400000

(68320)

(120000)

51240

(300000) 128100

(3843000)

420000* 811980

Appropriate discount rate: Current after tax coupon rate (7%) considering it as market interest rate Rs. Million (i) Call premium net of tax 300 x 4% (1 - .30) 8.40 (ii) Issue cost on new bond =6 Less: tax saving over 6 years (6/6) x .30 x 4.766 = 1.4928 4.5702 (iii) Tax saving on amortized portion of issue cost of old 9 x .30 = 2.70 Less: tax saving lost (9/6) x .30 x 4.766 = 2.1447 (.5553) (iv) PV of Interest savging 300 (12% - 10%) x (1 - .30) x 4.766 (20.0172) (7.6023) Decision : Refund the old bond. Ans. 25(1) (a) 20 x 12 = 240 (c) (265/240) 1 = 10.42% Nov 12 (b) (265/235) 1 = 12.77% (d) (265/20) = 13. 25%

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Ans. 25(2) Step I: Straight value of Bond = 12 x CDF for 1 t o 5 y ears at 8% th + 100 x DF for 5 year at 8% =116 Step II: Conversion value at share price 5 6 4 20 x 4 20 x 5 20 x 6 = 80 = 100 = 120 When MPS is Rs. The exercise of conversion feature will be beneficial. Ans. 25(3) (i) 2 x 21 = 42 (ii) 50 42 / 42 = 19% (iii) PAT (3 x 5 lacs) Less: Pref. dividend 40,000 x 50 x 7% No. of shares EPS (iv) PAT Less: Pref. dividend No. of shares

Before conversion 15,00,000 1,40,000 13,60,000 5,00,000 2.72 25,00,000 1,40,000 23,60,000 5,00,000

After conversion 15,00,000 Nil 15,00,000 5,80,000 2.59 25,00,000 Nil 25,00,000 5,80,000 4.31

EPS 4.72 Ans. 25(4) Step I: Conversion value = 14 x 80 = 1120 Step II: Premium over conversion value = (1475 - 1120) / 1120 = 31.7% Ans 26.

before conversion after conversion 200000 200000 EBIT Less: Intt on RS 5 lacs 70000 EBT 130000 200000 Tax 35% 45500 70000 EAT (i) 84500 130000 No. of shares (ii) 10000 15000 EPS (iii)=(i)/(ii) 8.45 8.667 PE(given) (iv) 20 25 MPS (iii)x (iv) 169 216.67 The company should convert its share into shares as its market price will rise. Ans 27. conversion value = 4.8 x 20 =96 Conversion premium = (108- 96)/ 96 =12.5% Ans. 28(1) (a) straight value of bond = 40 x CDF for 1 to 20 years at 5.125% th + 1000 x DF for 20 year at 5.125% = 875 (approx). (b) Conversion value 20 x 54 = 1080 (c) Conversion premium = 6.48% Ans. 28(2) (i) Market value of bond Step I: Redemption value = 100 th Conversion value at expiry = MPS in 5 year x conversion ratio 5 = 4.45 (1.065) x 20 = 122 th Step II: MV of Bond = 9 x CDF for 1 to 5 years at 7% + 122 x DF for 5 year at 7% = 123.89. (ii) Floor value = 9 x 4.10 + 100 x .713 = 108.20 (iii) Conversion premium = 123.89 (4.45 x 20) 4.45 x 20 = 39.33

Ans. 29 Share vs convertible bond Share (i) Yield = 6/ 93.50 = 6.42% (ii) Capital gain potential = (122 93.50) / 93.50 = 30.48

Bond (i) current yield = 180/1940 = 9.28% (ii) downside risk = (1940 1090) / 1090 = 77.98% (iii) Conversion premium = (1940 / 93.50 x 20) -1 = 3.74% (iv) Break even period = [3.5 / { (1000x18-20x6)/20}] = 1.17 years

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(v) Potential capital gain = (expected debenture price bond price) / bond price = (122 x 20 1940) / 1940 = 25.77 Though t here is a l ittle pr otection f rom d ownside f all i n s tock v alue, t he higher c urrent y ield and a lmost matching capital gain potential with low conversion premium & premium recovery period, the debenture may be attractive to an investor. Ans: 31. Semi annualized YTM (approx.) = 14/2 = 7% th (a) Straight value of bond = 6 x CDF @ 7% for 1 to 10 years + 120 x DF @ 7% for 10 year = 94.52 (b) YTC = {6 + (105 275)/6} / {105 + 275)/2} = -11.75% The YTC is negative at the current bond price. (c) (275 50 x 5) / 50x5 = 10% Ans: 33. Since bond is sold at par hence YTM = coupon rate = 10% Step I: calculate donation for 7 year period and the answer is 5.35 years. Step II: A fter on e y ear t he d uration w ill c hange. A ssume YTM = 10%. N ow c alculate d uration f or 6 y ears period (as this is the time to maturity). New duration would be 4.79 years. The investment horizon of the investor is not given. The investor has to rebalance his portfolio by matching duration of bond with investment horizon. This will provide immunization. Ans: 34. A 11.11% 17.705% B 11.22% 11.67%

[short-cut result would be different] (c) Duration 2.739 3.438 The bond A is low volatile (low duration) and high CY and YTM. Therefore, it is better for the investor as compared to B. Ans: 35. Step I: Duration (D) = 4.55 years Step II: MD = 4.55 / (1 + .1353) = 4.01 years. Step III: % change in bond price = - 4.01 x 1.5% Price of bond would fall by = 470 x (-)4.01 x 1.5% = 28.27 Ans: 36 Step I: Calculate YTM = 13.86 p.a. (donot follow short-cut as at the end of third year principle is just half.) Step II: Since intt. is paid on semi-annual basis, first carry out three adjustments and then calculate duration. Coupon amount = 30; period = 2 x 4 = 8. semi annual YTM = 6.93%. CF PV W (w x t) T 30 1 30 2 30 3 30 4 30 5 6 280 .6689 187.292 .394 2.364 7 *15 .6256 9.384 .019 .133 8 265 .5851 155.04 .3264 2.611

(a) CY (b) YTM

DF @ 6.93%

.9352 28.056 .059 .059

.8745 26.235 .055 .110

.8179 24.537 .052 .156

.7649 22.947 .048 .192

.7153 21.459 .045 .225

* The principal is now 2250 and not 500. D = 5.85 on semi annual basis. [ or D (in years) = 5.85 / 2 = 2.925 years] MD = 5.585 / 1.1386 = 2.56 years. Interest risk = P / P = -MD x Y = -2.56 x 1% = -.0256 This means for 1% price increase the bond price will fall by 2.56%. Ex 38. May 07 Ans Let c is the coupon amount per annum. Year 1 2 3 CF c C c DF at 16% .862 .743 .641 Nov 12 study notes by: Rajiv Singh

4 C .552

5 c .476

6 C+ 100000 .410

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Bond price= 3.684c+ 41000 (i) As per definition the duration is equal to 4.3202= 1/(3.684c +41000) * [1x.862c + 2X .743c + 3x .641c+ 4x.552c +5x.476c + (6x.410c+246000)] C= 14983 Put the value of c in equation (i) Bond price= 96198 Ans: 40(1) (i) current price = 964.40; Duration = 4.236 years. Volatility = MD = D / (1 + YTM) = 4.236 / 1.17 = 3.62. (ii) Expected market price = 964.40 26.18= 938.22 SFM June 09 Ans: 40(2) The bond price will increase when YTM falls. Bond A (i) price with 6% YTM = 80 x CDF 1 to 5 years (i) Price with 6% YTM at 6% + 1000 x DF for 6 year = 1084.22 (ii) Increase in price = 1084.22 1000 = 84.22 (iii) Price increase due to principal = [1000 x DF at 6 % f or 5
th th

Bond B

Price = 1229.40 (ii) Increase in price = 229.40 (iii) price change due to principal = 97.26
th

year) (1000 x DF at 8% f or 5

year) = 66.68 (iv) % change in price due to principal = 66.68 / 84.22 = 79.16% (v) price change due to intt. = [80 x CDF at 6% for 1 t o 5 y ears] [8- x C DF at 8% f or 1 t o 5 years] (vi) % c hange i n pr ice due t o i ntt. = 1 7.57 / 84.22 = 20.84% (vi) % change in price due to intt. = (132.07/229.40) x 100 = 57.60% (iv) % change in price due to principal = 97.26/229.40 = 42.40% (v) price change due to intt. = 132.07

(b) D = 5.09 Years. (c) when YTM goes up the current price of bond will go down and this will pull down weight. As a result of this duration w ill de crease. ( y ou can check t his by c alculating current bon d pr ice a t 10% and dur ation o f 10 % YTM.) (d) T he dur ation of a coupon c arrying t he av erage t ime ov er w hich a bon d i s r epaid. T herefore, w hen an investor receives part of his investment back (intt.) before maturity date, the duration will be lower than maturity. (Thats why duration of zero coupon bond is its maturity period). Ans: 41 (a) Bond 1 is a z ero coupon bond and therefore doe not have reinvestment risk hence YTM of 6% will be achieving. In contrast to this bond 2 has reinvestment risk. (b) It all depends upon market view about intt. rate. Bond 2 will be more implied by intt. change as it has high duration. (c) MD = D / (1 + YTM) = 13/1.06 = 12.26 years. P / P = - 12.26x .50% = -6.13% P = 80 x (-)6.13 % = 4.90. New price = 80 4.90 = 75.10 Ans: 42 Post tax coupon = 150 x .70 105 CG on redemption = (1000-950) x .20 = 10 Step I: post tax YTM = 11.34% Step II: Take after tax CF and post tax YTM. The duration would be approximately 6.30 years. Step III: MD = 6.30/1.1134 = 5.66 years. Step IV: Intt. rate risk = = P / P = (-) 5.66 x 1%.

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Ans: 43 (a) CY = 12/95.75 = 12.53 Before calculating YTM first count CF for each period. Point CF 1 6 2 6 3 6 4 6 5 6 6 6 + 20 7 6 x .80 8 6 x . 80 + 30 9 6 x .50 10 6 x . 50 + 50

Now calculate YTM as IRR. Semi YTM = 6.68. (b) D = 6.86 semi annual period = 3.43 years. Two major applications of duration are (i) price estimation (ii) immunization. (c) MD = 6.86 / 1.0668 = 6.43 = 3.22 years. % change in bond price = -3.33 years x (-)1.20% = +3.86%.

Ans: 44 (a) Step I : price bond using individual spot rate for each coupon payment. A B 2 2 P0 = 5/1.0335 + 5/(1.035) + 5/(1.0375) + P 0 = 112.14 5/(1.0415) = 103.23 YTM = 4% D = 3.73 MD = 3.73/1.04 = 3.59 % change in bond price = -3.59 x .50= -1.795% (b) Step I: price of bond after one year A P0 = 5/1.0310 + 5/(1.0325) + 5/(1.035) = 104.24 HPR = {(104.24 103.23) + 5} / 103.23 = 5.82%
2 3 4

YTM = 4.64% D = 4.927 MD = 4.927/1.0464 = 4.927 % change in bond price = -4.927 x .50 = -2.464% B P 0 = 112.565 [remember the life is just 5 years now] HPR = {(112.565 112.14) + 7} / 112.14 = 6.62%

Ans: 48. 12.5 = (10 x 100/140) + (X x .40/140) [Portfolio duration is weighted average duration of individual assets] Ans: 49. SFM NOV 08 (i) CY = 14/90 = 15.55% YTM = 17.14% (ii) Intt. Payments through post dated cheques have no impact on timing of CF. T CF YTM 8.57% PV W (w x t) 6.45 .072 .072 5.94 .066 .132 5.47 .061 .183 5.04 .056 .224 4.64 .052 .26 4.27 .047 .282 3.93 .044 .308 3.63 .040 .32 3.34 .037 .333 46.97 .522 5.22 7.064 90 (approx.) 1 7 .921 2 7 .848 3 7 .781 4 7 .720 5 7 .663 6 7 .610 7 7 .562 8 7 .518 9 7 .477 10 7 .439

Duration in years = 7.064/2 = 3.53. [Remember computation of duration of a bond paying semi-annual on annual basis is conceptually wrong.] (iii) RY : Since there are no reinvestment the computation of RY is very simple. 90 (1 + RY) = 7 x 10 + 100 10 or, .529 = { 1 / (1 + RY) }
th 10

or, 90/170 = { 1 / (1 + RY) }

10

Refer DF table in 10 year row and locate intt. rate for the figure .529. Nov 12 study notes by: Rajiv Singh

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RY = 6% +

(.558 - .529 ) (.558 - .508)

x (7% - 6%)

= 6.58% or 13.16% p.a.

Ans Ex 50. Step I: Actual investment in portfolio 2006 Purchase 106.50 price Investment 500/100*106.50 = 532.50 Weight .202 Duration 3.5

2010 105 525 .199 6.5

2015 105 525 .199 7.5

2022 110 550 .209 8.75

2032 101 505 .191 13

Total 2637.50

Average donation of existing portfolio = summation of weighted duration of assets = 7.808 Step II: Churn out and Action Decrease in intt. rate by 2.5 bp Increase duration by purchasing GOI 2032 & disposing GOI 2006 Revised portfolio dur ation = . 199 x 6. 5 + .199 x 7.5 + .209 x 8.75 + .393 x 13 = 9.72 Ans Ex 54(1). Nov 07 (i) 91500 = 100000 x (ii) 98500 = (iii) 99000 = Ans: 54(2) Step I: one year intt. rate = 1,00,000 / 91,000 = 9.99% Step II: 99,000 = 10500 1.099 f 4 = 12.8% + 110500 (1.099) (1 + f 2 ) f 2 = 12.4% 100000 1.0929 10500 1.0929 1 1 + f1 + + 110000 (1.0929) (1 + f 2 ) 110000 (1.1265) (1.0929) (1 + f 3 ) Increase in intt. rate by 75 bp Reduce portfolio duration by purchasing GOI 2010 & deposing GOI 2032 Revised duration = .202 x 3.5 + .390 x 6.5 + .199 x 7.5 + .209 x 8.75 = 6.57

f 1 = 9.29% f 2 = 12.65% f 3 = 11.07%

Similarly f 3 = 11.5%

Ans: 55 SFM NOV 08 3 (1 + y) = (1 + y 1 ) (1 + f 2 ) (1 + f 3 ) (i) (1 + 12) = (1.050) (1.12) (1 + f 3 ) or, f 3 = 13.51% WKN: (1 + f 2 ) = (1.1125) / 1.1050 = 1.12 (ii) Compounded value of bond @ 12% YTM (after 5 years) Step I: 1000 x (1.12)
5 5 5 2 3

Step II: [{1000 x (1.12) } / (1.12) ] = 977.97

% change = 2.22%

Ans: 56. Suppose F is the average fwd rate p.a. then for 7, 8 and 9 years (a) (1 + f)3 = [1 + y 9 ] / [1 + y 6 ] = [1.145] / [1 + .13] f = 17.56% (b) (1 + f) = (1.15)
5 10 9 6 9 6

/ (1.10) f = 20.22%

Ans: 57. Step I: 475 = 500 x 1/(1+Y A ) or Y A = 500 / 475 1 = 5.263%. Y B = 500/445) / 2 1 = 6%. (1 + f 2 ) = (1.06) / 1.05263 1 = 6.742%. Comment : to lock in fwd rate the bond trader should buy 1 year bond and sell 2 year bond. The no. of 2 year bonds to be sold should make initial CF zero. Nov 12 study notes by: Rajiv Singh
2 1

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t=0 -475 -445 x 1.0675 00 % return = (533.70 500) / 500 = 6.74% 1 bond bought (1 year) 1.0675 bond sold

t=1 +500 +500

t=2 500x1.0675 533.70

Ans: 58. Assuming r eal r ate t o be c onstant in ea ch case ( i n pr actice t his may not b e t he c ase), w e c an guess expected inflation and hence nominal intt. rate (Real return + inflation) Step I: we can estimate inflation of each year by taking geometric mean of the expected 1 year inflation rate. (1 + i 2 ) = (1.045) x (1.040) = 4.25% (1 + i 3 ) = (1.045) x (1.040) x (1.05) = 4.50% (1 + i 4 ) = 1.045 x 1.04 x 1.05 x1.055 = 4.748% (1 + i 5 ) = 1.045 x 1.04 x 1.05 x1.055 x 1.045 = 4.70% (1 + i 6 ) = 1.045 x 1.04 x 1.05 x1.055 x 1.045 x 1.04 = 4.58% Step II: Now estimate nominal intt as adding inflation with real intt. rate. 1 Real rate Inflation (as per Step I) Nominal intt. rate 7 4.5 11.50 2 7 4.25 11.25 3 7 4.5 11.50 4 7 4.75 11.75 5 7 4.70 11.70 6 7 4.58 11.58
6 5 4 3 2

Step III: To construct yield curve of Govt. bond plot maturity on X-axis and Nominal return on Y-axis. Ans: 59. f 2 = [{(1.086) / (1.078)} 1] = 9.4% 3 f 3 = [{(1.095) / (1.078)(1.094)} 1] = 11.02%
2

Ans 60. a 1 2

We can calculate forward rates by calculating the price of zero coupon bonds YTM 10 11 Price
1, 000 1.10

Maturity

Forward rate

= 909.09 = 811.62
(1.11) 1.10 2

1, 000 (1.11) 2

1 = 12.01%

12

1, 000 (1.12) 3

= 711.78

(1.12) (1.11)

1 = 14.03%

b.

The nex t years pr ices a nd yields c an be c alculated b y di scounting e ach zeros f ace value at the forward rates for the next year that we have calculated in part (a) Maturity 1 year Price YTM 12.01%

1, 000 (1.1201)

= 892.78

2 year

1, 000 (1.1201) x (1.1403)

= 782.93

13.02%

Nov 12

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study notes by: Rajiv Singh

Sol. Fixed Income Securities Professional Studies & Research Centre

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Next year, the 2 year zero c oupon bond will be 1-year zero coupon bond and will therefore sell at
1, 000 1.1201

= 892.78. Similarly, the current 3-year zero coupon bond will be a 2-year

1, 000 zero and will sell at = 782.93. (1.1201) x (1.1403) Expected total return

d.

= 9.99% 10% 811.62 1 3-year bond = 1 = 9.99% 10% For part (d) the coupon rate is 12%. (There is typing error in the question.) The current price of the bond should equal the value of each payment times, the present value of Rs.1 to be received at the time of maturity. The present value can be calculated in the following manner: = 109.09 + 97.39 + 797.19 = Rs.1,003.67 Similarly, the expected price after 1 year can be calculated using forward rates. = 107.13 + 876.88 = 984.01

2-year bond =

892.78

Total expected return

120 + 984.01 1, 003.67 1, 003.67

= 9.99% 10%

Ans 61. P

6 6 6 106 + + + 2 3 4 = (1.0340) (1.0355) (1.0380) (1.0420) P = 5.803 + 5.596+ 5.365+ 89.916 = Rs.106.68 YTM of the bond A= approximately 4%. Duration of Bond A
Year 1 2 3 4 C.F 6 6 6 106 P.v. of C.F at 4% 5.77 5.55 5.33 90.61 107.26 Year x P.V. of C.F 5.77 11.10 15.99 362.44 395.30

Duration =

395.3 = 3.685 years 107.26

3.685 = 3.54 years Modified duration = 1 + .04 For a 0.50% increase in YTM change in the price of the bond A

P = 3.54 x 0.50 P = 1.77%. Price of the bond A will decrease by 1.77%.

Nov 12

Ph: 9818002742,011-22041814

study notes by: Rajiv Singh

Sol. Fixed Income Securities Professional Studies & Research Centre

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Price of the bond B P = =

8 (1.0340)
1

8 (1.0355)
2

8 (1.0380)
3

8 (1.0420)
4

8 (1.0455)
5

108 (1.0480)
6

7.737 + 7.461+ 7.153+ 6.786+ 6.404+ 81.518= Rs.117.06 4.68%. Duration of the Bond B Year 1 2 3 4 5 6 C.F 8 8 8 8 8 108 Present value of cash flow at (4.68%) 7.642 7.301 6.974 6.662 6.365 82.08 117.02 5.077 years Year x PVCF 7.642 14.602 20.922 26.648 31.825 492.48 594.119

Yield to maturity of the bond B =

Duration =

594.119 = 117.02

Modified duration =

5.077 1 + .0468

b.

= 4.850 years Change in the price of the bond = 4.850 x 0.50 = 2.425% Therefore, price of the bond B will decline by 2.425%. Price of the bonds after one year Bond A

1 2 (1.0315) (1.0330)

106 (1.0355) 3

= 4.85 + 4.69 + 94.70 = Rs.106.91

One year holding period return on bond A = Bond B

106.91106.68 + 6 106.68

= 5.84%

8 2

8 (1.0355) 3

8 (1.0395) 4

108 (1.0430) 5

(1.0315) (1.0330)

= 7.756 + 7.497+ 7.205+ 6.852 + 87.5= 116.81 One year holding period return =
116.81 117.06 + 8 = 6.62% 117.06

Ans 62. a. Maturity (year) YTM(%) Price (Rs.) Forward rate (%) 1 11 900.90 2 2 12 797.19 (1.12 /1.11) 1 = 13.01% 3 2 3 13 693.05 (1.13 /1.12 ) 1=15.03% b. We obtain next years prices and yields by discounting each zeros face values at the forward rates for next year that we derived in part (a): Maturity (Year) Price (Rs.) YTM (%) 1 1000/1.1301 = 884.88 13.01 2 1000/(1.13011.1503) = 769.26 14.02
Nov 12 study notes by: Rajiv Singh

Ph: 9818002742,011-22041814

Sol. Fixed Income Securities Professional Studies & Research Centre

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Note that this years upward sloping yield curve implies, according to the expectations hypothesis, a shift upward in next years curve. c. Next year, the 2-year zero will be a 1-year zero, and will therefore sell at Rs.1000/1.1301 = Rs.884.88. Similarly, the current 3-year zero will be a 2 year zero and will sell for Rs.769.26 Expected total rate of return: 2-year bond: (884.88/797.19) 1=0.11 = 11% 3-year bond: (769.26/693.05) 1 = 0.10996 = 10.996% d. The current price of the bond should equal the value of each payment times the present value of Rs.1 to be received at the maturity of that payment ( in other words each coupon payments should be discounted as is they ar e s eparate zero coupon bond. That m eans first payment should be di scounted at 11% f or one y ear and the second coupon payment should be discounted at 12% for second year and so on. (The present value schedule can be taken directly from the prices of zero-coupon bonds calculated above.) Current price = 1300.9009 +130 0.79719 +1,130 0.69305= 117.117 + 103.6347 +783.1465= Rs.1003.9 Similarly, t he expected prices of z eros i n 1 y ear can be u sed t o calculate t he expected bond v alue at that time: Expected price 1 year from now = 1300.88488 +1130 0.7692 = 115.0344 + 869.2638 = 984.23 Total expected rate of return = [130+(984.23 1003.9)]/1003.9 = 0.1099 =10.99%. 63. The intrinsic value of the above PCD is calculated as under: a. Present value of interest payments = 9 CDF at 5% for 1to 3 + 4.50 CDF at 5% for 1 to 11 DF at 5% for 3 year = 9 2.7232 + 4.5 8.3064 0.8638 = 56.80. b. Year Ended Bonus adjusted EPS (Rs.) 2001 2.50 2002 3.00 2003 3.38 2004 3.60
rd

Growth rate (g) implicit in the bonus adjusted EPS can be obtained from the equation 2.5 (1 + g) = 3.60 :
Projected EPS in July, 2004
3

g = 12.92%
2.40 1 +

0.1292 3

Rs.2.50 =

Average P/E ratio between January 2004 to July 2004 (6 months period prior to conversion)

12 + 11.8 + 11.5 3

= 11.77.

Therefore, projected market price of share after 18 months = 2.50 11.77 = Rs.29.43 Present value of market value of conversion after eighteen months = 29.43 2 PVIF (5%, 3) = 58.86 0.8638 = Rs.50.84 Present value of non-convertible portion redeemed after 7 years = 100 PVIF (5%, 14) = 50.51 Intrinsic value of the PCD = 56.80 + 50.84 + 50.51 = Rs.158.15

d.

Therefore, it is recommended not to invest in the proposed PCD as its intrinsic value is less t han t he i ssue price and t he pr ojected declining P /E r atio m ay t ake t he price of convertible portion further down.

Nov 12

Ph: 9818002742,011-22041814

study notes by: Rajiv Singh

Sol. Fixed Income Securities Professional Studies & Research Centre

Page - 14 P S R C