Assignment

Q1. : The effective quarterly rates of return obtained by an investment fund in four
consecutive quarters were 2.1%, 1.8%, 2.6% and 1.1%. What is the linked rate of
return for the whole year.

Q2. An investor borrows Rs10,000 at an effective rate of interest of 12% pa to finance a

project. Income from the project is received at a level rate of Rs3,000 pa payable
continuously for 10 years. Calculate the discounted payback period of the project.

Q3. Describe the role of the following in the markets for derivatives:
(i) margin
(ii) the clearing house.

Q4.An investor obtains a nominal rate of return on a 10-year bond of 6.4% pa effective.
Calculate the annual effective real rate of return if inflation is assumed to be 3% pa
throughout the 10 years.

Q5. An investor purchases a newly issued bond with six-monthly coupons of 9% pa on

1 January 2004. He is liable to 40% tax on income, which he pays on 1st April each
year for the income earned in the preceding year. He is also liable for capital gains tax
of 35%, payable when the gain is made. The bond is redeemable at 110% in 5 years
time. What price should the investor pay in order to achieve a yield of 8.5% pa?

Q6. At time 0, the following n-year spot rates were observed:

1-year spot rate of interest: 6% pa effective
2-year spot rate of interest: 5% pa effective
3-year spot rate of interest: 5% pa effective
4-year spot rate of interest: 5% pa effective
5-year spot rate of interest: 5% pa effective
Calculate the three-year forward rate of interest from time 2.

Q7. A telecommunications company has perfected a video telephone that costs Rs300 to
manufacture. The company intends to offer the telephone for rental only, on three-year
contracts. The net rental income will be received continuously at the constant rates of
Rs120 pa during the first year, Rs150 pa during the second year and Rs180 pa during the
third year. At the end of the three year contract, the telephone will have a salvage value
to the company of Rs80.Calculate, to the nearest percent, the internal rate of return achieved by
the company on a video telephone.

Q8. On 1 July 2002 an investor subject to 40% tax on income purchased a fixed interest
security paying half-yearly coupons at 3% pa (on 1 January and 1 July) and
redeemable at par on 1 July 2010. Income tax is payable on 1 November each year in
respect of any coupons received during the previous tax year (running from 6 April to
5 April). Calculate the price paid by the investor who requires a net yield to maturity of
6% pa effective.

Q9. Rs14,000 will be invested for the next 4 years at a constant annual rate of interest i.
(1+ i) has a lognormal distribution with mean 1.05 and variance 0.007. What is the
probability that the investment will accumulate to more than Rs20,000 in 4 years time?

Q10. A training company is planning to expand into another country. The set up costs (which
are paid out at the start) are expected to be $50,000. Rent and salaries totalling
Rs120,000 pa are to be paid monthly in arrears for the first two years. After two years,
the total monthly payment for rent and salaries increases each month by Rs100.
The expected sales of courses and materials during the first three years of business are
shown in the table below:

Year Total income from sales of materials Total income from sale of courses
1 Rs40000 Rs 20000
2 Rs120000 Rs120000
3 Rs 140000 Rs160000

The income is to be payable monthly in advance but, in the first year, no income is
received until the beginning of the 8th month. After the first three years, sales of both
materials and courses are expected to grow at a rate of 0.5% per month compound.

(i) Assuming that the business continues indefinitely, calculate the net present value
of this project at an effective rate of interest of 8% pa.
(ii) Show that the discounted payback period for the project, at an effective rate of
8% pa, is less than 2 years. Hence calculate the discounted payback period.
(iii) Calculate the accumulated profit for this project after 5 years, using an annual
effective rate of interest of 8% pa.
(iv) A year after setting up the project, it is sold. The original investors earned an
effective annual rate of return of 9% pa. For what price was the project sold?

Q11. As company has just borrowed Rs 100,000 at a fixed rate of 8% pa. The loan is to be
repaid at par value in five years and interest must be paid at the end of each year.
In order to reduce its exposure to fixed rate borrowing, it arranges an interest rate swap to
exchange the 8% pa fixed rate for a variable rate that is % higher than the central banks base
rate at the time when the interest payments are due. Over the next five years, the base rates turn
out to be:
(7%, 6%, 7%, 8%, 9%)
(a) State the constant effective annual interest rate that would have been paid by the company if
it had not arranged the swap.
Q12. The British Government wishes to issue a new fixed-interest stock with a 25-year term,
which will pay half-yearly coupons (payable in arrears) and will be redeemable at par. The Bank
of England has advised the government that future interest rates (expressed as nominal rates
convertible half-yearly) can be assumed to be 7% pa over each of the next 5 years, 8% pa over
each of the following 10 years and 8% pa thereafter. If the government wishes to issue the new
gilt at a price of Rs100%, what coupon
rate should be chosen for this gilt? (Quote your answer to the nearest %.)

Q13. At time t = 0 , the 2-year spot rate is 4% pa effective, the 3-year spot rate is 5% pa
effective and the 4-year spot rate is 6% pa effective. Calculate the 2-year continuous time
forward rate from time t = 2

Q14. On 1 October 2004, the share price of Company X was 3.15. A 6-month forward contract
is written on that day, for the purchase of 1,000 shares in Company X.

Calculate the forward price under each of the scenarios below. Assume that the effective risk-
free rate of interest is 4% pa and that there is no arbitrage.

(a) There are no dividends due in the next 6 months.

(b) A dividend of 10p per share is expected on 1 December 2004.
(c) Dividends are payable continuously and are immediately reinvested in the shares.
The force of dividend is 3% pa.

Q15. An investor purchases a 5-month forward contract on 1 January 2004 to buy 1,000
shares at the end of the contract. The price of a share on 1 January 2004 is Rs50. Dividends are
received continuously and the dividend yield is 6% pa. The risk-free rate of interest is 4% pa
effective and there is no arbitrage.
(i) Calculate the forward price.
(ii) The investor decides to sell the contract on the 1 April 2004, when the price of the stock is
Rs49.50 per share. Calculate the value of the contract at this time.

Q16. The liabilities of a fund consist of two lump sum payments due at known times in the
future. The second lump sum is due for payment 5 years after the first and is twice the
amount of the first.

(i) If the total present value and the discounted mean term of the liabilities (both calculated using
a market interest rate of 6% pa) are Rs75,000 and 8 years, respectively, determine the timing and
amounts of the payments.
(ii) If the assets of the fund consist of a single zero coupon bond that will mature 8 years from
now with a redemption payment of Rs119,540, what can you say about this portfolio on the basis
of Redingtons theory of Immunization?
Q17 An equity that pays annual dividends is purchased immediately after a dividend payment
has been made. The next dividend is expected to be d per 1 invested. If dividends are expected
to grow at a compound rate g and price inflation is expected to operate at rate e , show that the
real rate of return obtained on this equity will be

. Assume that the equity is held indefinitely.

Q18: Two projects A and B the following cahflows:

Project A Project B
Initial outlay Rs170000 Rs200000
Other expenses Rs20000 at the end of year 1 -
Rs10000 at the end of year 2 -
Income Rs20000 at the end of year 1 Rs14000 pa at the end of each of
Rs20000 at the end of year 2 the first year.
Rs200000 at the end of year 3 Rs200000 at the end of year 6

(i) Calculate the internal rate of return (correct to 1 decimal place) for each project.

(ii) Calculate the net present value of each project using a risk discount rate of 6% pa.

(iii) If funds for the projects can be raised by borrowing from a bank, determine the interest rate
charged by the bank above which each project becomes unprofitable. Mention any other factors
that should be taken into account when deciding between the projects.

Q19. At time t = 0 , the 2-year spot rate is 4.5% pa effective, the 3-year spot rate is 5.5% pa
effective and the 4-year spot rate is 6% pa effective. Calculate the 2-year continuous time
forward rate from time t = 2.

Q20. An investor borrows Rs10,000 at an effective rate of interest of 12% pa to finance aproject.
Income from the project is received at a level rate of Rs3,000 pa payable continuously for 10
years. Calculate the discounted payback period of the project.

Q21. An investor obtains a nominal rate of return on a 10-year bond of 5.4% pa effective.
Calculate the annual effective real rate of return if inflation is assumed to be 3.5% pa throughout
the 10 years.
Q22 i) Calculate, using an effective annual interest rate of 10%, the present value, volatility and
convexity of the portfolio consisting of the following set of payments: Rs1,000 payable in 5
years time,Rs5,000 payable in 10 years time and,Rs25,000 payable in 25 years time.
(ii) Calculate the present value and volatility in 2 years time assuming no change in
the interest rate.

Q23. An investor has purchased a 99-year property lease, which will pay Rs100 at the end of
each of the first 33 years, Rs200 at the end of each of the next 33 years and Rs300 at the end of
each of the last 33 years. Calculate using 8% pa interest:
(i) the present value of the income from the lease
(ii) the discounted mean term of the income from the lease.

Q24. The 1, 2, 3, 4 and 7-year spot rates are 4%, 3.75%, 3.6%, 3.5% and 3.9% pa respectively.
The 3-year forward rate from time 3 is 3.8% pa and the 3-year forward rate from time 2 is 3.7%
pa.
Calculate:
(i) the 2-year forward rate from time 5
(ii) the present value of payments of 5 at the end of each of the 7 years
(iii) the accumulated value at time 6 of a payment of Rs100 at time 1

Q25. : The following data relates to the assets of an investment fund:

Date Market value
1 January 2002 Rs4.2m
1 January 2003 Rs4.6m
1 January 2004 Rs5.1m
1 July 2004 Rs5.1m
31 December 2004 Rs5.5m

The only cashflow during the calendar years 2002, 2003 and 2004 that was not generated from
the assets of the fund was a payment of Rs800,000, received by the fund on 30 June 2004.
For the period from 1 January 2002 to 31 December 2004 calculate:
(a) the money-weighted rate of return
(b) the time-weighted rate of return
(c) the linked annual rate of return (using equal year-long linking periods).
Express your answers as annual rates rounded to the nearest 0.1%.

Q26 Company XYZ is considering investing in a capital project. The costs for the project will
be Rs 5 million at the beginning of the first year, and Rs (0.5*1.04k-2) million payable at the
beginning of year k , k = 2, 3, ..., 10 . The returns will be Rs2 million at the end of each of the
first 5 years, increasing by
Rs 250,000 at the end of each of years 6 to 10.
Company XYZ decides to use a risk discount rate of 12% pa to assess this project.
(i) Calculate the net present value of the project.
(ii) Calculate the discounted payback period for the project.
Q27: An investor purchases a newly issued bond with six-monthly coupons of 9% pa on 1
January 2004. He is liable to 30% tax on income, which he pays on 1st April each year for the
income earned in the preceding year. He is also liable for capital gains tax of 35%, payable when
the gain is made. The bond is redeemable at 110% in 5 years time. What price should the
investor pay in order to achieve a yield of 8.5% pa?

Q28. The following data relate to the assets of a small trust fund:

Date Market value

1/1/2004 Rs 25000
1/4/2004 Rs 29000
1/7/2004 Rs 30000
1/10/2004 Rs 32000
1/1/2005 Rs 31500

The only cashflow during 2004 that was not generated from the assets of the fund was an
injection of Rs 5000 on 31st march . Calculate

1) The money weighted rate of return for the fund 2004

2) Time weighted rate of return for the fund 2004
3) The linked quarterly rate of return for the fund 2004

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