CITY UNIVERSITY OF HONG KONG

CB3140 Assignment 2

Date due: 15 November 2024

Notes:

• For numerical answers, round to two decimal places. All returns/rates are in
annualised or annual terms unless otherwise stated. ‘t = 0’ is the initial investment
date or today. Year 1 means from ‘t = 0’ to the end of the first year of investment, etc.
• Returns are on a geometric rate basis, unless otherwise stated.
• Par value or maturity value of coupon-bearing bond is $1000 unless otherwise
stated.

1. John's annualized return over a four-year period from investing in asset XYZ is 23%.
The return in the first year is 15% and the return in the third year is 18%. The return in
the fourth year is 9%. What is the return of XYZ in the second year?

2. Today, you bought a 2-year debt security that pays you $60 at the end of year 2. The
required rate of return in the first year is 5.5%. Suppose in the second year, the
required rate of return is 7%. The applicable required rate of return in the second
year is obtained from these estimates:

real rate = 0.7%,

Assume the debt is default free and so there is no credit risk premium. Assume 0%
illiquidity premium.

The required rate in the second year = 0.7% + 6 + 0.3% = 7%

What is the price of the debt security today?

3. Five years ago, you bought a 15-year bond that pays an annual coupon of $70, has a
face value (par) of $1,000, and had a yield to maturity of 9%. Suppose you reinvested
the coupon payments at 5% annually for the last five years. The yield to maturity
today is 8% and you are selling the bond today (assume the fifth coupon payment
has already been collected by you). What is your geometric rate of return?

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4. What would you pay for a bond that has just been issued that pays an annual coupon
of $100, has a face value (par) of $1,000, matures in 7 years, and has a yield to
maturity of 10%?

5. Evaluate if the following is true or false. Provide the right sentence or explanation
only if the statement is false. One or two sentences would be enough.

a. The real risk-free rate of return is the reward investors seek as compensation for
the loss of purchasing power.
b. The inflation premium is the reward investors seek in return for loss of
purchasing power or the general rise in the price level of consumers.

6. Evaluate if the following is true or false. Provide the right sentence or explanation
only if the statement is false. Credit risk premium referred to below incorporates the
risk of the borrower defaulting as well as the risk that the borrower’s credit rating
will go up or go down, i.e., changes in the borrower’s credit worthiness. One or two
sentences would be enough.

a. The credit risk premium is the reward investors seek in return for bearing credit
risk.

b. The required return on a risky security is the return required by investors to

Questions 7 - 9

Asset BCD is expected to provide a cash flow of $80 one year from now. You require a
return of $10%. The risk-free rate is 5%. The value of asset BCD is equal to 72.727 (Value
= 80/1.10).

Asset LBO is expected to provide a single cash flow of $80 two years from now. You
require a return of $10%. The value of LBO is 66.116 (Value = 80/(1.10)2).

Asset XTE is expected to provide a single cash flow of $1000 two years from now. You
require a return of $10%. The value of XTE is 826.446 (Value = 1000/(1.10) 2).

The debt security DEF is expected to provide annual coupon interest of $80 at the end of
each year for two years. Further, the debtholder is expected to receive a par value of

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 $1,000 at the end of year 2. The required return on DEF is 10%. What is the value of DEF
today?

Q7.

a. Suppose you buy asset BCD today at 72.727 (Price = 80/1.10). You will hold the
asset for one year. What is your return?

b. Suppose you buy asset LBO today at 66.116 (Value = 80/(1.10)2). You will hold the
asset for two years. What is your annualized return over the two-year holding
period?

c. Suppose you buy asset XTE today at 826.446 (Value = 1000/(1.10)2). You will hold
the asset for two years. What is your annualized return over the two-year holding
period?

d. Given the returns that you calculated in a to c, is it true that if there was only one
single cash flow at maturity of the debt security, your return is already known
today assuming you hold the debt security till it matures? Compare the returns of
assets LBO and XTE with your investment in a two-year coupon-bearing bond for
the same holding period (two years). Is your return already locked in if you were
to invest in a coupon-bearing debt security? Assume the debt securities do not
default.

8. The debt security DEF is expected to provide annual coupon interest of $80 at the
end of each year for two years. Further, the debtholder is expected to receive a par
value of $1,000 at the end of year 2. The yield to maturity of DEF is 10%. The price of
DEF today = 72.727 + 66.116 + 826.446 = 965.289. Suppose you could reinvest the
intermediate coupon payment of DEF at 20%. What is your geometric rate of return?

9. The debt security FGH is expected to provide annual coupon interest of $80 at the end of
each year for two years. Further, the debtholder is expected to receive a par value of
$1,000 at the end of year 2. The yield to maturity of FGH is 10%. The price of FGH today
= 72.727 + 66.116 + 826.446 = 965.289. Suppose you could reinvest the intermediate
coupon payment of FGH at 10%. The geometric rate of return from investing over the
two-year holding period is 10%. Explain why the annualized return that you obtain from
Question 8 is different from this return of 10%?

10. Suppose the current yield to maturity of 7%-annual coupon rate, $1,000 par, 12-year
note of DLC Co. Ltd is 6%. The current yield to maturity of 7%-annual coupon rate,
$1,000 par, 12-year note of Radium Co. Ltd is 12%. Describe two major factors that

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could account for the differences in the yield to maturity of these two bonds and
provide the basis for your explanations.

Hint: For this question, note that the maturities and the coupon rates of the two
securities are the same. However, the companies are different.