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?

(1+0.23)4 = (1+0.15)(1+x)(1+0.18)(1+0.09)
X = 54.74%

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?

P = 60/(1.055)*(1.07) = 53.15
Ans: 53.15
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 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
reinvest 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?

Initial Price = 70 PVAF(9%, 15) + 1000 PVF(9%, 15) = 838.79

FV coupon = 70 FVAF 5%, 5 = 386.79

Price at the end of year 5 = 70 PVAF(8%, 10) + 1000 PVF(8%, 10) = 932.90

Total ending value = 386.79 + 932.90 = 1319.69

Initial Investment = 838.79(1+Rg)5 = 1319.69

Geometric rate = 9.487%

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%?

Ans: On coupon payment date, when coupon rate = yield to maturity, price = par.

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.

Ans: False. The real risk-free rate of return is the component return to compensate
investors for postponing their consumption in a world with no inflation and risk. So, if
one does not consume, he/she will invest. The real rate then is to compensate investors
for postponing their consumption in a world with no inflation and no risks.

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 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.

Ans: True.

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.

True

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

Ans: Not true. It also includes the risk premium.

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

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 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?

72.727 = 80/1.10

72.727*1.10 = 80

Return = 10%

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?

66.116 = 80/(1.10)2

66.116*(1.10)2 = 80

Return = 10%

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?

826.446 = 1000/(1.10)2)
826.446*(1.10)2 =1000

Return = 10%

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 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.

Yes, if there was only one single cash flow at maturity of the debt security, the issue of
reinvestment of the intermediate cash flows does not arise. So, your return is already
locked in if you hold till the debt security matures.

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However, return is not locked in if you were to invest in a coupon-bearing debt security.
If there were intermediate cash flows, your return (which is measured by the geometric
rate of return) will depend on the reinvestment rate of the intermediate cash flows
though the holding period is the same.

The details below are for your reference:

Example, debt security ACD pays a single cash flow of $1000 at the end of year 3. Debt
security GHI Co. pays $90 annual coupon interest and $1,000 upon maturity at the end
of year 3. The yield to maturity is the same for both securities. The holding period is
three years and is the same for both ACD and GHI.

Even though the holding period for the two securities ACD and GHI is the same, the
geometric rate of return of GHI depends on the reinvestment rate of the intermediate
coupon payments. However, if the investor holds ACD till it matures, i.e., for three years,
the return of ACD is already locked in (assuming no default).

In general, the reinvestment rate and the number of years for your holding period affect
the geometric rate of return from investment in a coupon-bearing debt. E.g., if you were
to sell the GHI debt after two years, the price that you could get after two years is
uncertain as it depends on the required rate of return at that time.

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?

Ending value = 80*1.20 + 80 + 1,000 = 1176

Initial Investment = $965.289

965.289*(1+r)2 = 1176

the geometric rate of return = 1.103760841 – 1 = 0.1038, after rounding.

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

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 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%?

Ans: The reinvestment rates are different. In Q8, the reinvestment rate is 20% but for Q9,
it is 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
could account for the differences in the yield to maturity of these two bonds and
provide the basis for your explanations.

Note: Answers in red are already sufficient.

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

Ans: The credit risk premium of Radium is higher, reflecting the investors’ evaluation
that the creditworthiness of Radium is lower than that of DLC. You may also say that the
investors expect the creditworthiness of Radium to be worse than that of DLC.

Also, the illiquidity premium of Radium Co is probably higher than that of DLC’s, i.e.,
Radium Co’s debt securities are less heavily traded.

The maturity risk premium is the same as the debt securities are of the same maturity.
Also the real rates and inflation rates are common to both debt securities as they are of
the same maturity. So, maturity risk premium, real rates and inflation rates cannot
explain the differences in the yield to maturity.