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Advanced Master in International and Development Economics

EDV M312












Academic year 2013-2014
Macroeconomics stabilization & structural adjustment: monetary &
financial aspects
Prof. Paul Reding

Small Individual Home Assignment 1


Horace Owiti Onyango





1. You have paid 980.30 for an 8% coupon bond with a face value of 1000 that matures in 5
years:
a) Which one of the following values is the correct yield to maturity of the bond? 8.50%; 7.55%;
8.87% (Justify!)
Solution
The correct yield is 8.50% and it is calculated from the relationship below.

P = c(1 + r)-1 + c(1 + r)-2 + . . . + c(1 + r)-Y + B(1 + r)-Y
Where:
c = annual coupon payment (in dollars, not a percent)
Y = number of years to maturity
B = par value
P = purchase price
r = Yield to maturity
Substituting in the equation we get:
980.30 = 80 {[1- (1+r)
-5
] /r} + 1000(1+r)
-5
Solving for r using a financial calculator gives 8.50%
b) You plan on holding the bond for one year. If you plan to earn an expected rate of return of
10% on this investment, what price must you sell the bond in one year? (Justify!)
Solution
To find this, the relationship below is used:


Where: R= Rate of return on the bond
C = Coupon payment
P
t+1
= Price of the Bond one year later
P
t
= Price of the Bond today
Hence solving:

0.1 =

= 998.33
The value of

yields 998.33, usually the rate of return on a bond is composed


of the change in value of the bond due to difference in prices and payments to the
owner in terms of coupons.

c) Do you think this expectation is realistic if you consider the implication of the market price of
the bond in one year being at that level?
For this to be realized, the interest rates would have to fall so that the price of the bond in the
same year increases. As such, it is only realizable if the interest rate increase sizably within the
year.

2. Using portfolio_simulation.xls file on the courses web-campus site, consider the following
two assets, whose returns R
A
and R
B
are jointly normally distributed with:

~ N {


}
Indicating the vector of expected returns and the variance-covariance matrix of the joint
distribution. Consider the portfolio composed of 30% of asset A and 70% for asset B and
compare it with the minimum variance portfolio, in terms of expected return and volatility. Is
this portfolio attractive for you! Discuss!
Solution:
Asset A Asset B
Expected R 0.05 0.14
Sigma of R 0.015 0.1
Corr(Ra,Rb) -0.8
Minimum Variance Portfolio is For X* = 0.89
Expected Return on Portfolio Xa+(1-X)B 0.1130
Sigma (Std Dev.) of Portfolio Xa+(1-X)B 0.0665
Expected Return Minimum Variance Portfolio 0.0602
Sigma (Std Dev.) of Minimum Variance Portf. 0.0080
The portfolio has more expected return (0.1130) compared to the minimum variance portfolios
(0.0602). However, it is also more risky (0.0665) than the minimum variance portfolio (0.0080)
by comparison of their standard deviations. Additionally, more returns can be realized by
reducing the proportion of asset A in the portfolio but this also amplifies the risk. On the other
hand reducing the proportion of asset A not only reduces the risk, but also the expected return.
Since I am very risk tolerant, this portfolio is attractive to me due to its high expected returns
relative to the minimum variance portfolio, though it be more risky.
3. How do you interpret the following data: on February 4, 2014, the price of a 5 year Sovereign
credit default swap for Indonesia is 241 basis points?
Solution:
The Sovereign Credit Default Swap for Indonesia being 241 basis points on the given date
implies that the credit insurer (Indonesia) will charge 2.41% each year for covering the risk
against default (1 basis point = 0.01%). As such, it reveals the annual amount the protection
buyer must pay the protection seller over the length of the contract (5yrs) or until default.
4. Consider the stock of Company Z, for which the current price is $55. It is expected to pay out a
dividend of $1.20 in one year. Given all the information you could gather about Company Z and
its prospects for the coming year, you expect to resell the stock, the next day of the dividends
pay-out, at a price of $62.

a) What is the expected holding period return of this stock (over the coming year)?
Solution



Therefore:
55 = 1.20/(1+K
e
) + 62/(1+K
e
) K
e
=0.14909 or 15%
Thus the expected holding period return of this stock is 15%.

b) Would you be willing to buy this stock if the following alternative investment opportunity
were available to you: a one year time deposit at 12% interest rate? Justify your answer,
also explaining which additional factors you would consider before taking your decision!
Solution
Though its expected return is higher (15%) compared to the one year time deposit (12%), I will
have to consider if the difference in return would compensate me enough for the risk, since the
bank has no default hypothesis. Additional factors I would consider include: the volatility of the
stock prices and the aspect of liquidity.

5. Discuss what is meant by the risk premium embodied in an assets expected return. Apply this
discussion to the one year expected return on the stock of a given company (e.g. Coca-Cola):
Suppose, in this context, that currently the beta of such a stock is 1.7, that the market risk
premium is equal to 6.8% and that the risk free rate is 4%. If you feel that the CAPM is a good
reference for assessing the pricing of stocks, would you buy this stock if, based on the expected
future payouts and its current price, the expected return is 12.5%. Explain briefly!
Solution
Risk Premium is the return in excess of the risk-free rate of return that an investment asset is
expected to yield. An asset's risk premium is a form of compensation for investors who tolerate
the extra risk - compared to that of a risk-free asset - in a given investment.

E(r
j
) ( Expected return of stock)= r
f
(Risk free rate) +
j
(beta)*r
m
(market risk
premium)
Therefore:
E(r
j
) =0.04 +1.7(0.068) E(r
j
)=15.56%
No, since I feel that the return is 15.5%, but the CAPM says it is 12.5%, then I will not buy it if I
believe CAPM is a good reference and also if I am not comfortable with an amount less than
15.5%.