4/19/23, 7:53 PM Practice Review | ACCA Study Hub

Advanced Financial Management (AFM): Valid for exams Sept 2022-June 2023   
 
k Chapters

g Flashcards
Review Category Chapter 2: Security Valuation and the Cost of Capital Done Reviewing
v Quizzes

r Practice

  Question 1 of 1 Toolbox 3 4 7 6

complete
GADDES
Time Spent:
(a) Briefly discuss possible reasons for an
26 secs
upward sloping yield curve. (4 marks)
Related Sections:
(b) The financial manager of Gaddes Co’s
Learn more about this topic
pension fund is reviewing strategy
regarding the fund. Over 60% of the fund is
invested in fixed rate long-term loan notes.
Interest rates are expected to be quite
volatile for the next few years. It is currently
June 20X3.

Among the pension fund’s current

investments are two AAA rated loan notes:

(1) Zero coupon June 20Y8

(2) 12% Gilt June 20Y8 (interest is

payable semi-annually)

The current annual redemption yield (yield

to maturity) on both loan notes is 6%. The
semi-annual yield may be assumed to be
3%. Both loan notes have a nominal value
and redemption value of $100.

Required:

(i) Estimate the market price and

percentage change from their
current value of each of the loan
notes if annual interest rates
(yields):

(a) increase by 1%;

(b) decrease by 1%.

The changes in interest rates may be

assumed to be parallel shifts in the
yield curve (yield changes by an
equal amount at all points of the yield
curve). (6 marks)

(ii) Comment on and briefly explain

the size of the expected price
movements from the current prices
and how such changes in interest
rates might affect the strategy of
the financial manager with respect
to investing in the two loan notes. (3 marks)

(iii) Comment on how the loan note (2 marks)

investment strategy of the financial
https://studymaterials.accaglobal.com/app/advanced-financial-management-afm-valid-for-exams-sept-2022-june-2023#quiz/review/categories/75… 1/3
4/19/23, 7:53 PM Practice Review | ACCA Study Hub
manager may be affected if the
Advanced Financialyield
Management
curve was(AFM): Validtofor exams Sept 2022-June 2023 
expected   
Chapters steepen (the gap between short-
k
and long-term interest rates to
g Flashcards
widen) and interest rates are
v Quizzes
expected to rise.
r Practice
(15 marks)

Your Answer:
1.

(a) Possible reasons for upward sloping yield curve

Future expectations. If short-term interest rates are
expected to be higher in the future than at present then
the yield curve will be upward sloping.
Liquidity preference. It is argued that investors seek
extra return for giving up a degree of liquidity with
longer-term investments. Other things being equal, the
longer the maturity of the investment, the higher the
required return, leading to an upward sloping yield curve.
Preferred habitat/market segmentation. The interest rate
at each point on the yield curve represents the 'price of
money with that term to maturity', as determined by the
supply and demand for funds with that term to maturity. If
there are few investors seeking to invest long term, but
many borrowers wishing to borrow long term, then the
price of long term money will be high, and the yield curve
is likely to be upward sloping.

(b)(i) Market price

Current market prices

(1) Zero coupon ​ ​= $41.73

(2) 12% gilt with a semi-annual coupon

PV of an annuity for 30 periods at 3% is ​ ​

= 19.6

PV of interest payments $6 × 19.6 = 117.60

$100 ×
41.20
​ ​ 0.4120 =

158.80

(a) If interest rates increase by 1%

(1) Zero coupon ​ ​= $36.25, a decrease of $5.48 or

13.1%

(2) 12% gilt

PV of an annuity for 30 periods at 3.5% is ​

​= 18.392

https://studymaterials.accaglobal.com/app/advanced-financial-management-afm-valid-for-exams-sept-2022-june-2023#quiz/review/categories/75… 2/3
4/19/23, 7:53 PM Practice Review | ACCA Study Hub

$6 ×exams
18.392Sept 2022-June 2023  
Advanced Financial
PV Management (AFM): Valid for
of interest payments 110.35  
=
k Chapters

g Flashcards $100 ×
35.63
v Quizzes ​ ​ 0.3563 =

r Practice
145.98

This is a decrease of $12.82 or 8.1%.

(b) If interest rates decrease by 1%

(1) Zero coupon ​ ​= $48.10, an increase of $6.37 or

15.3%

(2) 12% gilt with a semi-annual coupon:

PV of an annuity for 30 periods at 2.5% is ​

​= 20.93

PV of interest payments $6 × 20.93 = 125.58

PV of redemption using $100 × 0.4767 = 47.67

173.25

This is an increase of $14.45 or 9.1%.

(ii) Expected price movements

The price/yield relation is not linear; it has a convex shape.

There is a bigger absolute movement in loan note prices
when interest rates fall than when they rise. The percentage
movement is also higher for low coupon loan notes than
high coupon loan notes. Other things being equal, a
financial manager would prefer to hold high coupon loan
notes if interest rates are expected to increase and low or
zero coupon loan notes when interest rates are expected to
decrease.

(iii) Loan note investment strategy

If interest rates are expected to rise, and the gap between

yields on short and long dated loan notes to widen, the
financial manager would not want to hold longer dated loan
notes as these would suffer a larger fall in price than short
dated loan notes. Short dated loan notes with high coupons
would be preferred.

 Report Content Errors

© 2023 BenchPrep. All Rights Reserved.

https://studymaterials.accaglobal.com/app/advanced-financial-management-afm-valid-for-exams-sept-2022-june-2023#quiz/review/categories/75… 3/3