ATW216 Test 1

February 2013

Total: 60 marks
1. Theory Questions i) Describe the cashflow characteristics of an index-linked coupon bond for the borrower. [3] For the borrower, or issuer, there is a relatively large outflow, followed by regular smaller inflows and a final larger inflow at maturity [relative size, direction, timing] [2]. The timing is guaranteed by the contract, but the actual amounts of the coupons and redemption payment are linked to an index, and are therefore unknown at the start of the transaction [certainty of timing and amount] [1].

ii) Explain the main differences between issuing a fixed-interest security and a taking out a repayment loan, in terms of the cashflow characteristics of these two transactions. [3] In both of these scenarios there is an initial large inflow [1]. For the FIS, there are regular smaller outflows followed by a large outflow repaying the initial capital [1]. For the RL, there are only regular smaller outflows these outflows consist of interest and principal portions, so the entire loan is repaid by these outflows [1].

iii) List at least 4 factors that would influence the return offered on an investment product. [2] Term (and/or term structure), type of rate, amount invested, risk of the investment, liquidity of the investment, etc. [0.5 ea.]

2. Explain in words which rates of return are represented by the following: i) [ ] This is the effective 2-year interest rate. [1]

ii)

( )

[1]

This is 3 times the nominal discount rate compounded every 4 months, or 9 times the effective four-month discount rate. [1]

iii)

[1]

This is the nominal interest (or discount) rate compounded continuously (or the force of interest). [1]

iv)

[1] This is the effective month interest rate. [1]

3. Perform the following return equivalence conversions: i) Calculate

( ( ) )

if the effective 2-month interest rate is 2%. [2]

( )

(
( )

) (

( )

) [ ] [ ]

( )

ii) Calculate
( )

if the nominal discount rate compounded once every 2 years is 7% pa. [2] ) ( ( )] ) [ ] [ ]

(
( )

iii) Calculate the effective monthly discount rate that is in effect over 5 years, if the simple discount rate applicable over those 5 years is 8% pa. [2]
( )

(
( )

) [

( (

) )]

[ ] [ ]

iv) Calculate the nominal interest rate compounded monthly that would double an investment after 4 years. [2]
( )

(
( )

) (

( )

[ ] [ ]

4. Consider a 180-day Treasury Bill that is floating in the market a number of days after issue. Calculate the number of days till maturity of this Bill, if it is currently trading at a price of R99.5 per R100 face (or final) value, and is currently valued at a simple discount rate of 5% pa. [2] ( [ ] [ ] )[ ]

5. On his birthday on 1 March 1993, James father deposited R5 000 into a savings account to pay for some of James tuition at university, should he decide to attend university after he was due to matriculate. On 1 June 1995, another R5 000 was deposited into the account. A third and final deposit of R5 000 was made into the account on 1 January 2000. The plan was for James is to receive equal amounts at the start of each of the three years 2012, 2013 and 2014.

i)

Calculate the size of these three payments if the savings account was guaranteed an 8% nominal interest return pa, compounded monthly. [4] ( [
( )

) (

( )
( )

) (
( )

( )] [ ]

[(

(
( )

)
( )

[ [( ( ) [

( ( (

) ) ) [ ]

( ( ( ) (

) ) )

][ ] ] ] )[ ]

ii) Another savings option existed at the time the account was made. This option would guarantee a nominal interest return of 12% compounded monthly until 1 January 2004. Thereafter, the guaranteed return would drop to 4% nominal annual interest, compounded monthly. Would this have been a better investment choice for James father? Show all calculations. [4] ( [ ) ( ( ) ( ) ( )] )

( [ ( (
( )

( ) )] [ ]
( )

) ( )

[(

)
( )

)
( )

)
(

]
)

[( [( ( ( ) ) ( [( )

) ( )

( ) ] ( ) ( )

][ ]

] )[ ]

So this would not have been a better investment. [0.5]

6. You are given the force of interest is ( ), a function of time in years, is as follows: ( ) {

i)

Explain the Principle of Consistency. [1] PoC states that in a consistent market the return on an investment will be the same regardless of the action of the investor [1] (as long as the investment is always fully invested). Or, ( ) ( ) ( ) ( ) ([ ])

ii) Prove

the

relationship ). [5] ( )[
( )

between

variable

force

of

interest, ( ),

and

the

accumulation ( ( ( ) ) ( )

( )[ ( ( )

] ) [ ]

( )

) ( ) [ ( )

( ) [ ( )

] ] ( ) [ ] ][ ] [ ] ( ) ] [ ] [ ] ( ) [ ]

( ( )) [ ( ( )) ( ( ))] ( ) ( ( ) ) ( ) ( ) [ ) [

( ) ( )

( ) ( ) (

( )

iii) Calculate the equivalent constant force of interest in effect over the time period from to ( ) . [4] ( ) ( ( [ ( [ ] [ ] ( ) ) ) ( )[ ] )] [ ]

iv) Calculate the equivalent effective 3-year interest rate in effect between times and ( . [3] ) ( [ ] ( ) [ ] [ ] )

v) Calculate the equivalent nominal discount rate compounded every 2 months that is applicable between times ( ) ( [ (
( )

and ) ( )]

. [3]

)[ ] [ ]

)
( )

[ ]

vi) Using your answers from above, calculate ( ( ) ( ) ( ) ( )

). [1]

[ ]

vii) Calculate the combined present value of a payment of payment of ( ) at time ( ) [1]

made at time

and a

[ ]

viii) Calculate the value at time times and

of a continuously paid payment stream paid between pa

, if the payment stream starts at a level of

a) and is constant throughout the term. [4] ( ) ( ( (

( )

) [
( )

[ ] ] )[ ]

[ [ ]

b) and increases continuously by a force of 5% pa. [4] ( ) ( ( (

( ) ( )

)) [ ] )[ ]

[ ]

[ ] c) and decreases continuously by a rate of 10% pa. [4] ( ) ( ( ( ( ( ) [ ] ) ) ) ( )

( ( ) )

(
( )

[ ] [ ]

( (

( (

)[ ]