Investment Management

INVESTMENT MANAGEMENT
TUTORIAL SET 1
QUSETION 1
Consider two investments A and B with the following annual returns
Year As Return Bs Return
1 4% 14%
2 5% 12%
3 6% 10%
Compute the correlation between the return on A and B.
Answer
The correlation between return on A and B is
AB
AB
A B

.
R
A
R
B
(R
A
-E(R
A
))
2
(R
B
-E(R
B
))
2
(R
A
-E(R
A
))(R
B
-E(R
B
))
4 14 1 4 -2
5 12 0 0 0
6 10 1 4 -2
15 36 2 8 -4

15 36
5 12
3 3
A B
E( R ) , E( R )

2 2
2 8 4
3 3 3
A B AB
, ,
4
3
1
2 8
3 3
AB
AB
A B

QUSETION 2
Consider two investments A and B with the following annual returns
Year As Return Bs Return
1 7% 14%
2 5% 10%
3 3% 6%
Compute the covariance and correlation between the return on A and B.
Tutorial Questions Set 1 1
Investment Management
Answer
The correlation between return on A and B is
AB
AB
A B

.
RA RB (RA
-E(RA))
2
(RB -E(RB))
2
(RA -E(RA)) (RB
-E(RB))
7 14 4 16 2x4=8
5 10 0 0 0x0=0
3 6 4 16 -2x-4=8
15 30 8 32 16
15 30
5 10
3 3
8 32
3 3
16
3
A B
A B
A B
E( R ) %, E( R ) %
Var( R ) , Var( R ) ,
Cov( R ,R ) ,

16
3
1
8 32
3 3
A B
A B
Cov( R ,R )

.
QUSETION 3
Asset price in
USD
USD\SGD rate of
exchange
Start of January 10.00 2.00
End of June 11.00 2.00
End of December 15.00 1.60
Compute the continuously compounded SGD per annum rate of return, for a
Singaporean investor, investing in the above US asset over the one year interval.
Show that this per annum rate of return,
(i) can be decomposed into (1) a rate of return on the asset and (2) a
rate of return on currency and
(ii) is consistent with the rate of return achieved in the first six-months of
the year and the second six-months of the year.
Tutorial Questions Set 1 2
Investment Management
Answer
The continuously compounded return is computed as

,
_

before
now
P
P
ln r
(i)
0 1 1 1
0 0 0 1
0 1
0 1
overall
equity foreign exchange
E P E P
r ln ln( )
P E P E
E P
ln ln r r
P E

+ +
(ii) Consider the return in USD over the year
4055 . 0
10
15
ln r
,
_

The two year continuously compounded increase in the SGD value is

(+18,23%) is equal to the USD increase (+40.55%) plus the appreciation of
the USD against the SGD (-22.31%)
Asset price
in USD
USD\SGD
rate of
exchange
Asset price
in SGD
Return
Start of January 10.00 2.00 20.00
End of June 11.00 2.00 22.00 9.53%
End of
December
15.00 1.60 24.00 8.70%
Whole year 40.55% -22.31% 18.23% 18.23%
The annual continuously compounded increase in the SGD value is (+18.23%)
is equal to the first year change (9.53%) plus the second year change (8.70%).
Tutorial Questions Set 1 3
Investment Management
QUSETION 4
Suppose immediately after you purchased a 5 year 10% (paid semi-annual) coupon
bond, yields fell from a flat 8% to a flat 6% and remained there for 5 years of your
investment.
Compute realized HPY on
a) quarterly-annual compound basis and,
b) continuously compound basis.
Answer
b) 5 year 10% pa (semi-annually) coupon bond.
(1) HPY on quarterly-annual compound basis
1
20
5 4
1 1 4
4
buy
buy
r FV
FV P ( ) HPY
P

1
_
1
+

1
,
1
]
10
10
10
10 0 03
0 10
100 5
2
1
1 1 0 04 100 100
5 5 8 111 108 12
0 04 1 04 1 48
1 1
1 03 1
100 100 5 100 57 32 157 32
0 03
buy
n n i
n
sell coupon
n i
.
.
c
F
P ca
( i )
( . )
. .
. ( . ) .
( i )
FV P S S
i
( . )
cS . .
.
1

1
1

+
+
+
+ +
+
+

+ + +
1
20
157 32
1 4 7 57
108 12
1 89
.
HPY . % p.a.
.
. % per coupon period
1
_
1


1
,
]

(2) HPY on continuously compounded basis

1
1 157 32
7 50
5 108 12
rt
buy
buy
FV
FV P e HPY ln
t P
.
HPY ln . % p.a.
.


Tutorial Questions Set 1 4
8%6%
5 yrs=10 periods
Investment Management
QUSETION 5
Consider the yields
Week Yield
0 10.0% p.a.
1 11.0% p.a.
Compute an annualized continuously compounded holding period return for an
investment entered into week 0 and exited week 1 if yields refer to
1) 90 day bank bill,
2) 10 year 10% semi-annual coupon bond.
Answer
The annualised continuously compounded holding period return is derived from the
equation
1
rt sell
sell buy
buy
P
P P e . HPY r ln .
t P

(1) 90 day discount bank bill
Recall that 1
1
FV
FV P( rt ) P
rt
+
+
and assume that FV = 100, then
100
97 5936
90
1 0 10
365
100
97 5597
83
1 0 11
365
buy
sell
P .
.
P .
.

+

+

1 52 97 5597
1 81
1 97 5936
sell
buy
P .
HPY ln ln . % p.a.
t P .


(2) 10 year 10% p.a. semi annual coupon bond.
100
buy
P FV ( par bond ).
Tutorial Questions Set 1 5
10% 11%
90 days 7 days 0
83 days
10% 11%
period 20
(10 years)
1week
period 1
(26 weeks)
0
19 periods
Investment Management
To evaluate
sell
P
, find
(Step 1:)
19
19
0 10
100 5
2
1 1
1
0 11
1 1
100 2
5 94 1962
0 11
0 11
1
2
2
n
next coupon date
n n i n i
next coupon date
.
c ,
FV ( i )
P ca where a .
( i ) i
.
P .
.
.

1 1

+
+
+
_
+

,
+
_
+

,
(Step 2:)Add coupon to the PV of the bond at the next coupon date:
5 + 94.1962 = 99.1962
and (Step 3:)Discount back to week 1 (sale date):
25
26
99 1962
94 2187
0 11
1
2
sell
.
P .
.

_
+

,
Then
1 52 94 2187
3 096 309 6
1 100
sell
buy
P .
HPY ln ln . . % p.a.
t P

Tutorial Questions Set 1 6