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Question 1

Calculate the nominal rate of interest per annum convertible half yearly that is equivalent to:

 (i) an effective rate of discount of 0.5% per month; [2] (ii) a nominal rate of discount of 6% per annum convertible every 2 years; [2] (iii) a nominal rate of interest of 6% per annum convertible quarterly. [2] [Total 6]

Question 2

The following table gives information concerning an investment fund:

 Year 2007 2008 2009 2010 Value of fund at 30 th June  1,250,000 1,360,000 1,450,000 Net cash flow received on 1 st July  50,000 40,000 30,000 Value of fund at 31 st December 1,000,000 1,300,000 1,390,000 1,500,000

(i)

(ii)

Calculate, to the nearest 0.1%, the effective annual time weighted rate of return (TWRR) achieved by the fund during the period from 31 st December 2007 to 31 st December 2010.

[4]

It can be shown that the effective annual money weighted rate of return (MWRR) achieved by the fund over the same period is different from the answer obtained in (i).

Explain briefly the key differences between the TWRR and the MWRR.

[2]

[Total 6]

Question 3

A fixed interest loan stock bearing interest at a rate of 4% per annum payable half yearly in arrears is issued by a company.

The stock is to be redeemed at 110% on any coupon payment date from 10 to 15 years after issue, with the exact date of redemption at the discretion of the company.

An investor, liable to income tax at 25% and capital gains tax at 40%, purchases the stock at outset at

a price which gives a minimum net yield to redemption of 4% per annum effective after tax.

Calculate the price per £100 nominal paid by the investor.

[6]

Question 4

A loan of £10,000 was issued on the 1 st January 2008, and was repaid at par exactly two years later. Interest was paid on the loan at a rate of 8% per annum payable annually in arrears.

The value of the Retail Prices Index over the period was as follows:

 Date Retail Prices Index 1 st January 2008 140.0 1 st January 2009 145.0 1 st January 2010 148.0

Calculate, to the nearest 0.1%, the real rate of return per annum earned by the lender.

[5]

Question 5

A property developer is constructing a block of offices.

It is anticipated that the offices will take 6 months to build. The developer will incur costs of £400,000 at the start of the project and a further £30,000 at the end of each month during the building period.

It is expected that rental income from the offices will be £120,000 per annum, received monthly in

arrears from the end of the building period. In addition, maintenance and management costs are expected to be £20,000 per annum, payable monthly in arrears from the end of the building period.

Using an effective rate of interest of 1% per month, find the discounted payback period for the project.

[7]

Question 6

An investor is considering the purchase of a number of ordinary shares in ABC plc.

Dividends from the share are payable half yearly. The next dividend is due in 6 months and is expected to be 5 pence per share.

 (i) Using a required rate of return of 4% per half ‐ year effective and an estimated rate of future dividend growth of 1% per half ‐ year , find the maximum price that the investor should pay for the portfolio of 1,000 shares. [4] (ii) As a result of the company announcing the launch a new product, the investor increases the estimated rate of future dividend growth to 2% per half ‐year. Calculate the maximum price the investor should now pay for the portfolio of 1,000 shares and comment on your answer (compared with that in (i) above). [2] (iii) The company has just appointed a new Chief Executive and, as a result, the investor decides to increase the required rate of return to 5% per half ‐year effective. (a) Briefly explain why it might be appropriate for the investor to increase the effective rate of interest in this case. [1] (b) Using the original estimated dividend growth rate of 1% per half ‐ year, calculate the maximum price that the investor should now pay for the portfolio of 1,000 shares and comment on your answer (again, compared with (i) above). [2] (iv) The investor fears that, as a result of change in government policy, inflation rates in the economy are likely to rise in future. As a result, he increases both the estimated rate of dividend growth and the required rate of return by 2% per half ‐year effective (i.e. to 3% and 6% per half ‐ year respectively).

(a)

(b)

Briefly explain why it is appropriate for the investor to increase both the future dividend growth rate and the required rate of return in this case.

[2]

Calculate the maximum price that the investor should now pay for the portfolio of 1,000 shares and comment on your answer (again, compared with (i) above).

[2]

[Total 13]

Question 7

A company is considering a project which requires an immediate payment of £2,000,000 and a further payment of £4,450,000 in one year’s time.

Income from the project will be received continuously from the start of the second year at a rate of £1,500,000 per annum, and this rate is expected be 3% greater in each subsequent year until the project finishes at the end of year 10.

Calculate the net present value of the project at 10% per annum effective.

[6]

Question 8

The following spot rates of interest were observed at time t 0 :

 term, n years 1 2 3 4 5 6 spot rate per annum, y n 4.0% 4.5% 5.0% 6.0% 6.5% 6.5%

(i) Calculate the two year forward rate of interest at time t 2 ,

f 2,2

.

 [2] (ii) Calculate the 6 ‐ year par yield at time t  0 . [3] [Total 5]

Question 9

£2,000 is invested in a bank account which pays interest at the end of each year.

The rate of interest is fixed randomly at the beginning of each year and remains unchanged until the beginning of the next year. The rate of interest applicable in any one year is independent of the rate applicable in any other year.

During the first year the effective rate of interest per annum will be one of 4%, 7% or 9% with equal probability. During the second year, the effective rate of interest per annum will be either 5% with probability 0.7 or 8% with probability 0.3.

Assume that the interest earned is reinvested in the account.

(i)

(ii)

Calculate the expected accumulated amount in the bank account at the end of two years.

[3]

Calculate the standard deviation of the accumulated amount in the bank account at the end of two years.

[5]

[Total 8]

Question 10

The force of interest at time t , t , is given by:



t

0.03 0.005

t



0.045

0.02

0.0025

for 0

for 2<

for

 

t

2

10

tt

t

10

(i)

(ii)

Calculate the accumulated amount at time t 8 of an investment of £10,000 made at time

t 1 .

[4]

Calculate the present value at time t 0 of a payment stream, paid continuously from time

t 10 to time t 12 , under which the rate of payment at time t is

t

100 e

0.02

t

.

[6]

[Total 10]

Question 11

A loan is repayable by annual instalments in arrears for 20 years. The initial instalment is of amount £5,000, with each subsequent instalment decreasing by £200.

The effective rate of interest over the period of the loan is 4% per annum.

 (i) Calculate the amount of the original loan. [3] (ii) Calculate the capital repayment in the 12 th instalment. [3] (iii) After the 12 th instalment, the borrower and lender agree to a restructuring of the debt.

The £200 reduction per year will no longer continue. Instead, future instalments will remain at the level of the 12 th instalment and the remaining term of the debt will be shortened.

The final payment will then be a reduced amount which will clear the debt.

 (a) Calculate the remaining term of the revised loan. (b) Calculate the amount of the final reduced payment. (c) Calculate the total interest paid during the term of the loan.

[8]

[Total 14]

Question 12

 (i) An irredeemable fixed‐interest stock pays coupons of c per annum, with the next coupon payment due in exactly one year’s time. The effective interest rate is i per annum. Show that the discounted mean term of the stock is:  i   1  1 i [4] (ii) A large institutional investor has liabilities of £20 million due at time t  5 and £30 million due at time t  10 . The corresponding assets consist of a zero ‐coupon bond redeemable in exactly one year’s time and an irredeemable stock paying annual coupons of 3% per annum with the next coupon being due in exactly one year’s time. If the effective rate of interest is 4% per annum, calculate the nominal amount of each asset that the institutional investor should hold in order that Redington’s first two conditions for immunisation against small changes in the rate of interest are satisfied. [8] (iii) Without undertaking any further calculations, comment on whether it is likely that the third condition for immunization is also being satisfied.

[2]

[Total 14]