Investment Planning 17% (29 Questions) Flashcards
Purchasing Power Risk *Inflation Risk
(Systematic Risk)
Potential loss of the purchasing power of an investment due to inflation
Reinvestment Risk
(Systematic Risk)
Proceeds available for reinvestment must be reinvested at a lower rate of return than that of the investment vehicle that generated the proceeds
Interest Rate Risk
(Systematic Risk)
Value of equity securities may be affected by the change in interest rate risk
Market Risk
(Systematic Risk)
Risk of volatility in the overall marketplace
Affected by overall change in economy
Exchange Rate Currency Risk
(Systematic Risk)
The risk that a change in the relationship between the value of the dollar and the value of the foreign currency during the period of investment will negatively affect the investor’s return
Systematic Risk v. Unsystematic Risk
Systematic:
1. Risk w/ entire market
2. non-diversifiable risk
Unsystematic Risk:
1. Diversifiable risk.
2. The risk that affects only a specific company, country or sector & its securities
Business Risk
(Unsystematic Risk)
The uncertainty of operating income
Financial Risk
(Unsystematic Risk)
Indicates the degree to which the company uses debt/leverage to finance its operations. It increases as a company increases the percentage of debt used in its capital structure.
Default Risk
(Unsystematic Risk)
The risk that a borrower will be unable to service its debt obligations
Political Risk
(Unsystematic Risk)
The risk that the political or economic climate of a country will negatively affect an investment
Investment Mgr. Risk
(Unsystematic Risk)
The risk associated with the skills and philosophy of the individual manager of an investment fund or account
Liquidity & Marketability Risk
(Unsystematic Risk)
Liquidity:
The ability to sell an investment quickly and at a competitive price, with no loss of principal and little price concession
Marketability:
The ability to find a ready market where the investor may sell the investment
Tax Risk
(Unsystematic Risk)
The risk that taxation of investment gains or losses will negatively affect investment return
Normal Distribution
- Bell shaped curve
Arithmetic Mean:
sum of observations ÷ the total number of observations
Median:
Midpoint (arranged smallest –> largest)
Mode:
observation w/ greatest frequency
Symmetric Distribution
Mean, median, & mode are EQUAL
50% chance that observation will fall to right of the mean & 50% chance that observation will fall to the left of the mean.
Right Tail (+) skewed
- Mean highest of 3 measures
Left To Right:
Mode- Median- Mean
- More outliers to the right of the mean than to the left.
Left Tail (-) skewed
- Mode is largest of the three measures
Mean-Median-Mode
- More outliers to the left of the mean than to the right.
Kurtosis
(more or less peaked than normal distribution)
Measures whether a distribution is more or less peaked than a normal distribution
Lepokurtic
(more peaked)
MORE peaked than a normal distribution
- More observations clustered closely around the mean
*For investors who want to minimize VOLATILITY in their portfolio
Platykurtic
(less peaked)
LESS peaked than a normal distribution
- More observations w/ large deviations from the mean
Lognormal Probability Distribution
One in which the series of observations is skewed to the LEFT of the arithmetic mean
A lognormal probability distribution implies that there is a greater than 50% chance that an observation selected at random will fall to the left of the mean
Indicating performance that is less than expected or predicted
Covariance
Measure extent to which two variables move together (+) or (-).
Correlation Coefficient
*Combining not perfectly correlated securities will reduce portfolio risk
Measures extent two returns on any two securities are related.
-1.0 = Move in opposite directions ↑ ↓
+1.0 = Movement is identical ↑ ↑
0.0 = Security movements are unrelated
Beta
Measure of systematic risk
Beta > 1 = more risky than the market
Beta < 1 = less risky than market
Market Beta = 1
Portfolio beta is calculated by weighting the individual assets betas and adding the results
Portfolio Weighted Beta
=
Total Product (#)
÷
Total FMV(#)
Standard Deviation
The dispersion of outcomes around the mean.
The greater the SD = the greater the risk
68% w/in 1 SD of mean
95% w/in 2 SD of mean
99% w/in 3 SD of mean
Simple Return
Interest = principle x interest rate x time
John borrows $1000 for 2 years @ 8%. What is interest charged.
1000 X .08 X 2 = $160.
*John would ultimately pay $1160 back to lender
Compound Interest
Interest earned on interest
John invest $1000 for 2 years @ 8%
PV: 1000
N: 2
I/YR: 8
Solve for FV: $1166.40
Holding Period Return
Total return of an investment for the given period over which the investment is owned
HPR = ending value - beginning value (+ or -) cash flows ÷ beginning value
Arithmetic Mean
Sum of observations
÷
total # of observation
Expected Rate of Return
Probability x single period rate of return
Probability (30%)
Single Per. Return (.50)
= 15%
Inflation Adjusted Rate of Return
[(1 + Rate of Return) ÷ (1 + Inflation Rate) -1] X 100
Nominal Annual Percentage Rate
(Compounded not involved)
Yearly cost expressed as a %
*If lender advertises 1.25% monthly, the APR = (1.25% X 12 mos)= 15%
Tax Adjusted Return
TAR= return x( 1- marginal tax bracket)
Ex:
Allision: 32% tax bracket
Corp Bond Coupon: 7%
7% X (1-.32) = 4.76%
Time Weighted Return v. Dollar Weighted Return
Time Weighted:
1. Measure return w/o considering w/d’s or deposits
2. Preferred method for portfolio mgr. performance
Dollar Weighted:
1. Provides assessment of actual performance including w/d’s and deposits.
2. CF method for this problem.
Tax Adjusted Return
TAR = realized return X (1- marginal tax bracket)
Ex:
Allison 32% tax bracket
Corp Bond coupon 7%
TAR = [7% X (1-.32)]
TAR = 4.76%
Risk Adjusted Returns
RAR = Actual Rtn ÷ Beta
Asset Allocation Client Considerations for Advisor
T-H-R-E
Client’s
Tax Situation
Horizon
Risk Tolerance
Economic Forecast
Strategic Asset Allocation
- Appropriate allocation based on the long-term financial goals of the client.
- Mirrors mkt index that seeks low cost means of generating long term returns w/ minimal turnover
Rebalance 1-2x/yr
Tactical Asset Allocation
(constant changing of mix of asset classes)
- Active Mgr w/ short term market adjustments,
- Tries to time market w/ indiv. stock picking
Sell overvalued security
Buy undervalued security
Core & Satellite Asset Allocation
Core:
Passive philosophy to achieve mkt based returns
Investing in broad mkt indexes (S/P 500)
Satellite:
attempt to achieve above mkt returns though high risk alternatives & global exposure
(REITS, high yield bonds, emerging mkts)
Current yield (CY)
(Bond Valuation)
CY = annual interest payment ÷ current market price
Jeff has a bond with an annual coupon rate of 4.25% that is currently trading at $965.
What is the bond’s current yield?
$42.50 ÷ $965 = 0.0440, or 4.40%
Yield to Maturity (YTM)
Bond Valuation
The internal rate of return (IRR) for cash flows associated with the bond, including the purchase price, coupon payments, and maturity value
Ex: End Mode 2 p/yr
Bond currently at $970
PV: +/- 970
PMT: 30
FV: 1000
N: 15
I/YR: 6.31%
Duration
Determines the weighted average number of years until an investment is recovered.
Fundamental Analysis
Fundamental analysis is concerned with the earnings potential and risk associated with a PARTICULAR firm.
Top Down:
Economy
Industry
Specific Company
Bottom Up:
Reverse of Top Down
The process of determining the fair or intrinsic value of a security. This value is then compared with the current market value to determine what course of action will be undertaken: buy, sell, or hold
(Factors: Econ environment, stock mkt tendencies, int rates & biz cycles)
Focuses on company’s PERFORMANCE & EARNINGS that company’s industry, and its financial statements. Looks at financial P/E ratios Look at a company’s financial condition, as revealed by its income statement and balance sheet
Technical Analysis
Is an attempt to determine the demand side of the supply/demand equation for a particular stock or set of stocks
Rely on stock charts PRICE & VOLUME
believe that the history of the stock price will tell the whole story of the security and that there is no need to be concerned with corporate factors such as earnings, financial leverage, product mix, and management philosophy
NOT USED FOR Efficient Market Hypothesis
Price to Earnings Ratio
P/E Ratio
P/E = mkt price per share ÷ earnings per share
indicates what the market is willing to pay per dollar of earnings.
P/E = mkt price per share ÷ earnings per share
If ABC Stock is currently trading for $50/share and has an earnings per share of $2.50, the P/E ratio would be 50 ÷ 2.5 = 20
High PE = overpriced
Low PE = buying opp!
Price to Earnings Dividend by Growth PEG Ratio
PEG = P/E ÷ g
Is a measure of relative valuation that can be used to com-pare companies with different growth rates
Companies with a low PEG ratio will have higher rates of return
Stocks with PEGs < 1.0 will have higher future rates of return & are good value stocks.
Dollar Cost Averaging (DCA)
Purchasing securities over times predetermined amounts at regular intervals.
Buy less securities when market rises
Buy MORE securities when market falls
Works best in fluctuating markets.
Value Averaging
Aims to have MV of account increase at regular intervals to predetermined amounts.
Amounts are either invested or shares are liquidated to bring account MV in line with predetermined target.
Share Averaging
Investor buys the same amount of shares every time.
Dividend Reinvestment Plans (DRIPs)
Dividends are automatically reinvested back into the company’s stock
Reinvested dividends are treated the same for tax purposes as cash dividends
Bond Ladder
Bonds with equal dollar amounts but w/ staggered maturities (3 yrs, 2 yrs, 1 yr)
Helps reduce portfolio interest rate risk
Bond Barbell Strategy
Portfolio consisting of short term & long term bond maturities
Active mgmnt required for this strategy.
Bullet Bond Strategy
Bonds with target maturity date to match the cash needs of an investor.
Parents buying bonds for child’s expected college start date (Bonds each maturing in 14 yrs.)
Buy & Hold Investing Strategy
Buying a set percentage of assets in each class.
Buying an index fund
Transaction cost & taxes are minimized
Passive Investing (Indexing)
*Diversified & low turnover
Based on the concept that the markets are efficient in pricing securities and that it is unlikely that an investor will be able to outperform the market on a consistent basis
Active Investing
Based on the concept that above-market returns can be achieved through security selection & market timing.
Those who believe that active management can outperform the market do not believe the market is perfectly efficient.
Short Selling Investing
Elayne believes ABC stock is overpriced.
She sells short 100 shares of ABC when it is trading at $100 per share.
Three months later ABC may be purchased for $85 per share.
Elayne repurchases 100 shares of ABC on the open market and replaces the borrowed stock for a profit of $15 per share, or $1,500.
Margin Transactions
Margin- When an investment is purchased on margin, one-half of the funds are put up by the investor and one-half is borrowed from the broker (assumes a 50% initial margin)
a. Initial margin—the percentage of the original purchase that must be provided by the investor (currently 50%)
b. Maintenance margin—the level at which an investor will be required to add funds to the margin account. Maintenance margins are usually set at 35% but may differ from broker to broker.
c. Debit balance—the loan amount owed to the broker. This amount will include the original amount borrowed plus any accumulated interest.
d. Equity—the value of the security less the debit balance. Another term for equity is “margin.” The margin in a stock is the equity, not the debt.
Margin call =
debit balance ÷ 1 − maintenance margin
Margin Call (Example)
Harry pays $20,000 to purchase shares of Solvent Company (trading at $25 per share). If Harry uses a margin account (50% initial margin) to purchase this stock, he can buy 1,600 [(20,000 × 2) ÷ 25] shares. An amount of $20,000 is borrowed from the broker. Harry is concerned about receiving a margin call. At what point will Harry receive a margin call (assume a maintenance margin of 35%)?
Margin call =
debit balance ÷ 1 − maintenance margin
margin call =
$25 × 0.50 ÷ 1 − 0.35 = $19.23
Harry will receive a margin call when the price of the stock declines below $19.23.
NOTE: Margin call can be determined on a per share basis or on a total market value basis.
Call Option
A right to BUY a security for a specified price w/in specified timeframe
Buy (being long) a call
Write (being short) a call
Put Option
A right to SELL a security for a specified price w/in specified timeframe
Buy (being long) a put
Write (being short) a put
CALL
Options Max Gain & Losses
Buy (being long) a call
Write (being short) a call
Bull v Bear Options Mkt
Bullish:
mkt prices ↑
Buy a CALL
Write a PUT
Bearish:
mkt prices ↓
Write a CALL
BUY a PUT
Intrinsic Value of Call Option
ABC Stock currently trading at $45
Call Option at $40
Intrinsic Value of Call Option = $5
*If ABC was trading at $35
intrinsic value = $0 b/c you could buy stock for less than your $40 call option.
Intrinsic Value of Put Option
ABC stock currently trading at $45
Put Option at $40
Intrinsic Value of Put Option: $0
*If ABC was trading at $35
intrinsic value = $5
Efficient Market Hypothesis (EMH)
Weak:
Fundamental/ insider info
Semi strong:
No Fundamental/ only insider info
Strong: stock price reflect all public & priv. info
No Fundamental/ no insider info
Investors are unable to outperform the market on a consistent basis.
Current stock prices reflect all available information for a company & that prices adjust to reflect any new information.
Any new information must be unexpected, therefore any changes in the stock price resulting from this new info will be random.
Expected Return
Exp Rtn = Rtn x Prob
Add each observation together if multiple selections.
Return Probability
A: 12% 0.15
B: 11% 0.55
C: 8% 0.30
What is the expected return of the portfolio?
E(r) = P1(R1) + P2(R2) + P3(R3)
Current Yield
Current Yield = Annual Interest Payment ÷ Current Market Price
8% coupon bond, maturing in 5 years, & selling currently for $850. What is current yield?
CY = $80 ÷ $850
CY = 0.09412, or 9.41%
If a bond is immunized against interest rate risk, a dollar decrease in the bond’s price, resulting from rising interest rates, will be approximately offset by a dollar increase in the:
Income from coupons reinvested over the investment horizon.
By investing in bonds that have a duration equal to the investor’s investment time horizon, any bond price/value changes caused by interest rate fluctuations, will be approximately offset by changes in the interest earned on the reinvested coupons.
- An investor purchasing a high price-to-earnings ratio is exploiting the P/E effect anomaly.
- An investor studying annual reports and analysts’ reports in his stock selection process believes that markets are weak-form efficient.
- An investor who buys the securities of firms that are not followed by many analysts is trying to benefit from the neglected-firm effect.
- An investor who befriends the chauffeur of a firm’s CEO to solicit information about the firm’s plans before making investment decisions believes the markets are strong-form efficient.
- An investor who buys the securities of firms that are not followed by many analysts is trying to benefit from the neglected-firm effect.
- An investor who befriends the chauffeur of a firm’s CEO to solicit information about the firm’s plans before making investment decisions believes the markets are strong-form efficient.
The P/E effect suggests that portfolios consisting of stocks with low price-to-earnings ratios have higher average returns than do portfolios consisting of stocks with high P/E ratios. Strong-form market efficiency suggests that all public and private information is included in market prices. A person who solicits private information believes that it is possible to profit by making trading decisions based on private information, and does not believe that the markets are efficient in the strong form. Weak-form efficiency suggests that all historical price and volume information is included in stock prices but that gains may be made by analyzing other publicly available information.
Mark’s company, located in Oregon, makes unfinished wood furniture. The company sells furniture directly to the public from a large warehouse. Theresa’s company, located in southern Georgia, grows cotton for t-shirts manufacturers. Which of the following statements correctly identifies hedging strategies for Mark and Theresa?
I. Mark should buy lumber futures.
II. Theresa should sell cotton futures.
III. Mark should sell lumber futures
IV. Theresa should buy cotton futures.
I. Mark should buy lumber futures.
II. Theresa should sell cotton futures.
Mark is SHORT lumber because he needs lumber to produce his products. A hedge position for Mark would be to go long lumber futures, that is, to purchase lumber futures.
Theresa is LONG cotton because she owns cotton for manufacturing purposes. A hedge position for Theresa is to go short, that is, to sell cotton futures.
Immunization offsets which two risks in a bond portfolio?
Interest rate risk
Reinvestment rate risk
Lucy is considering purchasing shares in ABC stock that have
a 35% probability of experiencing a negative 10% return,
a 40% probability of experiencing a positive 12% return,
a 25% probability of experiencing a positive 5% return.
If Lucy has a required rate of return of 7%, should she invest in the stock?
The expected rate of return for ABC stock is 2.55%, calculated as follows: (0.35 × –0.10) + (0.40 × 0.12) + (0.25 × 0.05) = 0.0255, or 2.55%.
Therefore, Lucy should not purchase the stock because the expected rate of return is lower than her required rate of return.
As investors’ required rates of return decrease due to a decrease in interest rates caused by expectations of lower inflation rates, the stock market and investors can be expected to react in which of the following ways?
The value of stocks will increase, and investors will buy them because the lower required return increases the present value of future stock benefits.
Sally, Michael, and Anita use different methods for choosing assets for their investment portfolios. Sally uses technical analysis to determine when to buy and sell the stocks in her portfolio. Michael is committed to a passive investment strategy and a well-diversified portfolio of randomly selected stocks. Anita ignores historical volume and price information but reviews the financial statements of the firms in which she is interested. Which of the following statements best describe Sally, Michael, and Anita?
I. Anita accepts the strong form of the efficient market hypothesis (EMH).
II. Michael accepts the semi-strong form of the EMH.
III. Sally accepts the weak form of the EMH.
Under the weak form of the EMH, access to fundamental analysis and insider information can achieve superior results.
Under the semistrong form of the EMH, only access to insider information can achieve superior results.
Under the strong form of the EMH, not even access to insider information can achieve superior results.
Anita uses fundamental analysis, which is supported only by the weak form of EMH.
Michael does not use fundamental or technical analysis. His strategy is supported by the semistrong and strong forms of the EMH.
Sally uses technical analysis, which is rejected by all forms of the EMH.
Holding Period Return
Ralph bought 400 shares of LOA stock at $36 per share on margin (assume a 50% initial margin requirement). The margin interest was 7.5% annually. He sold the stock after one year for $49.50 per share. LOA did not pay any dividends during the holding period. What was Ralph’s holding period return using margin?
Answer: 67.50%
His HPR using margin was 67.50%, calculated as follows:
Ending value = 400 shares × $49.50 per share = $19,800
Beginning value = 400 shares × $36.00 per share = $14,400
Cash outflow = margin interest = 0.075 × 0.50 × $14,400 = $540
Initial investment = 0.50 × $14,400 = $7,200
HPR = ($19,800 − $14,400 − $540) ÷ $7,200 = 67.50%
Baylor stock is currently selling for $63 per share. A put option for this security with an exercise price of $65 per share can be purchased for $4 per share. The option expires in 3 months. Which of the following statements best describes this option?
A) Out-of-the-money
B) By-the-money
C) In-the-money
D)At-the-money
C) In-the-money
A put option is in-the-money when the exercise price > than the market price of the underlying security.
A put option is out-of-the-money when the market price is > than the exercise price.
DCA
- This technique involves investing a specific amount into an investment vehicle, regardless of whether the recent trend in the investment has been up or down.
- If prices decline, the fixed investment amount will purchase a greater quantity of the security.
- For the long-term investor, the presumption is that prices will eventually rise, so a lower average price translates into greater profits.
Jim Tripp is in the 32% tax bracket.
If Jim invests in a 4.75% municipal bond, his taxable equivalent yield (TEY) would be:
6.99%
TEY = tax-exempt yield ÷ (1 − marginal tax rate)
4.75% ÷ (1 − 0.32) = 6.99%
Arbitrage Pricing Theory (APT)
The APT determines returns based on multiple factors. These factors might include inflation, growth in GDP, major political upheavals, or changes in interest rates.
The security market line (SML):
The security market line (SML) shows the relationship between the rate of return and systematic risk (beta).
Thus, the SML depicts a security’s expected return as a function of its systematic risk
Grant purchased 100 shares of XYZ stock on margin when it was selling for $75 per share.
Today, the stock price fell to $52 per share. If the initial margin was 50% and the maintenance margin is 40%.
How much will his broker ask him to add to his account to satisfy the margin call?
Grant’s current equity in XYZ: $52 − (50% × $75) = $14.50
Required equity: $52 × 40% = $20.80
Difference: $6.30 × 100 shares = $630
Beatrice, a portfolio analyst, is reviewing the performance of the following diversified portfolios.
5-year average return σp βp
Portfolio A 8.65% 10% 1.36
Portfolio B 7.45% 12% 1.52
The risk-free rate of return is 1.55%
Portfolio A
Sp = (0.0865 - 0.0155) ÷ 0.10 = 0.71
Tp = (0.0865 - 0.0155) ÷ 1.36 = 0.05221
Portfolio B
Sp = (0.0745 - 0.0155) ÷ 0.12 = 0.4971
Tp = (0.0745 - 0.0155) ÷ 1.52 = 0.03882
Security A has a standard deviation of 23% and the market has a standard deviation of 18%. The correlation coefficient between Security A and the market is 0.80. What percent of the change in Security A’s price can be explained by changes in the market?
64%
Because the correlation coefficient is 0.80, the coefficient of determination (R-squared) is 0.64 (.80²) Therefore, 64% of investment returns can be explained by changes in the market (i.e., systematic risk represents 64%).
A benefit offered by a fund of funds (FoF) over a traditional hedge fund is:
economies of scale.
Benefits of FoF over traditional hedge fund investing include expertise and information advantage, monitoring, immediate exposure, improved diversification, economies of scale and accessibility, liquidity, improved access to managers, lower negotiated fees, education, more favorable regulation (not necessarily less regulation), possible currency hedging, and leverage opportunities. FoFs usually result in less investment transparency and FoF investors must give up control through the FoF form of hedge fund investing.
A call option to purchase 100 shares of WARCO common stock at an exercise price of $40 is currently priced at $15. WARCO’s common stock is currently selling for $50. Which of the following statements are CORRECT?
I. The time value of the call option is $5.
II. The call option is out-of-the-money.
III. A writer of the call option will receive a premium of $1,000.
IV. The intrinsic value of the call option is $10.
I. The time value of the call option is $5.
IV. The intrinsic value of the call option is $10.
The time value of the call option is calculated as follows: time value = market price of call option − intrinsic value of call option.
Intrinsic value = $50 − $40 = $10. Time value = $15 − $10 = $5.
Because the current market price of the stock is greater than the exercise price, the call option is in-the-money.
The writer will receive an option premium of $1,500 (100 shares × $15 call option price).
John sells a naked call option for a $3 premium.
The call option has an exercise price of $20. Which of the following statements is CORRECT?
A) John’s maximum gain is $3
B) The call will likely not be exercised while the stock is trading at $24
C) John’s loss is limited to $20
D) The option will not be exercised until the market price is $17
A) John’s maximum gain is $3
John’s maximum gain is $3, but his MAX LOSS IS UNLIMITED.
Because the call option was written as a naked call option, the seller (John) will have to buy the stock at the prevailing market price if the call option is exercised by the buyer. The buyer would exercise the call option when the stock price exceeds $20. Any price level over $20 begins to reduce the call option buyer’s potential loss, and at $23 the seller and buyer break even.
Zero Coupon Bond
I. The investor must recognize annual interest accumulation as taxable income, even though no money is actually received.
II. Duration = YTM
III. A zero-coupon bond sells at a deep discount to par value.
IV. An increase in market interest rates adversely impacts the market value of the bond.
Security Master Line
(Uses Beta)
Depicts the risk-return relationship for efficient portfolios of securities.
Securities OVER SML line are “undervalued”
Securities UNDER SML line are “overvalued”
Black/Scholes European call option pricing model
An ↑ in the RFR ↑ the value of the European call option.
An ↑ in the price of the underlying stock and/or the variability in the price of the underlying stock ↑ the value of the European call option.
An ↑ in the time to expiry also ↑ the value of the European call option
Preferred Stock
I. Preferred stockholders are paid after bondholders but before common stockholders in terms of priority of payment of income and in case of corporate liquidation
II. If the issuer of a cumulative preferred stock fails to pay the dividend in any year, the unpaid dividend(s) will have to be paid in the future before common stock dividends can be paid.
III. Preferred stock dividends are not legally binding but must be voted on each period by the corporation’s board of directors.
IV. Preferred stock dividend income continues forever, unless the stock issue is called or otherwise retired
Simon and Alexandra Baker are interested in U.S. savings bonds. The couple is expecting their first child in three months. Their financial goals are to save for retirement and the education of their child. The Bakers should purchase:
Series I bonds for inflation-protected savings for their child’s education.
Series HH bonds cannot be purchased and are no longer available for exchange of Series EE bonds.
To receive the tax benefits for qualified higher education, Series EE or I bonds must be purchased by a taxpayer who is at least 24 years old and who uses the proceeds to finance qualified education expenses for himself, his spouse, or a dependent.
Series I bonds provide inflation protection because they have a fixed base rate and an inflation adjustment. However, they do not provide tax-free earnings for retirement.
YIELD TO MATURITY
Jeff purchased a 30-year bond for $977.36 with a stated coupon rate of 8.5%. What is the yield to maturity for this investment if Jeff receives semiannual coupon payments and expects to hold the bond to maturity?
The yield to maturity for this bond is 8.71% calculated as follows:
End Mode
2 P/Y
PV: –(977.36)
N: 60 (30 × 2)
PMT: 42.50 (85 ÷ 2)
FV: 1,000
Solve for I/YR : 8.71%
Interest Rate Change in Bonds Price:
Lauren owns a AA rated corporate bond with a current market value of $987.34. The bond’s YTM changes from 5.45% to 4.98%. What is the estimated percent change in the price of the bond assuming a Macaulay duration of 4.6 years?
2.05%
ΔP/P = -D x (new yield - old yield) ÷ (1 + old yield)
ΔP/P = −4.6 × [(0.0498 − 0.0545) ÷ (1 + 0.0545)]
ΔP/P = −4.6 × (−0.0047 ÷ 1.0545)
ΔP/P = 0.0205, or 2.05%
Change in Price = -D x (new yield - old yield) ÷ (1 + old yield)
bond portfolio immunization
I. Duration = to the investor’s investment time horizon.
II. Immunization allows an investor to earn a specific rate of return, regardless of whether interest rates increase or decrease.
