Topic 1 - Cash flow Models

Question 1

What is a Cashflow model?

Answer 1

A mathematical projection of the

payments from a transaction

Question 2

What are positive cashflows?

Answer 2

Inflows (income)

Question 3

What are negative cashflows?

Answer 3

Outflows (outgo)

Question 4

What are inflows and outflows in the context of a pensions scheme?

Answer 4

Inflows –Employer, employee contributions

Outflows –Pension payments, transfers out, professional fees

Question 5

Briefly comment on the nature of cashflow timing(s) and amount(s)

Answer 5

Timings of cashflows may be known or unknown
 Known –person about to retire on their 65th birthday
 Unknown –Benefits payable on death-in-service*

Amount of cashflows may also be known or unknown
 Known –pension payable to above pensioner
 Unknown –pension payable to someone aged 30 now, when they retire at age 65*

Question 6

Give some examples of cashflows

Answer 6

Zero-Coupon Bond
Fixed-Interest Bond
Index-Linked Bond
Cash on Deposit (Call Deposit and Term Deposit)
Equity
Interest-Only Loan
Repayment Loan

Question 7

What is a Zero-Coupon bond? What does a typical Zero-Coupon bond cashflow timeline look like?

Answer 7

Negative cashflow at start & single known positive
cashflow at specified future date
Timeline displayed on page 15 Week 1 lecture notes

Question 8

What is a Fixed-Interest Bond? What does a typical Fixed-Interest Bond cashflow timeline look like?

Answer 8

Negative cashflow at start
Series of regular known positive payments
Positive known lump sum at specified future date
Timeline displayed on page 16 Week 1 lecture notes

Question 9

What is an Index-Linked Bond? What does a typical Index-Linked Bond cashflow timeline look like?

Answer 9

Negative cashflow at start
Series of regular Unknown positive payments
Unknown Positive lump sum at specified future date
Positive cashflows unknown as they are linked to inflation
Consider the previous 5 year fixed-interest bond, however the positive payments are now linked to inflation

Question 10

Calculate the cashflows and lump sum payment of an index-linked bond using the following inflation index.
Negative cashflow at start = £100
Positive cashflows of £5 (not indexed for inflation)
Time Index
0       100
1        102
2       104
3       107
4       110
5       112

Answer 10

Time Index Cashflow Calc
0 100 -£100 =-£100100/100
1 102 £5.10 =£5102/100
2 104 £5.20 =£5104/100
3 107 £5.35 =£5107/100
4 110 £5.50 =£5110/100
5 112 £117.60 =£5112/100 + £100*112/100

Full table available on page 18 Week 1 lecture notes

Question 11

What are the two different types of Cash on Deposit?

Answer 11

Call Deposit

Term Deposit

Question 12

What is a Call Deposit?

Answer 12

Investor can choose when to invest & disinvest
Receive daily interest on deposit
Amount & timing of cashflows unknown

Question 13

What is a Term Deposit?

Answer 13

Monies deposited for fixed term (ranging from 1 week to 1 year)
Interest rate normally fixed at outset or can vary at specified intervals
Greater degree of predictability of cashflows compared to call deposit

Question 14

What is Equity?

Answer 14

Negative cashflow at start
Series of “regular” unknown positive payments
Positive unknown lump sum at unspecified future date

Question 15

Consider the cashflows for the following:
Equity share purchased for £100
Dividends paid annually increasing at 5% p.a.
First Dividend £5

Answer 15

Time   Cashflow    Calc
0          -£100
1              £5
2          £5.25     =£5*1.05
3          £5.51      =£5.25*1.05

Question 16

What is an Interest-Only Loan? What does a typical Interest-Only Loan cashflow timeline look like?

Answer 16

Positive cashflow at start
Series of regular known negative payments
Negative known lump sum at specified future date
Timeline available page 22 Week 1 lecture notes

Question 17

What is a Repayment Loan? What does a typical Repayment Loan cashflow timeline look like?

Answer 17

Positive cashflow at start
Series of regular known negative payments
Note that the repayments consist of capital and interest so no lump sum payment at the end of the term
Timeline available page 23 Week 1 lecture notes

Question 18

State whether the absolute amount of payment(s) and timing(s) of payment(s) are known or unknown in advance for the following cashflows:
Zero-Coupon Bond
Fixed-Interest Bond
Index-Linked Bond
Call Deposit
Equity

Answer 18

Contract Absolute amount Timing of payments
of payment known known in advance
in advance?

Zero-Coupon Bond Yes Yes
Fixed-Interest Bond Yes Yes
Index-Linked Bond No Yes
Call Deposit No No
Equity No No