Posted: August 26th, 2021
Student’s Name
Instructor’s Name
Course
Date
Portfolio Management Assignment
Section 1
Question 1
Zero-coupon bonds are the type of bonds whose face value is reimbursed at the maturity date as they assume a positive return and an increase in the time value of money (Sousa et al., 1). Thesebonds do not offer coupons or periodic interest payments as the investors receive the par value after the maturity date.
Par value =$1,000
Maturity (Years) Price of Bond
Forward rate for year 4
13.37734%
Question 2
The expectations theory states that future expectations of an increase in the short-term interest rates create a definite yield curve. When the short-term rates are expected to decrease in the market, it creates a negative yield curve (Calabresi, 1). The yield curve indicates investors are not sure of the inflation and future economic growth, thus resulting in speculations in the investment of financial instruments.
Yield to maturity on one-year bond = 8%
Yield to maturity on two- year bond = 9%
Treasury 2 years bond YMT= 10.5%
Face value= $100
Question 3
The liquidity preference states that investors should demand higher interest in long and medium-term investments as they forego their liquidity and the desire to sell and buy the financial instruments in the short-term (Calabresi 1). The theory is used in calculating the present value of bond amounts, as explained in the subsequent parts.
Yield to maturity on one-year bond = 8%
Yield to maturity on two- year bond = 9%
Treasury 2 years bond YMT= 10.5%
Face value= $100
Liquidity premium= 2%
To find the Yield to maturity on a two- year bond issued by the treasury, matrix pricing model, is adopted
= 8.33%
YTM= 8.33% + risk premium
YTM= 8.33% + 2%= 10.33%
Where: r= coupon rate
t= period
n=2, PMT=10.5%, I/Y = 10.33%, FV = 100
Question 4
A default zero-coupon bond refers to a debt security, which does not pay interests but is operated at deep discounts that render profits at the maturity period.
Maturity (Year/period) | Price |
1 | $ 988.54 |
2 | $ 888.39 |
3 | $ 824.92 |
4 | $ 762.60 |
5 | $ 680.44 |
Face value= $1000
For the synthetic loan, buy the 3-year bond now and sell the 4-year bond.
Number of 3-year bonds =1
1.08172
Current cash flow at period0 =0
Cash flow at period1=0
Cash flow at period2=0
Cash flow at period3= Face value= $1000
Cash flow at period4=-1000×1.08172
Cash flow at period4=-1081.72
Question 5
Yield to maturity or redemption yield is the return expected on bond value if it is held up to maturity period (Ferreira 1). Thus, it is the internal rate of return (IRR) of bond investment if the investor holds it to maturity with all payments made and subsequently reinvested.
3-year YTM=7.2%
1-year forward rate= 6.1%
3-years forward rate= 8.6%
Section 2: Memo
From: [your name]
Sent: 4th May 2020 1423hrs
To: Diane McLean
Subject: Portfolio management and others
Dear: Diane McLean, I trust you are well; this is a reply to your earlier e-mail on portfolio management. I will base my answers on the Portfolio Management course at Zayed University.
Question 1: Expectations and Liquidity Theory
The two theories refer to the interest rate maturity periods, which describe the correlation between the maturity periods and the interest rates. The two approaches show the investor expectations on the changes in future interest rates (Sousa et al. 67). The theories also show the impact on the country’s monetary policy conditions. The expectation hypothesis predicts the future value of short-term interest rates per the present long-term interest rates. The theory is also referred to as unbiased expectation theory, and it is expressed as the aggregate of the expected discounted dividends future value. More so, the value of the long term bond is equivalent to the future summation of all short term rates of the stock or portfolio.
The liquidity preference model notes that the market players who are major investors have to demand high-interest rates on financial securities in an extended maturity period. High risks and less liquid characterize an extended maturity period. Further, the theory explains that most investors prefer having their securities held in cash due to its high liquidity feature. As such, they can quickly sell or buy based on the current demand and supply conditions. The theory views demand for investment liquidity as exhibiting speculative power because liquid financial instruments are easily converted to cash with a full return based on their market value (Ferreira, Valéria Andreia Reyes). Thus, interests in short-term investments should be lower as investors are not preceding the opportunity cost of liquidity in their investments for a longer time compared to medium and long- term securities.
Question 2: Spot Rates
Interest and inflation rates directly related such that a rise in inflation rates leads to an increase in the interest rates. It results in Creditors demanding higher interest rates to cover the loss expected in the future value of money (Ferreira, Valéria Andreia Reyes). An increase in inflation rates leads to a drop in the face value of bonds and stocks. It will decrease the principal value of an investment as compared to the initial investment. Hence, one year is not essential than the two-year spot rate, as investors expect better short-term interest rates due to the rise of inflation rates.
Question 3: Markowitz Portfolio Optimization Model
The model holds that investors should maximize their investment returns at for any level of risk and also minimize the risk by adopting a diversified portfolio through investing in risky and risk-free assets. It is crucial for investors when investing in financial instruments to always consider their objectives, which will lead to maximization of the expected returns while also minimizing their financial risk. Thus, their portfolios should combine both the risky investments due to their high yields plus the risk-free investments, such as bonds to reduce the risk (Sousa et al. 67). Besides, it is advisable to diversify your portfolio during investment since it helps build the potential of proper management of risks.
Kind Regards,
[Your name]
Works Cited
Calabresi, Enrico. “The risk-taking channel of monetary policy.” (2018).
Ferreira, Valéria Andreia Reyes. Efficient frontier and the optimal risky portfolio: evidence from DAX30 and IBEX35 before and after the financial crisis of 2008. Diss. Instituto Superior de Economia e Gestão, 2017.
Sousa, J. Beleza, Manuel L. Esquível, and Raquel M. Gaspar. “Pulled-to-par returns for zero coupon bonds: historical simulation value at risk.” (2019).
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