Examiners’ commentaries 2011

23 Investment management Important note

This commentary reﬂects the examination and assessment arrangements for this course in the academic year 2010–11. The format and structure of the examination may change in future years, and any such changes will be publicised on the virtual learning environment (VLE).

Speciﬁc comments on questions – Zone A

Candidates should answer FOUR of the following EIGHT questions. All questions carry equal marks. Question 1 (a) List two recent ﬁnancial innovations, as described in the subject guide, and explain to what perceived problem they provide the solution. [7 marks] Reading for this question To prepare for this question you should read Chapter 3 in the subject guide, in particular the section on recent ﬁnancial innovations. Approaching the question A good answer will review two ﬁnancial innovations, e.g. the ﬂoating-rate debt innovation and the zero coupon bond innovation, and look at the reason why these instruments were a success initially (why investors believed they could perform a useful role) and why they later became standardised (in the case of zero coupon bonds, for instance, the initial tax-motive for trading zero coupon bonds became eliminated through changes in the tax-code, but they continued to be a success because of the ﬂexibility they oﬀered to investors following certain investment and risk-management strategies). Weak or satisfactory answers will typically simply review the mechanics of how these instruments work, whereas a good answer will go deeper to cover how these instruments work within a larger context – by highlighting how these instruments oﬀer beneﬁts to the investors (as explained above). Learning outcomes The key learning outcomes here are to ‘broadly identify established examples of ﬁnancial innovations and their fundamental characteristics’ and ‘discuss the main beneﬁts ﬁnancial innovations provide to investors’.

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23 Investment management

(b) There are three bonds A, B, and C, each with nominal capital 1,000 and trading at par value. You will also ﬁnd the following information about the bonds. Bond A B C Annual coupon interest rate 4.9% 5.0% 5.1% Maturity 1 year 2 years 3 years

Work out the yield to maturity for the three bonds, and the 1-year and 2-year spot rates. [9 marks] Reading for this question The main readings here can be found in Chapter 7 in the subject guide, in particular the section labelled ‘Bond math’. Approaching the question A good answer will distinguish between yield to maturity (which is the property of individual bonds) and spot rates (which is the property of the various points in time). Here, the candidates can make use of the fact that for bonds that trade at par value, the yield to maturity is exactly equal to the coupon rate of the bond. Therefore, the yield to maturity for the bonds are 4.9%, 5.0% and 5.1% respectively for A, B, and C. The spot rates for years 1 and 2 can be worked out using a standard calculator (but not for year 3 since this involves taking a cube root). For year 1 the spot rate must be equal to the yield to maturity for bond A, since this is a one-year bond (otherwise the bond would be discounted diﬀerently from the other bonds in the market). Therefore, the only real calculation involves the spot rate for year 2. We know that this satisﬁes the equation 5 105 100 = + , 1.049 (1 + r)2 which corresponds to r = 5.003%. Weak or satisfactory answers would confuse the two terms, and also probably not recognise the fact that for bonds trading at par value, the coupon rates and the yield to maturity are identical. Learning outcomes The key outcome is to ‘formally relate the concepts of yield to maturity, spot rates, and forward rates’ (although forward rates don’t appear in this particular question). (c) Work out the duration and convexity for bond C above. [9 marks] Reading for this question You can ﬁnd the relevant readings in Chapter...