Illustration of total return on investment, Financial Management

Assignment Help:

Illustration 

An investor with a 1-year investment horizon purchases a 20-year 5% corporate bond. The prevailing price of the bond is Rs.82.3488 for a yield of 6.2%. Borrowed funds are not used for purchasing. The yield for all the maturities is same; therefore, the yield curve is flat. The yield for the on-the-run 30-year treasury issue is 5.5%. Therefore, the yield spread over the on-the-run treasury issue is 70 basis points. 

The investor expects to reinvest the coupon rates at 5%; at the end of one year, the yield curve would shift down by 25 basis points. The yield for the 29-year treasury issue would be 5.25% and the yield spread to the 29-year treasury issue would be 80 basis points; therefore, the yield would be 6.05%, assuming that the price of the bond when discounted at a flat 6.05% is Rs.85.4376.

Solution

  1. Calculation of total coupon payment and reinvestment income.

Annual reinvestment rate is given as 5%. Therefore for six months the reinvestment rate would be 2.5%. The coupon payment received at the end of six months is equal to Rs.2.50. This amount is reinvested at a reinvestment rate of 2.5% for six months. The total return using the future value of an annuity is as follows:

Semiannual Coupon payment reinvested for the six months

= Rs.2.5 (1.025) = Rs.2.56

Next semiannual payment (not reinvested) = Rs.2.5

Total = Rs.5.06

  1. Price of the bond at the end of the 1-year investment horizon is Rs.85.4376

  2. Total future returns = Rs.5.06 + Rs.85. 4376 = Rs.90.4976

  3. Semiannual total return is:

(90.4976/85. 4376)1/2 - 1 = 2.92%

  1. The total return on a bond-equivalent basis and on an effective rate basis are as follows:

2 x 2.92= 5.84 (Bond Equivalent Yield)

(1.0292)2 - 1 = 5.93 (Effective rate basis).


Related Discussions:- Illustration of total return on investment

Analyse interest rate swap and currency swap, Problem: (a) Critically ...

Problem: (a) Critically analyse interest rate swap and currency swap. (b) Explain why a bank may face credit risk when it enters into offsetting swap contracts. (c) Two

Calculate the expected return and standard deviation, Benjamin Tang current...

Benjamin Tang currently has holdings in the following three companies:                                                                             E(R)                      σ

Problem 1, You work for a small, for-profit health system. Your system is i...

You work for a small, for-profit health system. Your system is interested in acquiring a Critical Access Hospital (CAH) at a price of $65,000,000. The purchase would be made from r

Cvp, Info on applying CVP to product mix limiting factors

Info on applying CVP to product mix limiting factors

Concept and measurement of the cost of capital, Concept and measurement of ...

Concept and measurement of the cost of capital The evaluation of the worth of a long-term project suggests a certain norm or standard against which benefits are to be judged. R

Beta, Beta Beta is a measure of the market risk, or methodical risk, o...

Beta Beta is a measure of the market risk, or methodical risk, of a particular privacy or portfolio. Systematic risk defines any risk that influences the value of a huge numbe

WACC, Keys Printing plans to issue a $1,000 par value, 10-year noncallable ...

Keys Printing plans to issue a $1,000 par value, 10-year noncallable bond with a 5.00% coupon, paid semiannually. It should sell at par. The company''''s marginal tax rate is 40.00

Settlement mechanism, Settlement Mechanism: Nifty index futures and opt...

Settlement Mechanism: Nifty index futures and option contracts are cash settled. All CMs are required to open a separate bank account with NSCCL designated clearing banks. T

What is share exchange, What is Share exchange    Predator company off...

What is Share exchange    Predator company offers their shares in exchange for target company's shares. So target shareholders become part of predator shareholders and so have

Why do analysts calculate financial ratios, Why do analysts calculate finan...

Why do analysts calculate financial ratios? The comparative measures are known as Ratios. Since the ratios show relative value, they permit financial analysts to compare inform

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd