Assignment 1: Yield Curves, Equities, Bonds, Efficient Market and the Capital Asset Pricing Model.Learning Outcomes of ACFI7012 Financial Markets & Institutions Assignment

• Knowledge of Interest rate dynamics
• Analysis of factors affecting the Yield Curve
• Comprehension of the structure and functions of Debt Instruments and Shares as key asset classes
• Application of Efficient Market Theory and evaluation of alternative investments using Capital Asset Pricing Theory

Objectives of ACFI7012 Financial Markets & Institutions Assignment

Your First Assignment is designed to assess your attainment of specific learning objectives from the first half of the module, weeks 1 to 6. The Assignment requires you to answer both objective computational questions as well as provide discursive interpretation of your results. You will be assessed for the correctness of your answers to objective components and the quality of your discursive response which may involve accessing and using a range of sources. In total, there are three questions with sub-parts. Each question is marked on the basis of 100% marks each. Together the three questions count 30% towards your overall grade for the Module.

Instructions

You should perform calculations, as required, for each question in an Excel Spreadsheet. The results including graphs from Excel must be copied into your word document for submission. In addition, you must upload your Excel spreadsheet to complete your submission. There should be one Word Document covering all Three Questions. There should be one Excel spreadsheet covering all three questions, having separate tabs labelled Q1, Q2 and Q3.)

Q1. Argentina has long-struggled with macro-economic policies. Historically, according to the IMF, when the rate of annual inflation was 15%, the base lending rate (prime rate as charged to the best borrowers) was 21%. When the new government of President Macri took office in November, 2015, it was hoped tighter monetary policy would reduce inflation but it was also feared that higher interest rates would bring recession. Given the following historic data, please answer questions a. to f.,

Year Inflation Rate
2014 13%
2015 9%
2016 7%
2017 6%
2018 6%

Please answer the following question a. to f. below.

a. What was the average inflation rate over the five (5) year period between 2014 and 2018?

b. If you purchased 5-year Treasury Bond issued by the Argentine Government in 2014, what nominal yield should have been offered in order to provide a provide a 2 percent real risk-free rate of return assuming a maturity premium of 2.93%? Using relevant theory, explain why.

c. If the real risk-free rate on the shortest Argentine government securities were 2% in 2014 and the maturity risk premium for a one year bond were 2% and increases at a compound annual rate of 10%, what would have been the interest rate in January 2014 on government bonds that mature in 2, 5, 10 and 20 years. Using this data, please plot your results on a yield curve. From the standpoint of market sentiment, explain the existence of a maturity risk premium.

d. If before the change of government, investors in early 2014 had expected inflation rate for every future year to be 10% instead of the historic data provided above, how would the yield curve have shifted? Explain why. Please show in a graph what was expected.

e. If after Year 5 (2019) the Maturity Premium rather than growing at a compound rate, started to fall by 10% per year, what sort of Yield Curve would we observe. From your readings, what might a Yield Curve of this shape portend about future economic conditions?

f. Using relevant theory, please explain the shape of the Yield Curve? Why may a Pure Expectations theory of the Yield Curve not always be true?

Q2. As an equity market portfolio manager, you spend most of your day looking for shares which appear to be undervalued. In the last week, you have received information about two shares that you have been examining, Style Group UK and Balfour Homes. Many analysts according to the financial press believe that Style Group’s shares and Balfour shares are
under-valued because their price-earnings ratios are lower than the industry average. Style Group has a P/E ratio of 6 versus an industry average P/E ratio of 8. Although expected to lower costs in the future, an announcement that its quarterly earnings would be lower than expected due to expenses from recent restructuring, did lead to its share price falling. Balfour homes has a P/E ratio of 9 versus an industry average of 11. Its earnings have been decent in recent years because of demand for new homes but it has not kept abreast of new technology which lower cost and it is feared may lose market share to competitors.

a. Using relevant theory to make to make your case, should you still consider purchasing shares in Style Group in light of the analysts’ arguments about why it may be undervalued?

b. Using relevant theory to make your case, should you still consider purchasing Balfour shares in light of the analysts’ arguments about why it may be undervalued.

c. Share analysts from Credit Suisse have recently predicted that the price of most shares may fall because interest rates are expected to increase with stronger economic condition but analysts from Barclays Capital have disagreed on the ground that capital gains are more important than dividends. Introducing relevant theory, with which set of analysts do you agree and why?

d. Quoting a noted financial market commentator, “Although P/E ratios have their uses, clever investors look at the big picture”. Using relevant theory, would you agree or disagree with this statement and why.

Q3. Imagine you are citizen of the United States and reside in the State of California. You have recently inherited $100,000 from your departed Uncle. Given the current financial climate and your personal circumstances, you are considering putting it all into long-term bonds. As choices, you may purchase highly rated Municipal Bonds issued by the State of California at
a par or face-value which have a coupon rate of 6%. The two maturities which are available are 10 years and 20 years. Alternatively, you could purchase highly-rated corporate bonds at par, with a coupon rate of 8%. These corporate bonds are offered with maturities of 10 and 20 years as well. Given your circumstances, you do not anticipate needing the money for five years. At the end of the fifth year, it is your plan to sell the bonds as you are planning a large purchase, such as a home. Please answer the following questions.

a. What is the annual interest rate you would earn (before taxes) on the municipal bonds and on the corporate bonds?

b. Assuming that you are in Federal Government tax bracket of 25% meaning that you keep 75% of what you earn, if the credit risk probability and the liquidity of the municipal and corporate bonds were the same, would you invest in the municipal bonds or the corporate bonds? Using relevant theory, please explain why?

c. Referring to the previous question, if the credit risk (probability of non-payment or default) and the liquidity of corporate bonds were lower than that of municipal bonds, how would it 5 affect your investment choice? Why? How large would the effects of greater credit risk and lower liquidity need to be to change your choices?

d. Suppose in a year’s time you have reason to believe that expected yields paid on newly issued notes and bonds (regardless of maturity) will fall for two years and afterwards increase. Would you select the 10-year maturity or the 20-year maturity for the type of bond you plan to purchase? Using relevant theory, please explain why.

e. The Corporate Bonds have a larger coupon than the California Municipal Bonds. Under what future market conditions would you favour bonds with a larger coupon, if all other factors were equal. Explain your logic.

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