Finm2003 - Fixed Income Assessment Answer

Assignment Task 

Instructions to Candidates:

1. This exam paper comprises a total of 5 pages. Please ensure your paper has the correct number of pages.
2. The exam includes a total of 4 questions, each containing multiple parts. The questions are of unequal value, with marks indicated for each question. You must attempt to answer all questions.
3. Do not round calculations until providing your final answer to each question. Final answers should be rounded to 2 decimal places.
4. Include all workings for each question, as marks will not be awarded for answers that omit necessary workings.
5. Ensure you include your student number on your answer book.

Question 1 

a) Describe TWO anomalies that relate to the EMH, and in doing so, discuss in words the trading strategies you could adopt to exploit them. (4 Marks)

b) Explain why information processing biases, behavioural biases, and limits to arbitrage may act as impediments to market efficiency. In answering, describe their role, and provide a specific example of each.

c) What is convexity and why is it important in fixed income portfolio management?

d) Explain the impact on a bond’s yield and expected life by adding a call feature to a proposed bond issue. Describe one advantage and one disadvantage of including callable bonds in your portfolio.

Question 2

a) You are the manager of a fund that has an obligation to pay $10,000 in 3 years, $8,500 in each of the following two years, and $17,000 in 6 years. You would like to ensure you have the capacity to pay these obligations when due, and given your uncertainty about the level of the future market interest rate (which is currently 6% p.a.), you have chosen to immunise your obligation. Upon considering your options, you have decided to immunise your liability with a combination of zero-coupon bonds that mature in 5 years, and a perpetuity making annual payments (at the current rate of interest).
 

(i) Calculate the duration of the liability 
(ii) Calculate the duration of the zero-coupon bond and the perpetuity.
(iii) What proportion of your investment should be put into the zero-coupon bond, and what proportion into the perpetuity, to immunise your position?
(iv) How much, in dollars, should you invest in the zero-coupon bond and the perpetuity?
(v) What is the face value of your investment in the zero-coupon bond?

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