Question

QUESTION 3

1. A colleague of yours has a K100,000-00, 2 years treasury Bond maturing in 12 months, issued at a fixed coupon of 10%, payable annually. He informs you that he has an urgent need of money and wants to sell you the Bond.

1. What’s the maximum price you would offer assuming the yield on a 12 months treasury bill is currently at 12%?

                                                                                    [04 Marks]

2. Briefly discuss how you may be affected by inflation over the holding period to maturity.

                                                                                    [06 Marks]

2. A 273 Days Treasury bill of K1,000 Face Value is currently on offer at K840.33.

1. Calculate its Yield to maturity (YTM) at this price.

                                                                                    [02 Marks]

2. Calculate its Effective Annual Return (APR).

                                                                                    [03 Marks]

3. Briefly explain why Treasury bills are treated as risk-free securities.                                                                                                 [05 Marks]

Total 20 Marks

Answer 1

Ans

1. Present rate of return on K100,000 bond at 10% coupen rate is

10% of 100,000 = k 10,000

Now since the coupen rate is fixed 10% normally the price should be k 100,000 but since present 12 month maturing treasury bill is offerring 12% ytm ,maximum price which I can offer to friend would be 2% less the face value of the bond I.e.

K 100,000- (2% of 100,000) =

K100,000- 2000 = k 98,000

ii.  Affect of inflation on maturity of bond.Bond is financial instrument which offers a fix rate of return and return of capital over a fixed period of time. Owning of bond is like owning future flow of cash.

Inflation is one of the most important factor affecting the price and the yield to maturity expectations of the bond .Not only inflation even expectations of inflation also affects bond.

If I already hold a bond and inflation or expectations of inflation start rising after my purchase than, I may loose higher yield which the new bond may carry as investor will demand higher yield to compensate high risk ,similary in the opposite case of lower inflation expectations I will stand to get benifit of present coupon rate which has a chance of getting low in future.

B. i . Yield to maturity =(Facevalue/current bond price ) ^(1/ years to maturity)-1  

Since time remaining of maturity is not given calculation of ytm maturity according to above formula is not possible.

ii. Calculation of effective annual return is also not possible as time remaining for maturity is not provided.

iii. Treasury bill. Any bill which has to be categorised as risk free ,must contain fix rate of return and repayment of principal value at a fixed expiry of time

Treasury bills or T bills are issued by US treasuries and as such are considered secured and sovereign because of saftey of being backed by unites states government.

The return on risk free asset is given but it does not guarantee profit in terms of inflation or interest rate movements. Technically it may be said that there is nothing like risk free asset in financial market but the level of risk is so small that for an average investor it is not appropriate to consider Treasury bills of U.S. Treasuries and other Treasuries of stable government as risky.

Risk free treasury bills are generally priced at low interest rate as they are certain to give fix return and saftey of capital over a period of time.