Question

In 2016 Cristiana purchased a 10-year, 3.20% p.a. semi-annual paying coupon bond with a Face Value (FV) of $2 000 000, as she was attracted by the fixed income stream in order to fund her retirement expenses.

a) What is the price of this bond in 2020 (6 years remaining) at a current market interest rate of 0.30% p.a.?

Show formula, variables, calculation and a concluding statement in your response.

b) Is Cristiana’s coupon bond currently selling at a premium, par or discount? Describe the relationship between bond prices and interest rates.

c) Cristiana decided to sell the bond from part a) and is considering her investment options. A friend suggested that she invests the proceeds by buying a short-term debt instrument. Explain two advantages of short-term debt instruments.

d) Warren, a Wall street portfolio manager, informed Cristiana that she should consider investing in his portfolio instead. He said his portfolio is perfect for someone who is looking to retire within the next 6 MONTHS . His portfolio has the following allocation of assets:

Asset Class	Allocation
Shares in Small Companies (High Risk)	0%
Shares in Blue Chip Companies (Low Risk)	20%
Bonds	50%
Cash	30%

Does Warren have a point? Why or why not?

Answer 1

A) The value of a coupon bond can be calculated by summing the present values of all of the bonds promised cash flows. Market interest rate is appropriate for discounting a bond's cash flows.

Following are the details available for calculation of bond price in 2020 (6 years remaining)

Number of period = 12 (As this bond is semiannual so there will be 12 period left till maturity)

Interest Rate = 0.15% (0.30% is annual market interest rate for semiannual it will be 0.30%/2 = 0.15%)

Coupon = $32000 ($2000000*3.2% =$64000 is annual coupon so semiannual will be $32000)

Future Value = $2000000

Based on the above details price of the bond in 2020 has been calculated in excel

Price of the bond in 2020 is $23,44,630.62

B)

Cristiana’s coupon bond currently selling at a premium. A bond that is selling for more than its par value is said to be trading at a premium to par.

There is inverse relationship between bond price and interest rates. When bond's market interest rate (yield) decrease, the present value of bond's payments, its market value increases.

C) Two Advantages of short term debt instruments

1. Investors capital is protected, it also generates return which is similar to its benchmark or government's risk free rate.

2. Interest rate risk or market risk is low compared to long term debt instrument.

D) Cristiana should not consider Warren's Portfolio as that portfolio is suitable for someone who is will retire within the next 6 Months and 4 years left in Cristiana retirement.

I am not agreeing with Warren's portfolio based on 30% allocation in cash, I suggest that 10% allocation to cash is sufficient and 20% he can shift to bonds.

According to me the first priority of retired person is always Income Generation further his priority can go to Capital Protection and Capital Growth.