SOLUTION:
Government bonds are a security against debt, issued by the government to support its expenditure. These bonds include savings bonds and treasury bonds. These bonds are backed by the government, which is why they are low risk or even risk-free. Additionally, there are individual government bonds that are tax-free. These provide a flat rate of return to their investors.
Corporate bonds are a debt security issued by a company and is purchased by its investors. It is backed by the company’s ability to pay back its investors from its profits. And, the company’s physical assets are used as a guarantee by the investors. The interest earned from corporate bonds is considered as taxable income. However, the assurance that the company( especially if it is a significant profitable company) will pay the investors makes it a lucrative opportunity.
Municipal bonds also a debt security. These are issued either by the state or municipality to finance its capital expenses. These bonds are tax exempt from most federal and local taxes. The tax-free policy, as well as the comparatively high yield, makes them an attractive investment option.
- As a financial advisor, you’ve been asked to review the portfolio allocation of a new client. The client is 35 years of age and is investing for long-term growth. Her goal is for her investments to grow at a rate of at least 13 percent per year—which is above the long-term average of the broad stock market—to fund her spending in retirement. She plans to retire in 30 years. Her current portfolio is shown below:
| Asset Category | Allocation | yearly performance |
| Small-company stocks | 10% | 17.5% |
| Large-company stocks | 20% | 11.7% |
| U.S. Govt. long-term bonds | 40% | 6.2% |
| U.S. Treasury bills | 30% | 3.7% |
Answer the following questions for the client. For each question, use only the asset classes listed in the portfolio and be sure to explain the reasoning underlying your advice.
- Review the portfolio and tell what changes, if any, you would advise that she makes to the portfolio to increase the likelihood of achieving her long-term objectives.
- Show the average return of the portfolio you recommend and how you computed it.
с. Does attempting to accomplish the client’s return objectives involve bearing additional risk and, if so, what would be your advice to the client about taking on such risk?
SOLUTION (A);
It seems from the table above that the investment from small company stocks and that from the large company stocks is earning more money, 17.5%, and 11.7% respectively(Staff, 2003). The investment from the Government related bonds is receiving a substantial amount of money, even though they have been allocated a large part of the investment (“Corporate Bond,” n.d.). Therefore, I would advise the client to reallocate her portfolio and sell her stocks; both large and small company stocks. The money would be used to buy more U.S Govt. Long Term Bonds. By doing this, the client would be able to earn an annual rate of 14.5%.
SOLUTION (B);
| Asset Category | Allocation | yearly performance |
| U.S. Govt. long-term bonds | 70% | 10.85% |
| U.S. Treasury bills | 30% | 3.7% |
| TOTAL (10.85+3.7) | 100% | 14.55% |
SOLUTION (C);
The attempt to achieve client’s return objectives carries a little risk. The risk being that the new allocation requires the client to sell her stocks and put all her money in Government bonds. In case the shares give a higher yield in the future the client would not be able to enjoy it; hence, the opportunity cost. Secondly, even though the Government bonds may be secure but they still carry some risk, that being the low return, which will reduce the client’s earnings.
Identify and explain two traditional theories which seek to define the term structure of interest rates. What are some problems with these arguments from a modem perspective? Explain what the modern view has to say about how investors approach investing in short-term and long-term bonds and the reason why they are supposed to take this approach.
SOLUTION;
The term structure of interest rates is the relationship between interest rate and maturities. It is also known as the Yield Curve. The two theories that explain the term structure of interest are; Preferred Habitat Theory; It is a continuation of the market segmentation theory; wherein it explains that lenders and borrowers will go for different maturities instead of their usual maturities if the yield is favorable for them.
The Liquidity Premium Theory; it explains a characteristic of the term structure of interest rates. It says that bonds with longer maturities usually have higher yields.
According to modern perspective and by these theories, people would usually prefer investing in bonds that have a higher yield. Typically, bonds that mature in a long time have higher yields. Therefore, an investor would find no problem with investing or switching to; if he has already spent previously, more lucrative opportunities.
PART B
- Consider the following two bonds:
- Bond A’s market value is $941, it pays an annual coupon of $90, and it will mature in five years, paying $1,000. The yield to maturity is 10 percent.
$x/941
- Bond B’s market value is $945, it pays an annual coupon of $70, and it will mature in three years, paying $1,000. The yield to maturity is 8 percent.
Which of the two bonds trades at a smaller discount to its present value? Show your work and explain how you arrived at your answer.
SOLUTION; First case Discount Rate = 90/941
= 0.09564
= (0.09564)^1/5
= 0.625
Second Case Discount Rate = 70/945
=0.0740
= (0.0740)^1/5
=0.59
Hence, bond B has a smaller discount rate.
- Identify two commonly used stock price ratios and explain what they can be used for.
1) P/E Ratio: It is a tool for stock selection. It gives the amount of money you will pay for each dollar worth of the earnings of a company.
2) P/B Ratio: It is used to compare a stock’s market value to its book value.
- Suppose you’re a portfolio manager looking to hedge your holdings of $15 million of large-company stocks. Assume you use S&P 500 call options with a delta of .489 to do so. You see that the S&P index has a value of 1854. How many contracts would be needed to hedge this portfolio fully? Show your work and explain how you arrived at your answer, and also explain what delta is.
SOLUTION;
Number of contracts = $15 million / (1854×0.489)
= 1654
- What does a historical study of financial markets reveal in regards to risk and return?
It reveals whether a stock is a safe bet and whether it has paid a significant return in the past or not.
- Identify one of the tools the Federal Reserve can use to help it achieve its objectives, and explain how the toot functions.
The Federal Reserve uses the Discount Rate as a tool to control monetary policy. It is the interest rate that banks have to pay on short-term loans from the Central Bank or Federal Reserve Bank.
REFERENCES
Corporate Bond. (n.d.). Retrieved October 10, 2017, from http://www.investopedia.com/terms/c/corporatebond.asp
Staff, I. (2003, November 24). Municipal Bond. Retrieved October 10, 2017, from http://www.investopedia.com/terms/m/municipalbond.asp
