Illustration of total return on investment, Financial Management

Illustration 

An investor with a 1-year investment horizon purchases a 20-year 5% corporate bond. The prevailing price of the bond is Rs.82.3488 for a yield of 6.2%. Borrowed funds are not used for purchasing. The yield for all the maturities is same; therefore, the yield curve is flat. The yield for the on-the-run 30-year treasury issue is 5.5%. Therefore, the yield spread over the on-the-run treasury issue is 70 basis points. 

The investor expects to reinvest the coupon rates at 5%; at the end of one year, the yield curve would shift down by 25 basis points. The yield for the 29-year treasury issue would be 5.25% and the yield spread to the 29-year treasury issue would be 80 basis points; therefore, the yield would be 6.05%, assuming that the price of the bond when discounted at a flat 6.05% is Rs.85.4376.

Solution

  1. Calculation of total coupon payment and reinvestment income.

Annual reinvestment rate is given as 5%. Therefore for six months the reinvestment rate would be 2.5%. The coupon payment received at the end of six months is equal to Rs.2.50. This amount is reinvested at a reinvestment rate of 2.5% for six months. The total return using the future value of an annuity is as follows:

Semiannual Coupon payment reinvested for the six months

= Rs.2.5 (1.025) = Rs.2.56

Next semiannual payment (not reinvested) = Rs.2.5

Total = Rs.5.06

  1. Price of the bond at the end of the 1-year investment horizon is Rs.85.4376

  2. Total future returns = Rs.5.06 + Rs.85. 4376 = Rs.90.4976

  3. Semiannual total return is:

(90.4976/85. 4376)1/2 - 1 = 2.92%

  1. The total return on a bond-equivalent basis and on an effective rate basis are as follows:

2 x 2.92= 5.84 (Bond Equivalent Yield)

(1.0292)2 - 1 = 5.93 (Effective rate basis).

Posted Date: 9/11/2012 1:48:11 AM | Location : United States







Related Discussions:- Illustration of total return on investment, Assignment Help, Ask Question on Illustration of total return on investment, Get Answer, Expert's Help, Illustration of total return on investment Discussions

Write discussion on Illustration of total return on investment
Your posts are moderated
Related Questions
Types of Mutual Funds The objectives of a Mutual Fund are as follows: To provide an opportunity for lower income groups to acquire property without much difficulty in the

Provide an argument for including or not current liabilities in the cost of capital calculation.

In the telecom industry of the Australia, these are some most important organizations such Vodafone Austrelia‎, TransACT Capital Communications, Optus, and Telstra. Vodafone A

Q. What are the Motives of Holding Cash? Motives of Holding Cash: - In every business assets are kept for the reason that they generate profit. But cash is an asset which doesn

What is the present value of an annuity that makes a quarterly payment of $37,110 for 11 years, assuming an annual yield to maturity of 5%?

These securities are backed by income-producing real estate, usually in the form of warehouses, shopping centers, apartments, office buildings, senior housi

Meaning merits nd demerits of modern approch of financial management

Potential drawbacks of divestment - There may be some loss of economies of scale. Fixed overheads would have a lower capacity to recover them. - Cash generated may not be

Takeover, Inc. is a Delaware corporation whose only stated purpose is to acquire companies.  It has virtually no assets and no employees other than the original founders who contri

A with-profit whole life assurance policy was issued to a life then aged 25 with: • basic (initial) sum assured of S = $100,000; • bonuses added to sum assured at the end of ea