FIN203: You are Looking at the Valuation of some risk-free Government Bonds It has Been Observed that the Current 3-year Discount Factor: Essentials of Financial Management Assignment, SUSS, Singapore

Question 1

You are looking at the valuation of some risk-free government bonds. It has been observed that the current 3-year discount factor for risk-free cash flows is 0.68. All bonds are assumed to have a par value of $100 and all cash flows occur at the end of the year.

(a) Propose the fair price for a zero-coupon bond that matures in exactly 3 years.

(b) Your friend makes the following comments about the above bond:
“Since there is no risk of default and there are no coupons to reinvest, buying the 3- year zero-coupon bond today is a risk-free investment. In addition, the guaranteed riskfree annual rate of return is 13.72%.”

Analyse if you would agree entirely with this statement.

(c) In addition to the bond observed in part (a), you also note the following:

• A 2-year coupon bond paying 10% annual coupons with a market price of $97.
• Two annuities that are priced exactly the same. The first annuity matures in 3
  years and pays annual cash flows of $20, while the second annuity pays annual
  cash flows of $28 and matures in 2 years.

Using the above information, compute the term structure of interest rates and determine the 1-year and 2-year discount factors, d1 and d2 respectively. Also, calculate the price of each of the annuities.

(d) Assume that the observed discount factors are such that d1 < d2 < d3. Analyse why it would be odd to observe such a situation in a competitive market.

Question 2

Patrick Poh is a Singapore equities fund manager and manages a fund with total assets worth S$100 million. He adopts an enhanced indexing strategy and hopes to deliver excess return above the STI index return.

He is considering the inclusion of a utilities stock, Gas Stop, into his portfolio. He has compiled the following information:

(a) Evaluate the covariance and correlation coefficient of Gas Stop with the market.

(b) Since the returns on the current portfolio resemble the returns on a broad market index, we can approximate the correlation of returns between the current portfolio and Gas Stop to be the same as that between Gas Stop and the market.

Analyse if the addition of Gas Stop to the existing portfolio improves the Sharpe ratio.

If yes, propose the recommended allocation to Gas Stop and his existing portfolio. Analyse other benefits that can be expected if Gas Stop is added into the portfolio.

Question 3

Interpret the pecking-order theory of corporate financing and its implications on capital structure. You are required to structure a response of between 400 – 700 words.