ASSIGNMENT #1

FINA3010, 2024
DUE DATE: February 18, 11 pm
Deliverables:
1. Report file (MS Word or PDF format only): You can type the answers in Word, or you can
manually write the answers on paper and scan them into a PDF file. DO NOT simply take
a picture of your handwritten answers if they are not readable. Please at least use a scanning
app if they are not readable. Unreadable handwriting will be regarded as a blank answer.

2. Supplementary Excel file: It contains your data analysis.

Please submit your report file in Word or PDF together with a supplementary Excel file that
contains your data analysis results to the assignment tab on Blackboard no later than 11 pm
on the due date. Please include your student number in the report. Late submissions are
automatically blocked on the system. If you do not include your data analysis results in
Excel and only provide ‘correct’ answers to the data analysis part in your report, your
marks for the data analysis will be zero .

Part 1. Problem-solving (80 points)

1. Bond Valuation (Time-value of money): (10 points) Claire wishes to have $1.5
million in 30 years. She cannot afford to make large deposits at the moment; however,
she believes that she will be able to increase her deposits by 3 percent per year for
the next 30 years. She will make her first deposit in one year. Her discount rate is 5
percent per year.

(a) how large an initial deposit is needed? (5 points)

(b) If instead of increasing his deposit each year, Rachel invested the same amount
each year, how large a deposit would she need to make each year? (5 points)

2. Bond Valuation: (20 points) The duration of a bond is defined as the weighted av-
erage maturity of its cash flows, with the weights proportional to the present values
of the cash flows at different maturities. That is, if a bond has cashflows C1 , C2 , ..., CT
with maturities of 1 year, 2 years, to T years, then the duration of the bond is defined
as
T
X P V (Ct ) P V (C1 ) P V (C2 ) P V (CT )
D= t =1× +2× + ... + T ×
t=1
P0 P0 P0 P0

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 where P V (Ct ) stands for the present value of the cash flow at time t, and P0 =
P T
t=1 P V (Ct ) is the current price of the bond. For this question, we assume the term
structure of interest rate is flat and the market interest rate is r=10%.

(a) What is the current price of a 30 year 5% annual coupon bond with a face value
of $1000? (7 points)
(b) Consider security that pays you $1 in year 1, $ 2 in year 2, and the payoff in-
creases by $ 1 per year until year 30. What is the present value of the cash flow
of this security? (7 points)
(c) What is the duration of the 30-year, 5% annual coupon bond? (Hint: use the
result in part (b)). (6 points)

3. Term Structure theory: (20 points) Suppose you have identified the following spot
interest rates:

Year Interest rate

1 3.0%
2 4.0%
3 5.0%
4 6.0%
5 7.0%

(a) Assume that one- and two-year pure discount (zero coupons) bonds each with
face value $1,000 are available. If you want to guarantee receipt of $3,000 each
at the end of Year 1 and Year 2, how much money would you have to invest
today? (5 points)
(b) A coupon bond with a face value of $1,000, three years to maturity, and annual
coupon payments can be purchased at $1,300. What is the annual coupon rate
of the bond? (5 points)
(c) Suppose today a bank offers you a four-year forward contract covering years 2,
3, 4, and 5 at a rate (f2→5 ) of 5% per annum, which allows you to either borrow
or lend $150,000 at the beginning of year 2. Is there an arbitrage opportunity?
If yes, how can you make an arbitrage profit that is generated only at the last
period (t = 5, year 5)? Please describe the exact transactions that you need
to make in order to obtain an arbitrage profit. Assume that one-, two-, three-,
four-, and five-year pure discount (zero-coupon) bonds each with $1,000 face
value (labeled as Bond 1, Bond 2, Bond 3, Bond 4, and Bond 5, respectively) are
available for trading at their fair values today. Note that the strategy can only
use the four-year forward contract at a rate (f2→5 ) and the pure discount bonds.
(5 points)
(d) Without doing any calculations, explain whether a 3-year 4% coupon bond or a
5-year 4% coupon bond should have a higher yield-to-maturity. (5 points)

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 4. Stock Valuation: (20 points) ABC stock is expected to sell for $10 three years from
now. The dividend growth rate is expected to be 8% (g1 ) for the next three years, and
then at 4% (g2 ) forever. The required rate of return on ABC stock is 16% throughout
parts (a)-(e).
(a) What should the dividend be four years from now? (5 points)
(b) What is the current stock price? (5 points)
(c) The current return on equity is 40% (ROE1 ). What is the current payout ratio?
The ROE will drop to 25% (ROE2 ) 3 years from now, what is the future payout
ratio? (5 points)
(d) Using the payout ratio solved in part (c) and dividend solved in part (b), what is
the net present value of growth opportunity (NPVGO)? (5 points)

5. Risk management: (10 points) You are a CRO (Chief Risk Officer) supervising a
portfolio manager who invests in two stocks AAL and AMZN. You have decided, for
capital adequacy reasons, to impose a daily loss limit computed from the ‘quantile’
associated with the 10% lower tail of the expected daily portfolio return distribution
for a $1,000,000 investment in an equally-weighted portfolio. Given the short forecast
horizon, you assume that the expected returns for AAL and AMZN are zero and also
that the correlation between the AAL and AMZN returns is zero. You have forecasted
the one-day ahead variance to be 0.05% and 0.06% for AAL and AMZN respectively.
(a) Please compute portfolio volatility (5 points) and also (b) compute your 90%
confident daily loss limit (5 points). Be sure to explain each step of your calculation
and the intuition in terms of VaR (Value-at-Risk). [The 10% ‘quantile’ of the standard
normal distribution is -1.28. You assume the normal distribution of daily returns].

Part 2. Data Analysis (20 points)

This part of the assignment is to get you to think about the relationship between term
spread, credit spread, and systematic risk in the financial market. It requires you to analyze
the data based on the regression tools. Please download ‘data.xlsx’ which contains monthly
time-series variables posted on the Quercus. The following is the description of the variables.

Column A: Date from January 1982 to December 2021.

Column B: Term spread (10-Year Treasury minus 3-Month Treasury yield), T ermSP
Column C: Credit spread, CreditSP
(Moody’s Seasoned Baa Corporate Bond Minus 10-Year Treasury yield)
Column D: S&P 500 index monthly returns, rS&P 500,t
Column E: NBER Recession indicator (1 = recession, 0 = normal period), Recess
Column F: 30-day Treasury yield per month, rf

1. Term spread: (6 points)

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 (a) What is the sign of term spread, on average, and what do you think the reasons
are for the sign? (2 points)
(b) Regress the recession indicator at time t on the term spread at time t − 6 as in
the following regression equation (Use recession variable from Jul. 1982 to Dec.
2021 and term spread from Jan. 1982 to June. 2021).

Recesst = β0 + β1 T ermSPt−6 + ϵ (1)

(i) How does the term spread predict the 6-month future recessions (the sign of
β1 )? (1 point)
(ii) Is the change statistically significant (significance of β1 )? (1 point)
(iii) Why do you think the term spread is related to the future recession as you
observe? (2 points)

2. Credit spread: (7 points)

(a) What is the sign of the credit spread and what do you think the reasons are for
the sign? (2 points)
(b) Regress the credit spread on the NBER recession as in the following regression
equation (Use the data from Jan. 1982 to Dec. 2021 for both variables).

CreditSPt = β0 + β1 Recesst + ϵ (2)

(i) How does the credit spread change during the recession (the sign of β1 )? (1
point)
(ii) Is the change statistically significant (significance of β1 )? (1 point)
(iii) Why do you think the credit spread changes as you observe? (1 point)
(iv) What does the result imply for the corporate bond risk during recessions?
(2 points)

3. Stock price: (7 points)

(a) Compute the average equity premium per annum as follows (Use the data from
Jan. 1982 to Dec. 2021 for both variables).
T
1X
(rS&P 500,t − rft ) × 12, (3)
T t=1

where T is the number of months in the sample What is the sign of the average
equity premium and what do you think the reasons are for the sign? (2 points)

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(b) Regress S&P 500 returns on the NBER recession as in the following regression
equation (Use the data from Jan. 1982 to Dec. 2021 for both variables).

S&P 500t = β0 + β1 Recesst + ϵ (4)

(i) How do the stock prices change during the recession (the sign of β1 )? (1
point)
(ii) Is the change statistically significant (significance of β1 )? (1 point)
(iii) Why do you think the stock prices change as you observe? (1 point)
(iv) What does it imply in terms of the overall risk of the stock market? (2 points)