Financial Management Assignment 6 Fixed Investment Management Submitted By-Faisal Ishaq B17079 Case Background

Financial Management Assignment 6
Fixed Investment Management

Submitted by- Faisal Ishaq B17079
Case Background-
Robert and his team of analysts are looking to give some advice to trustees of the Amboli
Golf Club who delegate the job of managing an investment portfolio of 50 crore to FIM. The
board of trustees of the AGC endowment included several professionals but none was a
financial specialist. Trustees provided FIM with some medium term goals, and then FIM
would get back to AGC with some bonds that would meet the stated criteria and then the
trustees would convene to decide which bond or bonds to buy. Trustees of AGC managed the
endowment with great caution and their emphasis was on repayment of principal. However,
after the RBI cut the interest rates of GOI bonds to 6.549% from 7.783%, the trustees were
leaning towards taking a more aggressive stance. They wanted some safe bonds with high
yields. There are suggestions of various bonds of the analysts of the FIM which have to
evaluated with respect to various aspects like the duration, yield to maturity, convexity, risk
to interest rates etc. These bonds will then be suggested to AGC to make the final choice. The
various suggested bonds are-
GOI treasury SBI DS Kulkarni AP State

bond Developers Ltd Financial Corp
Maturity 2 Aug 22 12 Sep 22 4 Aug 22 20 Mar 23
Coupon 8.08% 10.1% 12.75% 9.15%
Coupon Yearly Yearly Quarterly Semi Annual
payment
Credit rating AAA AAA BBB+ BB+
Last traded
price
Yield ? ? ? ?
Convexity ? ? ? ?
Interest rate risk ? ? ? ?
Instruments used to analyze the case
1) Valuation of bond
The bonds can be valued using the net present value
Let the interest rate on a bond of principal amount $ 100 is 9%. Then assume that the
government bond of similar term pays 7%. We will use this to discount the bond.
Let us also assume that the bond will mature in 10 years.
Then the price of the bond calculation is shown below-

year 1 2 3 4 5
return 9 9 9 9 109
discount 1.07 1.1449 1.225043 1.31079601 1.402551731
rate
net value 8.411214953 7.860948554 7.346680892 6.866056908 77.71549356
sum PV 108.2003949
2) Yield to maturity
The yield to maturity (YTM), book yield or redemption yield of a bond or other fixed income
security is the (theoretical) internal rate of return (IRR, overall interest rate) earned by an
investor who buys the bond today at the market price, assuming that the bond will be held
until maturity, and that all coupon and principal payments will be made on schedule.
"#$%#& ()*+-)"+ .)/$+

PV=
012
The calculation of YTM using online models is shown

3) Convexity of the bond
Convexity is a measure of the curvature in the relationship between bond prices and bond
yields that demonstrates how the duration of a bond changes as the interest rate changes.
Convexity is used as a risk-management tool, and helps to measure and manage the amount
of market risk to which a portfolio of bonds is exposed.
As interest rates increase, bond yields increases, and consequently, bond prices decrease.
Conversely, as interest rates fall, bond yields fall and bond prices rise. In the example figure
shown above, Bond A has a higher convexity than Bond B, which indicates that all else being
equal, Bond A will always have a higher price than Bond B as interest rates rise or fall.
The sample calculation of Convexity using online models is shown
4) Duration of a bond
Bond duration measures how long it takes, in years, for an investor to be repaid the bonds
price by the bonds total cash flows.
It is not to be confused with maturity which is how long a fixed-income investment lasts.
Using duration, you can estimate how much a bonds price is likely to rise or fall if interest
rates change (the bonds price sensitivity), and it can be thought of as a measurement of
interest rate risk. When interest rates rise, bond prices fall, and vice versa. As maturity
increases, duration also increases and the bonds price becomes more sensitive to interest rate
changes.
Factors that affect duration-
Time to maturity. The longer the maturity, the higher the duration, and the greater the
interest rate risk. Consider two bonds that each yield 5% and cost $1,000, but have different
maturities. A bond that matures faster say, in one year would repay its true cost faster
than a bond that matures in 10 years. Consequently, the shorter-maturity bond would have a
lower duration and less risk.
Coupon rate. A bonds coupon rate is a key factor in calculation duration. If we have two
bonds that are identical with the exception on their coupon rates, the bond with the higher
coupon rate will pay back its original costs faster than the bond with a lower yield. The
higher the coupon rate, the lower the duration, and the lower the interest rate risk.
Sample calculation of duration using online models is shown-
5) Volatility of the bond-
Investors and financial managers track duration because it measures how bond prices
change when interest rate changes.
For this purpose its best to use volatility or modified duration-
Volatility%= duration/(1+yield)
Modified duration measures the % change in bond price for 1%-point change in yield.
If a bonds modified duration is 6.2% it means that for every percentage point change
in yield the bond price rises or falls by 6.2%.
Analysis of the bond options
GOI treasury SBI DS Kulkarni AP State

bond Developers Ltd Financial Corp
Maturity 2 Aug 22 12 Sep 22 4 Aug 22 20 Mar 23
Coupon 8.08% 10.1% 12.75% 9.15%
Coupon Yearly Yearly Quarterly Semi Annual
payment
Credit rating AAA AAA BBB+ BB+
Last traded 105.55 101.48 73.50 49.15
price
Yield 6.74% 9.71% 5.38% 13.27%
Convexity 21.64 19.46 18.50 20.99
Duration 4.05 3.80 3.90 4.06
Volatility 2.79 1.81 2.89 1.47
Est bond price ~105 ~102 132.12 84.26
We have calculated the yield, convexity, duration and volatility of the bonds as shown above.
Analysis of the results-
If we look at the yields offered by the various bonds, we see that SBI and AP
State Bonds have a much higher YTM. This means that return to be expected on
these bonds for NPV=0 is very high. Given that these have a sufficiently high
YTM compared to government bonds, it does not make sense to invest in these
bonds. Also the AGC trustees are risk averse and will not want to invest in such
high risk bonds.
The other two bonds i.e. the GOI bond and DS Kulkarni bonds have lower
YTM. This means that these carry lesser amount of risk.
If we further analyze the aspects of these bonds we come across the following
results-
1) GOI has higher convexity which means that it is less vulnerable to changes in
price as the interest rate changes.
As far as DS Kulkarni bonds are considered they have comparatively lower
convexity. But it not too less.
2) DS Kulkarni bonds have lower YTM. This means that the bonds will become
profitable at comparatively low returns on the investment.
3) DS Kulkarni bonds also have lower duration compared to GOI bonds. This
means that the bonds can return the principal amount in lesser time. This is
also what the trustees at the AGC group want.
4) Volatility of the DS Kulkarni bond is also sufficiently low. For every 1

parentage point change in Yield its value changes by only ~2.9%.
5) This is a very important factor. The bond is massively underpriced. It makes

sense for the trustees to go for these bonds as they are selling well below their
expected market price.

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Financial Management Assignment 6

Fixed Investment Management

GOI treasury SBI DS Kulkarni AP State

Instruments used to analyze the case

The bonds can be valued using the net present value

Let us also assume that the bond will mature in 10 years.

Then the price of the bond calculation is shown below-

net value 8.411214953 7.860948554 7.346680892 6.866056908 77.71549356

"#$%#& ()*+-)"+ .)/$+

The calculation of YTM using online models is shown

Factors that affect duration-

For this purpose its best to use volatility or modified duration-

Analysis of the bond options

GOI treasury SBI DS Kulkarni AP State

4) Volatility of the DS Kulkarni bond is also sufficiently low. For every 1

5) This is a very important factor. The bond is massively underpriced. It makes

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