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INV3702 Assignment 2 2021
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Contains solutions for INV3702 assignment 2 Semester 1 of 2022. Calculations and explanations have been included to aid easy revision.
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INV3702 ASSIGNMENT 2 2022, Call/ Whatsapp 066 077 8000 for assistance and enquiries
Question 1
You observe the following sovereign bonds.
Time to maturity Coupon Yield to maturity
Bond A 1 year 5% 2.342%
Bond B 1 year 0% 2.350%
Bond C 2 years 5% 2.496%
Bond D 2 years 0% 2.500%
Bond E 3 years 5% 2.711%
Bond F 3 years 0% 2.725%
Determine whether Bond E is overvalued, undervalued or fairly valued. All coupons
are paid annually. (3)
Solution
Since Bond E has a coupon rate that is higher than the yield to maturity, this means
that the bond is trading at a premium, therefore it is overvalued.
Question 2
A student named Kgomotso needs to determine the arbitrage-free value of a 1-year,
semi-annual-pay, R1000-par bond with a coupon of 8% p.a. The following spot rates
are given to assist with the calculation:
6-month spot rate 7.0% p.a.
1-year spot rate 7.3% p.a.
1.5-year spot rate 7.6% p.a.
2-year spot rate 7.9% p.a.
She explains that she used a financial calculator, but did not arrive at the correct
answer. Below are the inputs that she made to the calculator.
FV = 1000
PMT = 4
N=2
I/YR = 7.3
Explain to Kgomotso why her method leads to an incorrect answer, and advise her on
the correct method to approach this question. No calculations are necessary. (3)
Solution
No calculations are needed to explain why the answer is incorrect. Kgomotso’s
method uses the yield-to-maturity to discount the cash flows. Yield-to-maturity is not
appropriate for arbitrage-free valuation when the yield curve is not flat. She should
value each cash flow separately using the corresponding spot rate Things that
Kgomotso got wrong:
• Using the yield rate of 7.3% for all calculations
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