Investments Analysis

Section A

Answer Question 1 (this question is compulsory)

Question 1
Estimate the price, duration and convexity for all 3 bonds in the table below. You may assume the current date is 31st December 2019 and that the bonds mature on the last day of the years shown below. (35 Marks)

Company Moody’s Credit rating Maturity Date Coupon
[% p.a.] Payment
frequency Duration
[in years] Yield
[% p.a.] Convexity
[in years] Bond Price

Motor Co ltd B++ 2025 6.5% annual ??? 4.5%
??? ???
Mining Co ltd A1 2027 3% annual ??? 2.5%
??? ???
Water Co ltd A3 2023 4.5% annual ??? 1.5% ??? ???

The longer dated bonds above have higher levels of convexity. Holding all other bond characteristics equal, it is normally better to hold a bond with higher convexity in volatile markets conditions. Explain why this is the case.
(15 Marks)

(c) You buy an annual coupon £100 bond with a 5% p.a. coupon when interest rates are 3% p.a. At this point in time the bond has 15 years until maturity. Interest rates rise to 4% p.a. immediately after your purchase and remain constant until you sell it in 8 years-time. What is your Realised Compound Yield on this bond?
Marks)

(d) Explain the differences between the following bond management strategies: (i) buy and hold (ii) laddering (iii) matched funds. Identify the advantages and disadvantages of each.
(30 Marks)
Continued…
Section B

Answer EITHER Question 2 OR Question 3. DO NOT answer both.

Question 2: The Dividend Discount Model

LoBank plc has just paid an annual dividend of £0.50 per share. The required rate of return is 8% p.a.

If that level of dividend payment is expected to be constant into the future, what is the intrinsic value (or fair price) of the shares?
(5 marks)

If the next dividend payment of LoBank plc is expected to be 5% higher than the last, and if this rate of dividend growth is expected to be maintained over time, what is the intrinsic value of the shares?
(10 marks)

HiBank plc has a new product and is enjoying rapid growth. It is estimated that dividends will grow at an annual rate of 15% over the next five years. After that, the growth rate will fall to 7% and remain at that rate. The directors have just paid an annual dividend of £2.50 per share. Calculate the intrinsic value of the share if the required rate of return is 10% p.a.
(20 marks)

MedBank plc has seen dividends per share grow at 10% p.a. recently but expects the growth rate to decline linearly over the next 6 years (period 2H) to 3% p.a. The beta of the stock is 0.75, the risk-free rate is 2% p.a. and the market risk premium is 4% p.a. The last reported dividend was £0.50. Calculate the intrinsic value of the share.

(20 marks)
Continued…
Explain how the 3-stage DDM takes into consideration: (i) changes in dividend growth rates (ii) changes in the cost of capital and (iii) changes in the pay-out ratio. Discuss the extent to which the additional parameters incorporated in this model make it more realistic than the 2-stage and H models. (45 marks)

Note. For the 2-rate growth model the intrinsic value may be estimated as:

P_0=∑_(t=1)^(t=n)▒(〖DPS〗_0 (1+g_a )^t)/〖(1+k_e)〗^t +((〖DPS〗_n (1+g_n ))/(k_e-g_n )*1/(1+k_e )^n )

For the H-model:
P_0=(〖DPS〗_0*(1+g_n ))/((k_e-g_n ) )+(〖DPS〗_0*H*(g_a-g_n ))/((k_e-g_n ) )

For the 3-stage model:

P_0=∑_(t=1)^(t=n1)▒(〖EPS〗_0 (1+g_a )^t*⊓_a)/((1+k_(e,hg) ) )+∑_(t=n1+1)^(t=n2)▒〖DPS〗_t/((1+k_(e,t) )^t )+((〖EPS〗_n2 (1+g_n)*⊓_n ))/(〖(k〗_(e,st)-g_n)(1+r)^n ))

Continued…
Question 3: Technical Analysis

Sketch two diagrams to show the following technical chart patterns:
flag,
head and shoulders.

Explain the process through which EITHER a continuation pattern, like a flag, OR a trend reversal pattern, like a head and shoulders, may develop.
(30 marks)
Continued…
Identify the nature of the technical relationships found in the in the London silver fix and Halliburton share price charts shown below. Explain the reasons why such technical patterns may develop.
(35 marks)

London Silver price fix September 2001 – November 2007

Continued…

Halliburton share price: August 1999 – April 2000

With the aid of examples, describe how technical analysts use moving averages to identify buy and sell signals. Explain why moving averages identify changes in the momentum of price movements.
(35 marks)

Continued…

Present Value Factors:

i.e.

where n is the number of periods and r is the interest (discount) rate as a decimal

Present Value of an Annuity:

Compound Sum factor:

Compound Sum of Annuity Factor:

Continued…
Table 1a: Compound (Future) Value Factors for £1 Compounded at R Percent for N periods

Continued…
Table 1b: Compound (Future) Value Factors for £1 Compounded at R Percent for N periods
Continued…
Table 2a: Present Value Factors (at R per cent) for £1 received at end of N periods

Continued…

Table 2b: Present Value Factors (at R per cent) for £1 received at end of N periods

Continued…

Table 3a: Compound Sum Annuity for £1 Compounded at R percent for N periods

Continued…
Table 3b: Compound Sum Annuity for £1 Compounded at R percent for N periods

Continued…

Table 4a: Present Value Annuity Factors (at R percent period) for £1 received per period for each of N periods

Continued…

Table 4b: Present Value Annuity Factors (at R percent period) for £1 received per period for each of N period

END.