MONDAY: 4 December 2023. Afternoon Paper. Time Allowed: 3 hours.
Answer ALL questions. Marks allocated to each question are shown at the end of the question. Show ALL your workings. Do NOT write anything on this paper.
QUESTION ONE
1. Describe TWO characteristics of a bond that determines the degree of reinvestment risk. (4 marks)
2. Explain THREE determinants of the Repo Rate. (6 marks)
3. Below is the information on four 180-day money market instruments:
Required:
Determine the bond equivalent yield of each instrument assuming a par value of Sh.100. (9 marks)
Advise on the best bond to invest in. (1 mark)
(Total: 20 marks)
QUESTION TWO
1. Explain TWO types of bonds with embedded options. (4 marks)
2. A floating rate note with a quoted margin of 90 basis points is selling for Sh.98 and matures in 4 years.
Required:
Calculate the floater’s spread for life. (4 marks)
Explain TWO limitations of the discount margin as a measure of the potential return from investing in a
floating-rate security. (2 marks)
3. The treasury spot rate curve is as follows:
The market price of a four year, 6% coupon non-treasury issue is Sh.91.4083.
Required:
Determine whether the zero volatility spread (Z-spread) relative to the treasury spot rate curve for this
issue is 80 basis points, 90 basis points or 100 basis points. (4 marks)
Calculate the 6 month forward rate, three years from now. (3 marks)
Calculate the 1 year forward rate, two years from now. (3 marks)
(Total: 20 marks)
QUESTION THREE
1. Summarise THREE characteristics of equilibrium term structure models. (3 marks)
2. Outline THREE differences in yield measures between the money market and the bond market. (3 marks)
3. A treasury bill has a face value of Sh.10,000 and has a price of Sh.9,800. The treasury bill has 90 days to maturity.
Required:
Compute the following:
Yield on a discount basis. (2 marks)
Yield on a money market basis. (2 marks)
4. The Kenlime Ltd. is contemplating retiring Sh.50 million of a 30 year, Sh.1,000 face value bond issued five years ago with a coupon interest of 9%. The bonds have a call price of Sh.1,090 and initially netted proceeds of Sh.48.5 million due to a discount of Sh.30 per bond. The initial floatation cost was Sh.400,000. The company intends to issue Sh.50 million, 25 year Sh.1,000 face value bonds with a 7% coupon interest to raise funds for retiring the old bonds. The flotation costs on the new issue are estimated to be Sh.450,000. The tax rate is 30%. The company will have a two month period of overlapping interest when it retires the old bonds.
Required:
Using net present value (NPV) approach, advise the management of Kenlime Ltd. on whether the bond should be retired. (10 marks)
(Total: 20 marks)
QUESTION FOUR
1. Distinguish between “stripping” and “reconstitution” as used in the fixed income markets. (4 marks)
2. Describe THREE risks faced by investors of floating rate notes (FRN). (6 marks)
3. The following four year step-up callable note pays 4.25% interest for two years and then 7.5% interest for the next two years. The note is callable at par at the end of year 2 and year 3. The note has a par value of the first Sh.100.
It is assumed that interest rate volatility is 10%.
Required:
Calculate:
The value of step-up option free bond. (4 marks)
The value of step-up callable bond. (4 marks)
The value of the embedded call option. (2 marks)
(Total: 20 marks)
QUESTION FIVE
1. Explain TWO types of municipal security structures. (4 marks)
2. Describe THREE theories of the term structure of interest rate. (6 marks)
3. Consider a 6% semi-annual coupon payment bond that matures on 14 February 2024 and it is priced to yield 6% for settlement on 11 April 2024. The full price of the bond is Sh.1,000.940423 per Sh.1,000 of par value and the annual modified duration is 6.1268.
Hakika Life Insurance company has a position in the bond for a par value of Sh.100 million.
Required:
The market value of the investment of Hakika Life Insurance Company. (2 marks)
The money duration. (2 marks)
4. Bima Ltd. has an option free bond with the following characteristics:
• Par value Sh.1,000,000
• Maturity 8 years
• Coupon rate 10%
• Initial yield to maturity (YTM) 8%
• Initial price Sh.1,114,960
Note: Interest is paid annually.
Required:
Assuming a yield of 100 basis points around the interest rate, determine the effective duration of the bond. (6 marks)
(Total: 20 marks)
