Today is 1 January 2019. Kim is looking for an investment that will give her $500,000 in 5 years’ time

Question

so that she will have a sufficient deposit to purchase a $2.5m house in Sydney. Currently she has
saved about $380,000 to contribute to the deposit. She has started looking at Treasury bonds as she
thinks they are a relatively low risk investment. However, she did not study finance at University so
does not have a good understanding of Treasury Bonds

• The expected change in market yield and reinvestment rates for the next 7 years is a 50
basis points increase per annum from the current market yield. This change is expected to
occur immediately after 1 January 2019.
• For a $500,000 investment in 5 years’ time, Kim can consider buying:
o Investment 1 – 2413 units of a 7 year 15.6% p.a. Treasury bond (bond 1) with a face
value of $100 at a yield of j2 = 6.2%. The bond is redeemable at par. The maturity
date is 1 January 2026.
o Investment 2 – 3511 units of a 6 year 7.2% p.a. Treasury bond (bond 2) with a face
value of $100 at a yield of j2 = 6.2%. The bond is redeemable at par. The maturity
date is 1 January 2025.
• On receipt of each coupon, Kim should deposit the coupon into a bank account earning the
reinvestment rate.
As you are a friend studying financial modelling, Kim has approached you to help her with some
analysis before she decides whether to invest in the Treasury bonds suggested by Matt. Her
questions are [25 marks]:
a) What is the price per bond and total price Kim will pay for 1 January 2019 for investment 1
and 2? [4 marks]
b) For each bond, calculate the accumulated value at years 4, 5 and 6 and maturity [7 marks]
c) For each bond, calculate the holding period yield rate (expressed as a j2 rate to 1 decimal
place) for each of the holding periods in b) [7 marks]
d) Calculate the duration of each bond using the weighted average cash flow method (to 2
decimal places). Based on your observation in c) and d), what is the reason Matt has given
Kim the advice to consider purchasing the 2 bonds? [4 marks]
e) Use a separate bar/column chart to plot your results for each bond in c). Provide an
explanation of why the holding period yield rate increases as the holding period increases. [3
marks]