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Need help with 1c, 2c and 3c, 3d please. Thanks, The attched document has the questions in the right format 0 1. Suppose that a
Need help with 1c, 2c and 3c, 3d please. Thanks, The attched document has the questions in the right format
0 1. Suppose that a two-factor model, where the factors are the market return (Factor 1) and the growth rate of industrial production (Factor 2), correctly describes the return generating processes of all assets and the corresponding two-factor APT correctly prices three well-diversified portfolios, A, B, and C. Portfolio Expected Return A B C 15% 20% 5% Sensitivity to Factor 1 1 1 0 Sensitivity to Factor 2 0 1 0 a. What are i) the risk premiums of the two factors and ii) the risk-free rate? (4 marks) b. Another well-diversified portfolio D has sensitivities 0 and 1 to factor 1 and factor 2, respectively. What is the APT-consistent expected return on Portfolio D? (2 marks) c. Suppose that Portfolio D's expected return is 8%. Given your answers above, design an arbitrage strategy involving Portfolios A, B, C, and D. (Hint: an arbitrage strategy requires no initial investment, has no risk and yet generates a positive return.) (4 marks) (Total for Question: 10 marks) (3 marks) (Total for Question: 14 marks) 1 2. Consider a pension plan that will pay $10,000 once a year for a 5-year period (5 annual payments). The first payment will come in exactly 5 years (at the end of year 5) and the last payment in 9 years (at the end of year 9). a. What is the duration of the pension obligation? The current interest rate is 10% per year for all maturities. (3 marks) b. To generate the scheduled pension payments, the pension fund wants to invest the present value of the future payouts in bonds and match the duration of its obligation in part a). If the fund uses 5-year and 10-year zero-coupon bonds to construct its investment position, how much money (dollar amount) ought to be placed in each bond now? What should be the total face value (not current market value) of each zero-coupon bond held? (3 marks) c. Right after the fund made its investment outlined in part b), market interest rates for all maturities dropped from 10% p.a.to 9% p.a. Show that the investment position constructed in part b) can still fund (approximately) the future payments by showing that the fund's net investment is close to 0 at the end of year 9 after making all the scheduled payments. Assume that interest rates will remain at 9% p.a. Any excess cash from the 5-year investment will be reinvested at 9% and any fraction of the 10year bonds held can be sold at the going market price at any time to fund the annual payments. (6 marks) (Total for Question: 12 marks) 2 3. The current yield curve for default-free zero-coupon bonds is as follows: Maturity (Years) 1 2 3 YTM 10% 11% 12% All bonds considered in this question have a face value of $1,000. Assume that the pure expectations hypothesis of the term structure holds. a. If market expectations are accurate, what are the expected yields to maturity on 1- and 2-year zero coupon bonds next year? (3 marks) b. If you purchase a 3-year zero-coupon bond now, what is the expected total rate of return over the next year assuming that you will sell the bond at the expected price (price that matches the expected yield in part a))? Ignore taxes. (3 marks) c. What should be the current price of a 3-year maturity bond with a 12% coupon rate paid annually? (3 marks) d. If you purchase the coupon bond at the price you calculated in part c), what would your total expected rate of return over the next year be (coupon plus price change)? Ignore taxes. (3 marks) (Total for Question: 12 marks) 3 4Step by Step Solution
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