Question #10

Nancy arrives at the meeting, the Finance Executive from Moneymatters Inc. is engaged in a discussion with a fellow meeting participant, Chin Lee, about why his company should issue a callable bond to raise new debt capital. Chin Lee does not like the idea of a callable bond. He says that it can prove to be costly for Moneymatters Inc. Both gentlemen hold their ground citing their reasons. Seeing Nancy walk in, they deflect the question to her and before she can catch her breath, she finds herself speaking on the pros and cons of callable bonds. After her input on the matter and a subsequent decision, there is a brief discussion on which of the following two bonds should be included in a portfolio of securities:

	Bond A	Bond B
Coupon Rate	4% p.a. semi-annually	5% p.a. semi-annually
Yield to Maturity	5% p.a.	4% p.a.
Maturity	2 years	2 years

As the meeting discusses Bonds A and B, there is a sharp division in opinion. Given that bonds with higher interest rate risk carry a greater potential for return at the cost of higher risk, there is no conclusive agreement on which of the two bonds should be allowed into the portfolio, with votes equally divided between selecting Bond A and Bond B. Finally, the meeting chair, Samantha Hill, uses her veto power to arrive at a decision and there being no other business, the meeting ends and the delegates pack up and leave for home. Nancy thanks the lord for another safe day in business. At home, she gets into an uneasy argument with her husband. Her husband says that she did not take a correct decision to commit to such a long term mortgage loan. According to him, they would now have to make primarily interest payments for a long time before their instalments begin to reduce the principal that they owe. He suggests that they should not keep the loan for too long and prepay it as early as year 2 but Nancy does not agree. The arguments heat up when they notice their daughter Shelly quietly watching them. They decide to postpone this discussion to the next morning. They would eventually proceed to sit back-to-back next morning after sending Shelly off to school and do their math to prove their point. Nancys husband would decide to prepare a statement for the first nine months of the first year so that Shelly could see how the bank was interested in collecting primarily interest and Nancy would evaluate the merit of repaying the loan after 2 years. It is now 5.00 p.m. Our friend John is good a teaching, which is a bit surprising, given his sullen nature. Towards the end of the day, he heads towards a local college where he teaches the course on Money and Capital Markets as a part-time instructor. He gives Mary a lift as her house is on the way but as he turns in to the College Road, he is upset to see it clogged with cars. Muttering to himself and complaining about almost everything under the sun, he arrives at the teaching venue where he administers the following snap test to his students: a) What is the current yield of 7% coupon bond selling for $950?

b) Assuming U.S.A to be the home country, how many US$ will an American tourist need to pay to acquire 1 TT$, given that the exchange rate is TT$6.7993 / USD?

c) What is a bankers acceptance?

d) What is the YTM of a perpetual bond that offers a 5% coupon and sells for its face value?

e) What is interest rate parity? By 6.00 p.m. he collects the answer-sheets and drives back home only to find that he has forgotten his home keys at the office. But this time, instead of getting rattled, he smiles and as he takes out a spare key from the glove compartment of his car, he remembers how in the world of finance also, financial instruments are fungible in nature.

Question 10 (15 marks)

i) If you were Samantha Hill and you cast your veto vote with a view that a bond with lesser interest rate risk should form a part of the portfolio, which bond would you vote for? Support your answer by computing the duration of both bonds and selecting the one with lesser interest rate risk. (5 marks) ii) If you were in Johns class, what answers would you offer to the questions in the snap test? Respond briefly to all questions in the snap test. (5 marks) iii) Why does a spare key in the glove compartment of his car remind John of something called fungibility of financial instruments. Research the term fungible and propose a definition for a financial instrument that includes this word. (5 marks)