Q6) (i) Discuss marking to market and margin accounts in the futures market.

      (ii) In an increasingly globalized investment environment, comparability problems become even greater. Discuss some of the problems for the investor who wishes to have an internationally diversified portfolio

(iii) Discuss rate anticipation swaps as a bond portfolio management strategy

(iv) Discuss contingent immunization. Is this form of bond portfolio management strategy an active, passive, or combination of both, strategy?

(v) (1.5 p) Although the expectations of increases in future interest rates can result in an upward sloping yield curve; an upward sloping yield curve does not in and of itself imply the expectations of higher future interest rates. Explain.

 

 

Q7. (i) Discuss the three theories of the term structure of interest rates. Include in your discussion the differences in the theories, and the advantages/disadvantages of each.

(ii) Discuss the M2 measure of performance by answering the following questions. Why is M2 better than the Sharpe measure? What measure of risk does M2 use? How do you construct a managed portfolio, P, to use in computing the M2 measure? What is the formula for M2 ? Draw a graph that shows how M2 would be measured. Be sure to label the axes and all relevant points.

(iii) Discuss some of the factors that might be included in a multifactor model of security returns in an international application of arbitrage pricing theory (APT).

(iv) Why are many bonds callable? What is the disadvantage to the investor of a callable bond? What does the investor receive in exchange for a bond being callable? How are bond valuation calculations affected if bonds are callable?

(v) Discuss some of the accounting comparability problems involved in international investing. 

Q6. (1 p) Discuss marking to market and margin accounts in the futures market. 

7 Ans: When opening an account, the trader establishes a margin account. The margin deposit may be cash or near cash, such as T-bills. Both sides of the contract must post margin. The initial margin is between 5 and 15% of the total value of the contract. The more volatile the asset, the higher the margin requirement. The clearinghouse recognizes profits and losses at the end of each trading day; this daily settlement is marking to market, thus proceeds accrue to the trader's account immediately; maturity date does not govern the realization of profits or losses. 

22. (1.5 p) In an increasingly globalized investment environment, comparability problems become even greater. Discuss some of the problems for the investor who wishes to have an internationally diversified portfolio. 

Ans: Firms in other countries are not required to prepare financial statement according to U. S. generally accepted accounting principles. Accounting practices in other countries vary from those of the U. S. In some countries, accounting standards may be very lax or virtually nonexistent. Some of the major differences are: reserve practices, many countries allow more discretion in setting aside reserves for future contingencies than is typical in the U. S.; depreciation practices, in the U. S., firms often use accelerated depreciation for tax purposes, and straight line depreciation for accounting purposes, while most other countries do not allow such dual accounts, and finally, the treatment of intangibles varies considerably across countries. Finally, the problem of obtaining financial information may be considerable for some international investments, varying currency exchange rates present additional complications, translation of statements into English is another complication; potential government expropriation of assets and political unrest may be problems in some countries. In general, for the individual investor, investing in global or international mutual funds is a less risky way to add diversification to the portfolio than is attempting to value individual international securities. 

23. (1 p) Discuss rate anticipation swaps as a bond portfolio management strategy. 

Ans: Rate anticipation swap is an active bond portfolio management strategy, based on predicting future interest rates. If a portfolio manager believes that interest rates will decline, the manager will swap into bonds of greater duration. Conversely, if the portfolio manager believes that interest rates will increase, the portfolio manager will swap into bonds of shorter duration. This strategy is an active one, resulting in high transactions costs, and the success of this strategy is predicated on the bond portfolio manager's ability to predict correctly interest rate changes consistently over time (a difficult task, indeed). 

24. (1.5 p) Discuss contingent immunization. Is this form of bond portfolio management strategy an active, passive, or combination of both, strategy? 

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Ans: Contingent immunization is portfolio management technique where the portfolio owner is willing to accept an average annual return over a period of time that is lower than that currently available. The portfolio manager may actively manage the portfolio until (if) the portfolio declines in value to the point that the portfolio must be immunized in order to earn the minimum average required return. Thus, the portfolio will be immunized contingent upon reaching that level. If that level is not reached, the portfolio will not be immunized, and the average annual returns will be greater than those required. Thus, this strategy is considered to be a combination active/passive bond portfolio management strategy. 

25. (1.5 p) Although the expectations of increases in future interest rates can result in an upward sloping yield curve; an upward sloping yield curve does not in and of itself imply the expectations of higher future interest rates. Explain. 

Ans: The effects of possible liquidity premiums confound any simple attempt to extract expectation from the term structure. That is, the upward sloping yield curve may be due to expectations of interest rate increases, or due to the requirement of a liquidity premium, or both. The liquidity premium could more than offset expectations of decreased interest rates, and an upward sloping yield would result.

Q7. 26. (1.5 p) Discuss the three theories of the term structure of interest rates. Include in your discussion the differences in the theories, and the advantages/disadvantages of each. 

Ans: The expectations hypothesis is the most commonly accepted theory of term structure. The theory states that the forward rate equals the market consensus expectation of future short-term rates. Thus, yield to maturity is determined solely by current and expected future one-period interest rates. An upward sloping, or normal, yield curve would indicate that investors anticipate an increase in interest rates. An inverted, or downward sloping, yield curve would indicate an expectation of decreased interest rates. A horizontal yield curve would indicate an expectation of no interest rate changes. The liquidity preference theory of term structure maintains that short-term investorsdominate the market; thus, in general, the forward rate exceeds the expected short-term rate. In other words, investors prefer to be liquid to illiquid, all else equal, and will demand a liquidity premium in order to go long term. Thus, liquidity preference readily explains the upward sloping, or normal, yield curve. However, liquidity preference does not readily explain other yield curve shapes.Market segmentation and preferred habitat theories indicate that the markets for different maturity debt instruments are segmented. Market segmentation maintains that the rates for the different maturities are determined by the intersection of the supply and demand curves for the different maturity instruments. Market segmentation readily explains all shapes of yield curves. However, market segmentation is not observed in the real world. Investors and issuers will leave their preferred maturity habitats if yields are attractive enough on other maturities.9