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Abdul Qadir Khan (Fixed Income Assignement No.1)
Abdul Qadir Khan (Fixed Income Assignement No.1)
SUBMITTED TO:
SIR SHOAIB HASHMI
SUBMITTED BY:
Assignment: Solve the following questions from the handout (4, 5 and 13)
Question no 04
Suppose a portfolio manager purchases $1 million of par value of a Treasury inflation
protection security. The real rate (determined at the auction) is 3.2%.
A. Assume that at the end of the first six months the CPI-U is 3.6% (annual
rate).Compute the following
(i) Inflation adjustment to principal at the end of the first six months,
(ii) The inflation-adjusted principal at the end of the first six months
(iii) The coupon payment made to the investor at the end of the first six months.
B. Assume that at the end of the second six months the CPI-U is 4.0% (annual rate).
Compute the following
(i) Inflation adjustment to principal at the end of the second six months
(ii) The inflation-adjusted principal at the end of the second six months
(iii) The coupon payment made to the investor at the end of the second six months.
Solution
A. Since the inflation rate (as measured by the CPI-U) is 3.6%, the semiannual inflation
rate for adjusting the principal is 1.8%.
B. Since the inflation rate is 4.0%, the semiannual inflation rate for adjusting the
principal is 2.0%.
Suppose that a 15-year mortgage loan for $200,000 is obtained. The mortgage is a level-
payment, fixed-rate, fully amortized mortgage. The mortgage rate is 7.0% and the
monthly mortgage payment is $1,797.66.
Solution
a. Monthly mortgage payment = $1,797.66
Monthly mortgage rate = 0.00583333 (0.07/12)
b. In the last month (month 180), after the final monthly mortgage payment is made, the
ending mortgage balance will be zero. That is, the mortgage will be fully paid.
c. The cash flow is unknown even if the borrower does not default. This is because the
borrower has the right to prepay in whole or in part the mortgage balance at any time.
Question no 13
a. What is a collateralized debt obligation?
b. What distinguishes an arbitrage transaction from a balance sheet transaction?
Solution
a. A collateralized debt obligation is a structure backed by a portfolio of one or more
fixed income products—corporate bonds, asset-backed securities, mortgage-backed
securities, bank loans, and other CDOs. Funds are raised to purchase the assets by the
sale of the CDO. An asset manager manages the assets.