The University of Melbourne

FNCE30001 Investments
Revision Questions for Mid-semester Test – Semester 1, 2024

Q1. What is the price of the following risk-free bond?

Face Value $1,000
Coupon 7.50%
Maturity 3.5 years
YTM 8.25%
Compounding Semi-annual

Q2. What is the duration of an 8.5-year zero-coupon bond yielding 7.15% annually on the date of issue?

Q3. If a bond’s coupon rate is lower than its YTM, is it trading at a premium or a discount?

Q4. What is the price of a $1,000 face value zero-coupon bond that matures in 10 years if its YTM is
6.45% with quarterly compounding?

Q5. On Thursday 14 March 2024 you agreed to buy a 5.0% 21 October 2028 Australian government
bond at 4.76% yield. The face value of the bond is $1,000. Using the RBA bond pricing formula, and the
attached calendar for 2024, how much do you pay on settlement date for this bond?

Q6. A risk-neutral investor buys a six-year corporate bond rated Baa. The bond has a default rate of 2.1%
and, if it defaults, the recovery rate is 47%. Its face value is $1,000. The annual risk-free rate is 3%.
a) What is the expected return?
b) What is the expected cashflow at maturity?
c) What is the price of this bond today?
d) What is the YTM of this bond?
e) What is the default premium?

Q7. You observe the following annual zero-coupon rates on offer in the markets:

Years to Maturity Yield

1 Year 7.25%
2 Years 7.65%
3 Years 8.15%
4 Years 8.55%

What is the annualised forward rate for a two-year investment starting in two years?

Q8. Using the rates from the table in Q7, if an investment bank offered a two-year rate in one year’s
time (F1,3) of 8.68% what dollar amount of arbitrage profit could be made on an investment of
$1,000,000?

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Q9. Consider the following bond and assume a flat yield curve with rates at 5.75%.
Face Value $1,000
Coupon 6.5%
Maturity 3 years
Compounding Semi-annual

a) What is the duration of this bond?

b) Using the duration from a) what is the approximate percentage gain or loss on this bond if
yields decrease by 50 basis points?

Q10. Two coupon bonds have terms to maturity of 9 years, and both have semi-annual compounding
periods. Bond A has a coupon rate of 6.75% and Bond B has a coupon rate of 5.25%. Which has the
longer duration?

Q11. One year ago, you bought a risk-free, annual coupon-paying bond for $96 with 4 years to maturity.
The annual coupon rate is 4.5% and the face value is $100. The prevailing risk-free interest rate is 5.0%
and the yield curve is flat. What is the holding period return?

Q12. A risk-free zero-coupon bond is currently worth $950, and its yield to maturity is 8.20%. If the yield
to maturity rises to 8.40% what will the value of the bond become if its duration is 3.5?

Q13. What is the annualised yield on a zero-coupon bond with the following characteristics?
Face Value $1,000
Price $877.53
Term to Maturity 2 Years

Q14. An investor bought a share and experienced a holding period return of 14.28%. After a dividend
was paid the share’s price was $51. It was purchased for $49. What was the amount of the dividend?

Q15. If the bond-equivalent yield of a quarterly coupon-paying bond is 9.5% what is its effective annual
rate?

Q16. Consider the data below. Which investment is best for an investor with a risk aversion score of 3?

Investment Expected Return Standard Deviation

1 8.5% 30%
2 9.2% 45%
3 10.6% 14%
4 12.3% 19%

Q17. Two Australian Commonwealth government bonds have the same maturity date and face value.
Bond A pays 6.75% semi-annual coupons and Bond B pays 5.50% semi-annual coupons. Which has the
least interest rate risk?

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Q18. What is the default probability of the following bond?
Face Value $100
Maturity 5 years
Price $64.97
Probability of Recovery 0.75
Proportion Recovered 0.80
Expected Return 7.85%

Q19. Consider the following predictions of a company’s future returns. What is the investment’s
expected return?
Return Probability
Pessimistic Case -2.10% 0.25
Base Case 5.75% 0.55
Optimistic Case 8.85% 0.20

Q20. Consider the following table of zero-coupon rates applicable at certain dates:

Term 1 March 2020 1 March 2021 1 March 2022 1 March 2023

1 Year 5.80% 6.10% 6.35% 6.15%
2 Years 6.25% 6.60% 6.90% 6.70%
3 Years 6.90% 7.70% 7.95% 7.45%
4 Years 7.45% 8.25% 8.60% 8.05%

An investor purchased a 4-year zero-coupon bond on 1 March 2020 and sold the bond 2 years later.
What was the annualised holding period return on the investment?

Q21. Consider the following prices and dividend payments on Devon Minerals, a cadmium producer.

Price at Start of Year Dividend Paid

2020 $37 $1.85
2021 $35 $1.50
2022 $41 $1.90
2023 $45 $2.05

You purchased 5 shares at the start of 2020, purchased an additional 5 shares at the start of 2021, you
sold 4 shares at the start of 2022 and then sold the remaining 6 shares at the start of 2023. What are the
arithmetic and geometric mean rates of return on your investment?

Q22. A zero-coupon bond with 7 years to maturity exists which, if it does not default will return 11.5%
annualised and, if it does default, will return -19%. If the probability of default is 6% what is the bond’s
expected return?

The University of Melbourne FNCE30001 - Investments MST Revision Questions Page 3

Q23. An investment opportunity set exists where the risk-free rate is 3.5%, and the expected return on a
portfolio of risky assets is 10.25% with an expected standard deviation of 16%. What is the Sharpe Ratio
if the complete portfolio is 80% invested in the risky assets and 20% is invested in cash?

Q24. The table below shows returns for two assets:

Zeus Lithium Artemis Nickel

Recession Economy -4.5% -3.8%
Steady Economy 6.5% 5.9%
Boom Economy 10.5% 9.6%

Calculate the standard deviation of Zeus Lithium, Artemis Nickel and of a portfolio consisting of 40%
Zeus Lithium and 60% Artemis Nickel.

Q25. A 6-year zero-coupon bond has an interest rate of 7.0% per annum. What is the percentage change
in the value of this bond if the prevailing interest rate decreases by 1 basis point?

Q26. A risky 4-year zero-coupon investment has a face value of $100 and has a 25% probability of
defaulting, in which case it will return $45. A similar-maturity risk-free zero with a face value of $100 has
a yield to maturity of 3.75%. What is the default premium on the risky investment?

Q27. An investor can choose to invest in a portfolio of risky assets with an expected return of 8.9% and a
standard deviation of 13% in combination with a risk-free asset which returns 4.5%. If the investor’s risk
aversion score is 3, what combination of the two assets will create the investor’s optimal complete
portfolio?

Q28. An investor, Janet Xiao, holds a portfolio consisting of only the assets listed below:

Asset Value Expected Return Standard Deviation

Minerva Forestry $25,000 6.5% 15.8%
Juno Engineering $15,000 8.9% 19.4%

The correlation coefficient of the returns of Minerva Forestry and Juno Engineering is 0.64. Calculate the
expected return and standard deviation of the investor’s portfolio.

Q29. If Janet Xiao sells all of her Juno Engineering shares and buys 10-year Australian Government
Bonds yielding 4.15% per annum with the proceeds, what will be the standard deviation of her resultant
portfolio?

Q30. What is the real rate of return on annual coupon paying bonds yielding 7.45% per annum if the
annual inflation rate is 3.25%?

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 Calendar 2024
Highlighted Dates are Public Holidays

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Revision Questions – Answers

A1. Price of bond

1000 × 0.075 ÷ 2 37.50 37.50 37.50 37.50 37.50 1037.50

𝑃= + + + + + +
(1 + 0.0825 ÷ 2) 1.041252 1.041253 1.041254 1.041255 1.041256 1.041257

𝑃 = 36.01 + 34.59 + 33.22 + 31.90 + 30.64 + 29.42 + 781.81

𝑃 ≈ 977.59

A2. 8.5 years. The duration of a zero-coupon bond equals its maturity.

A3. This bond is trading at a discount, i.e., its price is less than face value.

A4. Price of zero-coupon bond

1000
𝑃=
(1 + 0.0645 ÷ 4)40

𝑃 ≈ 527.37

A5. Using RBA Bond Formula

Previous Coupon Date: 21 October 2023 Coupon Amount: $25

Next Coupon: 22 April 2024 (Monday) Days to Next Coupon (f) 34
Settlement Date (T+3): 19 March 2024 Days in This Coupon Period (h) 184
Number of Coupons Remaining (n) 10
Annuity Factor 8.8065838
Yield to Maturity 0.0476 ÷ 2 = 0.0238

1 𝐶 1 𝑃𝑎𝑟
𝑃0 = {𝐶 + [1 − 𝑛−1
]+ }
(1 + 𝑦𝑡𝑚) 𝑓÷ℎ 𝑦𝑡𝑚 (1 + 𝑦𝑡𝑚) (1 + 𝑦𝑡𝑚)𝑛−1

1 1 1000
𝑃0 = 0.184783
{25 + 1050.42 [1 − 9
]+ }
(1.0238) 1.0238 1.02389

1
𝑃0 = {25 + 200.40 + 809.21}
(1.0238)0.184783

1
𝑃0 = {1034.61}
1.02380.184783

𝑃0 = 0.995663 × 1034.61

𝑃0 = $1030.12

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A6a. Investor is risk-neutral, so the expected return equals the risk-free rate of 3%.

A6b. Cashflow at Maturity

CF = (1000  0.9790) + (1000  0.47 0.021)

CF = 979 + 9.87
CF = 988.87

A6c. Price today

̃)
𝐸(𝐶𝐹
𝑃=
(1 + 𝐸(𝑅))𝑇

988.87
𝑃=
(1.03)6

𝑃 = 828.16

A6d. Yield to Maturity (annualised zero-coupon rate)

𝑃𝑟𝑜𝑚𝑖𝑠𝑒𝑑 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 𝐹𝑉
𝑃= 𝑇 =
(1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀)𝑇

1000
828.16 =
(1 + 𝑌𝑇𝑀)6

1.207496 = (1 + 𝑌𝑇𝑀)6
1.031924 = 1+YTM
YTM = 3.1924%

A6e. Default Premium

DP = YTM – rf
DP = 0.031924 – 0.03
DP = 0.001924 = 0.1924%

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A7. Calculate Forward Rate F2,4

1
(1 + 𝑍0,4 )4 4−2
𝐹2,4 =( ) −1
(1 + 𝑍0,2 )2

1
1.08554 2
𝐹2,4 =( ) −1
1.07652

1
𝐹2,4 = (1.198095)2 − 1

𝐹2,4 = 9.4575%

A8. Calculate “correct” forward rate

1
(1 + 𝑍0,3 )3 3−1
𝐹1,3 =( ) −1
(1 + 𝑍0,1 )

1
(1.0815)3 2
𝐹1,3 =( ) −1
(1.0725)

1
𝐹1,3 = (1.179457)2 − 1

F1,3 = 8.60%

Arbitrage is to borrow at the “correct” forward rate of 8.60% and invest at the investment bank’s
(incorrect) rate of 8.68%.

Interest Cost = 1000000  1.08602 = 179,396

Interest Earned = 1000000  1.08682 = 181,134
Arbitrage Profit = Interest Earned – Interest Cost = $1,738

The University of Melbourne FNCE30001 - Investments MST Revision Questions Page 8

A9a. Duration

Face Value 1000

Coupon 6.50%
YTM 5.75% Semi-annual

Timing of
Cashflow PV PV/P PV/P*T
CF
1 $32.50 $31.59 0.030960 0.0310
2 $32.50 $30.71 0.030095 0.0602
3 $32.50 $29.85 0.029254 0.0878
4 $32.50 $29.02 0.028436 0.1137
5 $32.50 $28.21 0.027642 0.1382
6 $1,032.50 $871.03 0.853613 5.1217
$1,020.40 5.55
Divide by n=2 2.7763

Duration is 2.7763 years

A9b. Approximate change in price. (Bond yield falls, so price will increase.)

−∆𝑌 × 𝐷
%∆𝑃 =
(1 + 𝑦)

− − 0.005 × 2.7763
%∆𝑃 =
1.02875

%∆𝑃 = +0.013494%

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A10. Bond B. Smaller coupons will increase duration.

A11. Holding period return

(𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑃𝑟𝑖𝑐𝑒 + 𝐶𝑜𝑢𝑝𝑜𝑛)
𝐻𝑃𝑅 = −1
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙𝑃𝑟𝑖𝑐𝑒

4.5 4.5 104.5

𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑃𝑟𝑖𝑐𝑒 = + + = 98.63
1.05 1.052 1.053

(98.63 + 4.5)
𝐻𝑃𝑅 = − 1 = 7.4271%
96

A12. Duration

∆𝑃 ∆𝑌
= −𝐷
𝑃 (1 + 𝑦)

∆𝑃 0.002
= −3.5 ×
950 1.0820

∆𝑃 0.002
= −3.5 ×
950 1.0820

∆𝑃 = −6.14

P = 950 - 6.14 = 943.86

A13. Solve for rate

1000
877.53 =
(1 + 𝑟)2

√1.13955625 = 1 + 𝑟

r = 6.75%

A14. HPR, Solve for dividend

𝑃1 + 𝐷 − 𝑃0
𝐻𝑃𝑅 =
𝑃0

51 + 𝐷 − 49
0.1428 =
49

7 = 51 + 𝐷 − 49

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D = $5.00

A15. Calculate EAR

𝑟𝐵𝐸𝑌 𝑛
𝐸𝐴𝑅 = (1 + ) −1
𝑛

0.095 4
𝐸𝐴𝑅 = (1 + ) −1
4

EAR = 9.84%

A16. Utility function

1
̃ − 𝐴𝜎 2
𝑈 = 𝐸(𝑟)
2

Investment 1 and 2 have lower returns and higher SD than 3 or 4 so can be left out of consideration.

1
𝑈3 = 0.106 − × 3 × 0.142 = 7.66%
2
1
𝑈4 = 0.123 − × 3 × 0.192 = 6.88%
2

Investment 3 is best as it has a higher Utility score.

A17. The bond with the higher coupon rate – Bond A – has the shorter duration, least interest rate risk.

A18. Calculate PD

(1 − 𝑃𝐷 ) × 𝐹𝑉 + 𝑃𝐷 × 𝑃𝑅 × 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 × 𝐹𝑉
𝑃=
(1 + 𝑟)𝑛

(1 − 𝑃𝐷 ) × 100 + 𝑃𝐷 × 0.75 × 0.8 × 100

64.97 =
(1 + 0.0785)5

100 − 100𝑃𝐷 + 60𝑃𝐷

64.97 =
1.459153

100 − 40𝑃𝐷
64.97 =
1.459153

94.80 = 100 − 40𝑃𝐷

−5.2 = −40𝑃𝐷

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PD = 13%
A19. Probability-weighted return

𝐸(𝑟) = ∑ 𝐸(𝑟𝑖 ) × 𝑃𝑖
𝑖=1

E(r) = -0.021  0.25 + 0.0575  0.55 + 0.0885  0.20

E(r) = 4.4%

A20. Calculate HPR, annualising the result since it is a 2-year investment

𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑃𝑟𝑖𝑐𝑒
𝐻𝑃𝑅 = −1
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙𝑃𝑟𝑖𝑐𝑒

1
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑃𝑟𝑖𝑐𝑒 =
1.07454

1
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 =
1.06902

0.875074 0.5
𝐻𝑃𝑅 = ( ) −1
0.750195

HPR = 8.00%

A21. Calculate annual returns then find means:

r = (EndPrice – StartPrice + Dividend) ÷ StartPrice

Period Return Calculation Return

2020-2021 = (35 – 37 + 1.85) ÷ 37 -0.0040
2021-2022 = (41 – 35 + 1.50) ÷ 35 0.2140
2022-2023 = (45 – 41 + 1.90) ÷ 41 0.1440

Arithmetic Return = (-0.0040 + 0.214 + 0.144) ÷ 3 = 11.80%

Geometric Return = [(1 + -0.0040) x (1 + 0.214) x (1 + 0.144)](1/3) - 1 = 11.42%

Note that the number of shares is not required for the calculation.

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A22. Calculate return given default probability

𝐸(𝑟) = 𝑌𝑇𝑀𝑁𝑜𝐷𝑒𝑓𝑎𝑢𝑙𝑡 × (1 − 𝑃𝐷𝑒𝑓𝑎𝑢𝑙𝑡 ) + 𝑌𝑇𝑀𝐷𝑒𝑓𝑎𝑢𝑙𝑡 × 𝑃𝐷𝑒𝑓𝑎𝑢𝑙𝑡

𝐸(𝑟) = 0.115 × (1 − 0.06) + −0.19 × 0.06

𝐸(𝑟) = 0.1081 − 0.0114

𝐸(𝑟) = 9.67%

A23. Sharpe Ratio

𝐸(𝑟𝑝 ) − 𝑅𝑓
𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 =
𝜎𝑝

(0.1025 × 0.8 + 0.035 × 0.2) − 0.035

𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 =
0.16 × 0.8

(0.082 + 0.007) − 0.035

𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 =
0.128

𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 = 0.4218

A24. Calculate E(r) and SD for each

𝐸(𝑟𝑍𝑒𝑢𝑠 ) = (−0.045 + 0.065 + 0.105) ÷ 3 = 4.17%

𝐸(𝑟𝐴𝑟𝑡𝑒𝑚𝑖𝑠 ) = (−0.038 + 0.059 + 0.096) ÷ 3 = 3.90%

𝐸(𝑟𝑃 ) = (0.0417 × 0.40) + (0.039 × 0.60) = 4.01%

1 1 1
𝑆𝐷𝑍𝑒𝑢𝑠 = √ (−0.045 − 0.0417)2 + (0.065 − 0.0417)2 + (0.105 − 0.0417)2
3 3 3

𝑆𝐷𝑍𝑒𝑢𝑠 = √0.002506 + 0.000181 + 0.001336

𝑆𝐷𝑍𝑒𝑢𝑠 = 6.34%

1 1 1
𝑆𝐷𝐴𝑟𝑡𝑒𝑚𝑖𝑠 = √ (−0.038 − 0.039)2 + (0.059 − 0.039)2 + (0.096 − 0.039)2
3 3 3

𝑆𝐷𝐴𝑟𝑡𝑒𝑚𝑖𝑠 = √0.001976 + 0.000133 + 0.001083

𝑆𝐷𝐴𝑟𝑡𝑒𝑚𝑖𝑠 = 6.62%

The University of Melbourne FNCE30001 - Investments MST Revision Questions Page 13

Expected return in each state for the portfolio

Recession= -4.08%; Steady = 6.14%; Boom = 9.96%

1 1 1
𝑆𝐷𝑃 = √ (−0.0408 − 0.0401)2 + (0.0614 − 0.0401)2 + (0.0996 − 0.0401)2
3 3 3

𝑆𝐷𝑃 = √0.002182 + 0.000151 + 0.001180

𝑆𝐷𝑃 = 5.93%

A25. There are two ways to answer this

a) The duration of the bond is 6 years. You should be able to recognise that duration affects bond
prices by approximately -D percent for a 1% change in interest rates. Therefore, the bond price
should rise by approximately 0.06%.
b) Do the calculation
∆𝑃 ∆𝑌
= −𝐷
𝑃 (1 + 𝑦)

∆𝑃 −0.0001
= −6 ×
𝑃 (1.07)

∆𝑃
= 0.00056 which is close to 0.06%
𝑃

A26. Calculate default premium from promised return

𝑃(𝑁𝑜𝐷𝑒𝑓𝑎𝑢𝑙𝑡) × 𝑁𝑜𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑃𝑎𝑦𝑚𝑒𝑛𝑡 + 𝑃(𝐷𝑒𝑓𝑎𝑢𝑙𝑡) × 𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑃𝑎𝑦𝑚𝑒𝑛𝑡

𝑃𝑟𝑖𝑐𝑒 =
(1 + 𝑟)𝑛

0.75 × 100 + 0.25 × 45

𝑃𝑟𝑖𝑐𝑒 =
(1 + 0.0375)4

86.25
𝑃𝑟𝑖𝑐𝑒 =
1.15865

𝑃𝑟𝑖𝑐𝑒 = $74.44

1
𝑃𝑟𝑜𝑚𝑖𝑠𝑒𝑑𝑃𝑎𝑦𝑜𝑢𝑡 𝑛
𝑟𝑃𝑟𝑜𝑚𝑖𝑠𝑒𝑑 =( ) −1
𝑃𝑟𝑖𝑐𝑒
1
100 4
𝑟𝑃𝑟𝑜𝑚𝑖𝑠𝑒𝑑 =( ) −1
74.44

𝑟𝑃𝑟𝑜𝑚𝑖𝑠𝑒𝑑 = 0.0765

𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑃𝑟𝑜𝑚𝑖𝑠𝑒𝑑𝑌𝑇𝑀 − 𝑟𝑓

The University of Melbourne FNCE30001 - Investments MST Revision Questions Page 14

𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = 0.0765 − 0.0375

𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = 0.0391 = 3.91%

A27. Calculate optimal complete portfolio

𝐸(𝑟̃
𝑝 ) − 𝑟𝑓
𝑦∗ =
𝐴𝜎𝑝2

0.089 − 0.045
𝑦∗ =
3 × 0.0169

0.044
𝑦∗ =
0.0507

𝑦 ∗ = 0.8678

Invest 86.78% in the risky asset and 13.22% in the risk-free asset to maximise utility.

A28. Calculate portfolio properties

Asset Value % of Portfolio

Minerva Forestry $25,000 62.5%
Juno Engineering $15,000 37.5%
Total $40,000

𝐸(𝑟𝑝 ) = 𝑤1 × 𝐸(𝑟1 ) + 𝑤2 × 𝐸(𝑟2 )

𝐸(𝑟𝑝 ) = 0.625 × 0.065 + 0.375 × 0.089

𝐸(𝑟𝑝 ) = 7.4%

𝜎𝑝 = √𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝜌1,2

𝜎𝑝 = √0.0098 + 0.0053 + 0.0092

𝜎𝑝 = 15.52%

The University of Melbourne FNCE30001 - Investments MST Revision Questions Page 15

A29. Standard Deviation of portfolio

Because there is zero correlation between the risk-free asset (Australian Government Bonds) and any
other investment the answer simplifies to

𝜎𝑝 = 𝑤𝑀𝑖𝑛𝑒𝑟𝑣𝑎 × 𝜎𝑀𝑖𝑛𝑒𝑟𝑣𝑎

𝜎𝑝 = 0.625 × 0.158 = 9.88%

A30. Inflation adjustment

1 + 𝑖𝑛𝑜𝑚𝑖𝑛𝑎𝑙
𝑖𝑟𝑒𝑎𝑙 = −1
1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

1.0745
𝑖𝑟𝑒𝑎𝑙 = −1
1.0325

𝑖𝑟𝑒𝑎𝑙 = 4.07%

The University of Melbourne FNCE30001 - Investments MST Revision Questions Page 16