CT1: CMP Upgrade 2010/11

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Subject CT1
CMP Upgrade 2010/11
CMP Upgrade This CMP Upgrade lists all significant changes to the Core Reading and the ActEd material since last year so that you can manually amend your 2010 study material to make it suitable for study for the 2011 exams. It includes replacement pages and additional pages where appropriate. Alternatively, you can buy a full replacement set of up-to-date Course Notes at a significantly reduced price if you have previously bought the full price Course Notes in this subject. Please see our 2011 Student Brochure for more details.

This CMP Upgrade contains: All changes to the Syllabus objectives and Core Reading. Changes to the ActEd Course Notes, Series X Assignments and Question and Answer Bank that will make them suitable for study for the 2011 exams.

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CT1: CMP Upgrade 2010/11

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1.1

Changes to the Syllabus objectives and Core Reading

Syllabus objectives
No changes have been made to the syllabus objectives.

1.2

Core Reading
Chapter 11
Page 11 The following sentence has been added to the Core Reading on Eurobonds in Section 2.4:
Eurobonds are issued and traded internationally and are often not denominated in a currency native to the country of the issuer.

Replacement pages 11 and 12 are attached.

Chapter 12
Page 10 The inequalities for n in (a) and (b) have been corrected. The inequality in (a) should read n1 < n n2 and that in (b) should read n1 n < n2 . Replacement pages 9 and 10 are attached.

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Changes to the ActEd Course Notes

There have been no changes to the ActEd Course Notes.

Changes to the Q&A Bank

Part 2
Solution to Question 2.16(i) This solution has been expanded to include the alternative approach of using the sum of a geometric progression. Replacement pages are attached. Solution to Question 2.18(i) This solution has been expanded to include the alternative approach of using the sum of a geometric progression. Replacement pages are attached.

Part 3
Solution to Question 3.1 This solution has been updated in line with the new Core Reading on Eurobonds. Replacement pages are attached.

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CT1: CMP Upgrade 2010/11

Changes to the X Assignments

Assignment X3 Question X3.3(ii) This part of the question has been deleted and replaced with the following question. Question Define the term futures contract and list the four main categories of financial futures. [2] Solution Definition of futures contract and types of financial futures A futures contract is a standardised, exchange-tradable contract between two parties to trade a specified asset on a set date in the future at a specified price. [1] The four main categories of financial futures are: Bond futures Short interest futures Stock index futures Currency futures. [ mark for each category]

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Other tuition services

In addition to this CMP Upgrade you might find the following services helpful with your study.

5.1

Study material
We offer the following study material in Subject CT1: Series Y Assignments ASET (ActEd Solutions with Exam Technique) and Mini-ASET Flashcards Mock Exam A and Mock Exam B Revision Notes.

For further details on ActEds study materials, please refer to the 2011 Student Brochure, which is available from the ActEd website at www.ActEd.co.uk.

5.2

Tutorials
We offer the following tutorials in Subject CT1:

a set of Regular Tutorials (lasting 4 half days, 2 full days or 3 full days) a Block Tutorial (lasting 2 or 3 full days) a Revision Day (lasting one full day).

For further details on ActEds tutorials, please refer to our latest Tuition Bulletin, which is available from the ActEd website at www.ActEd.co.uk.

5.3

Marking
You can have your attempts at any of our assignments or mock exams marked by ActEd. When marking your scripts, we aim to provide specific advice to improve your chances of success in the exam and to return your scripts as quickly as possible. For further details on ActEds marking services, please refer to the 2011 Student Brochure, which is available from the ActEd website at www.ActEd.co.uk.

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CT1: CMP Upgrade 2010/11

Feedback on the study material

ActEd is always pleased to get feedback from students about any aspect of our study programmes. Please let us know if you have any specific comments (eg about certain sections of the notes or particular questions) or general suggestions about how we can improve the study material. We will incorporate as many of your suggestions as we can when we update the course material each year. If you have any comments on this course please send them by email to CT1@bpp.com or by fax to 01235 550085.

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CT1-11: Investments

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2.3

Unsecured loan stocks

Unsecured loan stocks are issued by various companies. They are unsecured holders rank alongside other unsecured creditors (eg customers awaiting delivery

of goods, suppliers awaiting payment). If a company fails to make interest or capital repayments when they are due, the loan stockholders can apply to the courts to have the company wound up. The main difference between unsecured loan stocks and debentures is the different level of security (ie the priority should something go wrong). An unsecured loan stock is less secure than a debenture.
Yields will be higher than on comparable debentures issued by the same company, to reflect the higher default risk.

2.4

Eurobonds
Eurobonds are a form of unsecured medium or long-term borrowing made by issuing bonds which pay regular interest payments and a final capital repayment at par. Eurobonds are issued and traded internationally and are often not denominated in a currency native to the country of the issuer. Eurobonds are issued by large companies, governments and supra-national organisations. They are usually unsecured. Yields depend upon the issuer (and hence risk) and issue size (and hence marketability), but will typically be slightly lower than for the conventional unsecured loan stocks of the same issuer.

The Eurobond market is an international market, which is not controlled by any particular country. To illustrate just how international the Eurobond market is, a new Eurobond issue might involve, say: a Swedish company, borrowing from ... a Belgian investor, in Japanese currency (ie Yen) and arranged through a bank in London!

Eurobonds are issued in many different currencies so we have Euroyen, Euromark, Eurosterling and Euroeuro issues. The prefix Euro no longer refers to Europe. It now tends to be used for any financial arrangements in a currency external to the country where the arrangement is taking place.

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CT1-11: Investments

The features of Eurobonds vary a lot more than traditional bond issues. In the absence of any full-blown government control, issuers have been free to add novel features to their issues. They do this to make them appeal to different investors.

One example of such a novel feature is to give the holder of the bond the right to select the currency in which interest and/or capital is paid.

Question 11.8
An investor is trying to decide whether to invest in one companys debentures, unsecured loans or Eurobonds. Which is likely to give the highest yield and which will give the lowest yield?

2.5

Certificates of deposit
Unlike debentures, unsecured loans and Eurobonds, certificates of deposits are shortterm investments.
A certificate of deposit is a certificate stating that some money has been deposited. They are issued by banks and building societies. Terms to maturity are usually in the range 28 days to 6 months. Interest is payable on maturity. The degree of security and marketability will depend on the issuing bank. There is an active secondary market in certificates of deposit.

Certificates of deposit are issued at 100, with a fixed coupon rate. Both the coupon rate, used to determine the interest payment, and the dealing rate i are quoted as annual simple rates of interest. For a sterling certificate of deposit with t days between settlement and maturity, the price P is determined by the formula:
t P 1 + i =C+D 365 or:

P=

C+D t 1 + i 365

where C is the nominal value, D is the interest on maturity.

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CT1-12: Elementary compound interest problems

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Question 12.3
(i) An investor purchases a 100 zero-coupon bond for 80. Calculate the yield obtained if the bond is redeemed after (a) five years, and (b) ten years. Repeat the question with a purchase price of 120.

(ii)

1.5

Optional redemption dates

Sometimes a security is issued without a fixed redemption date. In such cases the terms of issue may provide that the borrower can redeem the security at the borrowers option at any interest date on or after some specified date. Alternatively, the issue terms may allow the borrower to redeem the security at the borrowers option at any interest date on or between two specified dates (or possibly on any one of a series of dates between two specified dates).

In such cases, the loan will be redeemed at the time considered to be most favourable by the borrower. If the interest rate payable on the loan is high relative to market rates, it will be cheaper for the borrower to repay the loan and borrow from elsewhere. Conversely, if the interest rate payable is relatively low, it will be cheaper to allow the loan to continue.
The latest possible redemption date is called the final redemption date of the stock, and if there is no such date, then the stock is said to be undated. It is also possible for a loan to be redeemable between two specified interest dates, or on or after a specified interest date, at the option of the lender, but this arrangement is less common than when the borrower chooses the redemption date.

The loan will be redeemed at the time when the party with the choice of date will obtain the greatest yield.
An investor who wishes to purchase a loan with redemption dates at the option of the borrower cannot, at the time of purchase, know how the market will move in the future and hence when the borrower will repay the loan. The investor thus cannot know the yield which will be obtained. However, by using equation (1.4) the investor can determine either: (1) The maximum price to be paid, if the net yield is to be at least some specified value; or The minimum net yield the investor will obtain, if the price is some specified value.

(2)

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CT1-12: Elementary compound interest problems

Suppose that the outstanding term of the loan, n years, may be chosen by the borrower subject to the restriction that n1 n n2 . (We assume that n1 and n2 are integer multiples of 1/p.) Using the notation of Section 1.3, we let A(n, i ) be the price to provide a net annual yield of i, if the loan is redeemed at time n.

From the previous section we know that: 1. If there is a gain on redemption (ie i ( p ) > (1 - t1 ) g ), the minimum yield will be obtained if redemption takes place at the latest possible date. If there is a loss on redemption (ie i ( p ) < (1 - t1 ) g ), the minimum yield will be obtained if redemption takes place at the earliest possible date.

2.

Suppose that the investor wishes to achieve a net annual yield of at least i. It follows from (1.2) that: (a) If i ( p ) < (1 t1)g , (ie a capital loss) then A(n1, i ) < A(n, i ) for any value of n such that n1 < n n2 . In this case, therefore, the investor should value the loan on the assumption that redemption will take place at the earliest possible date (ie the worst case scenario). If this does in fact occur, his net annual yield will be i . If redemption occurs at a later date, the net annual yield will exceed i . (b) If i ( p ) > (1 t1)g , (ie a capital gain) then A(n2 , i ) < A(n, i ) for any value of n such that n1 n < n2 . In this case, therefore, the investor should value the loan on the assumption that redemption will occur at the latest possible date (ie the worst case scenario). This strategy will ensure that the net annual yield will be at least i . (c) If i ( p ) = (1 t1)g , the net annual yield will be i irrespective of the actual redemption date chosen.

Example

A fixed interest stock with a coupon of 8% per annum payable half yearly in arrears can be redeemed at the option of the lender (ie the investor) at any time between 10 and 15 years from the date of issue. What price should an investor subject to tax at 25% on income, who wishes to obtain a net yield of at least 7% per annum, pay for 100 nominal of this stock?

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CT1: Q&A Bank Part 2 Solutions

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(i)(b) For Manager P the equation of value is:

80(1 + i )3 + 15(1 + i ) 2 + 20(1 + i ) = 172.32

[1]

Using a binomial approximation to obtain a first guess:

80(1 + 3i ) + 15(1 + 2i ) + 20(1 + i ) = 172.32 i = 0.1977 []

This first guess will be too high since the terms in i 2 and above have been omitted from the LHS in the binomial approximation. By trial and error, we obtain: i = 0.19 LHS = 179.85 i = 0.18 LHS = 175.93 i = 0.17 LHS = 172.06

[]

Using linear interpolation:

i = 0.17 +

172.32 172.06 (0.18 0.17) = 17.1% 175.93 172.06

[1]

Similarly, for Manager Q the equation of value is:

140(1 + i )3 + 15(1 + i ) 2 + 20(1 + i ) = 263.56

[1]

Using a binomial approximation to obtain a first guess: 140(1 + 3i ) + 15(1 + 2i ) + 20(1 + i ) = 263.56 i = 0.1884 Again, the value of i will be less than 18.84%. By trial and error, we find:
i = 0.18 LHS = 274.51 i = 0.17 LHS = 268.16 i = 0.16 LHS = 261.91

[]

[]

Then, by linear interpolation:

i = 0.16 +

263.56 261.91 (0.17 0.16) = 16.3% 268.16 261.91

[1]

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CT1: Q&A Bank Part 2 Solutions

(ii)

For Manager P the growth in each year is 10%, 20% and 20%. For Manager Q the growth in each year is 20%, 20% and 10%.

[] []

Because they each have the same overall growth rate the TWRR is the same, however Manager P performed worse during the first year, whereas Manager Q performed worse during the third year. [1] The MWRR puts more emphasis on the money (hence the name money weighted). Since for both managers the greatest money in the fund occurs during the third year, the MWRR will give this final year more weight than the other years. Manager Qs poorer performance in this year will be more heavily [1] penalised. Consequently, manager Q has a lower MWRR. (iii) The MWRR is higher for Manager P than for Manager Q, whereas the TWRR is the same for both managers. The TWRR is considered the better measure of performance as it ignores the effects of the cashflows, which are beyond the managers control. [1] Therefore, on this basis, both fund managers should be considered as having performed equally. [1]

Solution 2.16
(i) The IRR for Project B is the interest rate that satisfies the equation of value:
-100, 000 + 197, 750v8 = 0

[1]

Rearranging gives:
i = 1.977501/ 8 - 1 = 0.08897

So the IRR for Project B (correct to the nearest 0.1%) is 8.9%.

[1]

Working in thousands, a timeline for the cashflows under Project A is shown below:
-100 5 5(1.07) ...... ...... 5(1.07) 130.662 1/1/2016
7

Payment Time

1/1/2008 1/1/2009 1/1/2010

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CT1: Q&A Bank Part 2 Solutions

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The IRR for Project A is the interest rate that satisfies the equation of value:
-100 + 5 v + (1.07)v 2 + + (1.07)7 v8 + 130.662v8 = 0

(Equation 1)

The terms in brackets can be rewritten as an annuity as follows:

-100 + 5 (1.07)v + (1.07) 2 v 2 + + (1.07)8 v8 + 130.662v8 = 0 1.07 5 * a8| + 130.662v8 = 0 1.07 1+ i . 1.07 [1]

- 100 +

where the annuity is calculated at a rate of interest of 1 + i* =

Alternatively, the terms in brackets in Equation 1 can be summed as a geometric progression, with first term v and common ratio 1.07v , to give the equation:

-100 + 5

v 1 - (1.07v)8 1 - 1.07v

) + 130.662v

=0

Trying 9.05% (assuming that the IRRs for the two projects are similar) gives: LHS = -100 + = -100 + 5 @1.91589% a + 130.662v8@9.05% 1.07 8| 5 7.3521 + 130.662 0.50003 = -0.30964 1.07 [1]

Trying 8.95% (assuming that the IRRs for the two projects are similar) gives: LHS = -100 + = -100 + 5 @1.8224% a + 130.662v8@8.95% 1.07 8| 5 7.3819 + 130.662 0.50371 = 0.31070 1.07 [1] []

So the IRR for Project A (correct to the nearest 0.1%) is 9%.

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CT1: Q&A Bank Part 2 Solutions

(ii)

For Project B, the investor will need to take out the loan for 100,000, which requires interest payments of 7,000 each year and repayment of the 100,000 on 31 December 2015. In order to pay the interest payments, the investor will have to take out 8 extra loans for 7,000 each. (Note that for the extra loans, all the interest is paid at the end of the term, rather than in the form of annual payments.) On 31 December 2015 the investor will need to repay the 100,000 from the original loan and the accumulated value of 7,000 from each of the 8 extra loans required, making a total of: 100, 000 + 7, 000s8| @ 7% = 171,819 [2]

There will be no surplus funds to invest. The project will provide a payment of 197,750 on 31 December 2015. So the accumulated profit will be: 197, 750 - 171,819 = 25,931 [1]

For Project A, the investor will again need to take out the loan for 100,000, which will require interest payments of 7,000 each year and repayment of the 100,000 on 31 December 2015. The income from the project increases by 7% (compound) each year. So the cashflows in each year will be as follows: 31 December 2008 2009 2010 2011 2012 2013 2014 2015 Interest due on original loan 7,000 7,000 7,000 7,000 7,000 7,000 7,000 7,000 Income from project 5,000.00 5,350.00 5,724.50 6,125.50 6,553.98 7,012.75 7,503.64 8,028.90 [5]

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CT1: Q&A Bank Part 2 Solutions

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Solution 2.18
(i)
Net present value

The expected changes in the cashflows in the first year if the player is bought are:

extra wages of 2,000 per month, paid at the end of each month extra ticket sales of 10,000 per month, paid at the start of each month extra winnings of (40% - 10%) 200, 000 = 60, 000 in the Cup Final on 30 April. [2]

The increase in the net present value of the payments in year 1 (working in months) is: -2, 000a12| + 10, 000a12| + 60, 000v 4 @1% = 148,825 [2]

The increase in the net present values of the payments in years 2 to 9 (as at the beginning of each year) will be the same, but increased by 5% (compound) each year. In year 10, the cashflows for wages and ticket sales will only apply for 6 months. So the increase in the net present values of the payments in year 10 (as at the beginning of year 10) will be: -2, 000a6| + 10, 000a6| + 60, 000v 4 @1% = 104, 601 So the overall increase in the net present value will be:
DNPV = 148,825(1 + 1.05v12 + 1.052 v 24 + + 1.058 v96 ) + 104, 601 1.059 v108
* = 148,825a9| + 104, 601 1.073167 -9

[2]

= 148,825 6.8987 + 104, 601 0.52966 = 1, 082,103

* where a9| is calculated at a rate of interest of 1.0112 /1.05 - 1 = 7.3167% .

[4] [1] [1]

Since this exceeds the purchase price of 1,000,000, the purchase should go ahead. An alternative expression for DNPV using the sum of a geometric progression is:
1 - 1.05v12 1 - 1.05v

DNPV = 148,825

12

+ 104, 601 1.059 v108

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CT1: Q&A Bank Part 2 Solutions

(ii)

Sale price

If the player is sold for an amount P , the equation of value (ignoring any change in the teams chances of winning in the Cup Final, which do not affect the actual profit) becomes: -1, 000, 000 - 2, 000a12| + 10, 000a12| + Pv12 = 75,898v12 Rearranging to find P gives:
P = 75,898 + 1.0112 (1, 000, 000 + 2, 000 11.2551 - 10, 000 11.3676) = 1, 099,995

[2]

[2] [1]

So the sale price was 1.1m.

Solution 2.19
This question is taken from Subject 102, April 2004, Question 9. (i) Let us assume that we need n years of the annuity to pay off the loan. Then the equation of value is: 120, 000 = 14, 000a (2)
n

[1]

We must evaluate this using 7% interest since we have not yet paid off the loan. Rearranging this:
120 1 1.07 n = 14 2 1.070.5 1 1.07 n = 0.410148

Taking logs of both sides, we get:

n ln1.07 = ln 0.410148 n =

ln 0.410148 = 13.17 ln1.07

[3]

Since we need just over 13 years worth of payments, the discounted payback period is 13.5 years (since the discounted payback period must be a multiple of 6 months). [1]

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CT1: Q&A Bank Part 3 Solutions

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Part 3 Solutions
Solution 3.1
Eurobonds are a form of corporate or government borrowing. They are usually unsecured. They pay regular interest payments and are redeemable at par. [] [] []

They are issued in many different currencies, eg Yen, Euro, Sterling, where the currency used is usually different to the issuers domestic currency. [] They are traded internationally through banks, not in the traditional bond market. []

Yields depend on risk and marketability, but will typically be slightly lower than for conventional unsecured loan stocks of the same issuer. []

Solution 3.2
Debentures are part of the loan capital of companies. They are usually long-term investments. [] The issuing company provides some form of security to holders of debentures. []

They are more risky than government bonds and are usually less marketable. The yield required by investors in debentures will be higher than the yield required on government bonds. [1]

Solution 3.3
This question is taken from Subject 102, September 2000, Question 3. Assuming that the asset generates no income then the forward price, K, is calculated from the current price, S0 , using the formula: K = S0ed t = S0 (1 + i )t
= 1.20 1.0591/ 365 = 1.21

[1] [1]

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CT1: Q&A Bank Part 3 Solutions

Solution 3.4
The gross redemption yield solves the equation of value with no tax. So the price per 100 nominal is:
(2) P = 6a15| + 100v15 @10%

= 6 1.024404 7.6061 + 100 0.23939 = 70.69

[2]

Since the stock is redeemed at par, the capital gains tax payable is:

0.30(100 - 70.69) = 8.79

[1]

Solution 3.5
First, calculate the average nominal rates of return, which are: (i) (ii) (iii) (iv) for the set of gold coins in A: for the painting in B: for the diamond in C: for the statuette in D: 20, 000 14, 000
2 13

1 = 12.62%

3, 200 3, 000 1 = 13.78% 10, 000 13, 000

19, 000 7,500
12

1 = 12.29%
1 = 13.85%

2 1 7 12

The real rates of return, j , can then be calculated using an equation of the form:

1+ j =

1+ i i 0.2 j= 1.2 1.2

where i is the nominal rate of return.

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