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Incomplete Question in CA Final Nov 2010 - SFM Paper

Tejas (M.Com CA CS CFA (US) Prog. Grad..) (354 Points)

10 November 2010

There was this question in the CA Final New SFM Paper. I dont think it is complete. Does anyone know how to solve it without making major assumptions?

10% govt bond is quoting at Rs. 110. Find its market price if interest rates go up by 1%

Thanks

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13 Replies

CA SHABIR (CA) (336 Points)
Replied 10 November 2010

Dear Tejas,

I may be wrong but I suggest u following sollution. Pl dt treat it as final, because I am my self a ca final student.

Expectd interest @ 11% = 12.10

Risk Free return = 10% (because return on government securities is always a risk free)

Value = 12.10/0.10 = Rs. 121

Thanks

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Tejas (M.Com CA CS CFA (US) Prog. Grad..) (354 Points)
Replied 10 November 2010

When they say interest rates go up, it means the market yield goes up, not the coupon rate. I dont think in real life, coupon rates on govt bonds are revised in the middle of the term.

CA Konfused (Chartered Accountant & CFA Level 1) (302 Points)
Replied 10 November 2010

i think at market price of 110 and interest rate of 10% an investor earns Rs 11 ,to earn the same Rs 11 at 11% interest the market price would be 100

Tejas (M.Com CA CS CFA (US) Prog. Grad..) (354 Points)
Replied 11 November 2010

to say that at market price of 110 and interest rate of 10% an investor earns Rs 11 interest is not sure since we dont know the face value. What you mean is the amortisation of premium and the coupon payment together. but still that is not making entire sense.

CA Konfused (Chartered Accountant & CFA Level 1) (302 Points)
Replied 11 November 2010

NO maturity date is given,

so it can be assumed that it is a perpetual bond,

so in this case if we assume face value of rs 110 then the investor is geting 11 as his interest at 10 % interest, as market price is 110 ,his cost of capital is also 10 %.now when cost of capital rises to 11% ,the market price would be 100 as he would get his interest of Rs 11. even if we assume any amount as the face value the result would be more or less the same.

in case of a perpetual bond market prices fluctuate according to the prevailing interest rates .

if this was not a perpetual bond then the market price of the bond will not fluctuate much by a rise of 1 % interest.

the value of a perpetual bond is

fixed interest /discount rate.

so when discount rate is 10 %

market price is 11/0.1=110

when discount rate is 11%

market price is 11/0.11 =100

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Tejas (M.Com CA CS CFA (US) Prog. Grad..) (354 Points)
Replied 11 November 2010

So essentially it means we have to assume the maturity as perpetual, and assume the facevalue

as Rs 110. Thats two major assumptions.

And by the way, GoI bonds are never perpetual. Also their face value is not an odd amount like Rs. 110. It could be Rs. 100

CA Konfused (Chartered Accountant & CFA Level 1) (302 Points)
Replied 11 November 2010

yes my assumptions are not accurate,

but then if we make the assumption 10 years which is usually the maturity period of goverment bonds ,

then calculations become a bit too lengthy.

anyways i agree my solution is not correct,

i was jus tryin to answer it,cause it interested me,n i got to learn sumthin nee, i am not even a final student,so pls don take my answers tht seriously , i am sure u must have a better aproach towards this question, how did u answer this question

Tejas (M.Com CA CS CFA (US) Prog. Grad..) (354 Points)
Replied 11 November 2010

Sorry I didnt mean to be rude. Sorry if it came off that way. :)

I wrote an explanation on the formulaes that can get the answer and the list of items that are required to get it which are missing in the problem like the maturity period, face value and the current market yield.