Fixed income assignment
This is a group project assignment in my Masters course for fixed income in which we attained pretty good marks: 28/30. Putting it up here for reference. The topic is as follows:
On 1 January 2005, you are considering two investment opportunities. A six month risk-free bond with 4% p.a. coupon is priced at 98.45. It has a $1,000 par value and will mature on 30 June. Alternatively, you could invest in a one-day risk-free short-term note for which the return for the six-month period (1 January 2005 to 30 June 2005) is currently unknown. You are provided with the historical yields of the note. Using only the information provided, would you purchase the bond or the note? Write a report giving your recommendation.
Executive Summary
This paper describes at length how an investment problem was approached based on a choice between two alternative investments, a six-month Treasury bond and one-day short-term note. In order to estimate the six-month return of the short-term note, a regression of historical yields of a one-day risk-free short-term note is done based on the empirical model provided. Using a goodness of fit measure, it is found that the model explains for 99.9% of the variation in yield. Yields from 1 January 2005 to 30 June 2005 for the one-day note are then forecasted using the model.
To ameliorate the forecast model, a reduced forecast model containing only statistically significant variables is also adopted. However, there are no significant differences between the results obtained using the original and reduced model. The forecast accuracy of the model is illustrated thereafter. Two main problems affecting the accuracy are the smoothing effect of the regression and inappropriateness of value adjustment as highlighted.
The empirical forecast model is also compared against some representative short rate and forward interest rate models, from which several limitations of the forecast model are identified, such as the absence of mean-reversion function and no-arbitrage assumption. It is also observed that recent research has steered towards the incorporation of macroeconomic factors into interest rate forecasting.
From our analysis, the six-month return of the note is approximately 2.475% based on the original forecast model whereas the return for the Treasury bond is about 3.6%, which is higher. While the Treasury bond will appear to be a more attractive investment to any rational investor based on the expected return, it is worthwhile to consider other factors when making the investment decision. Specifically, the lower expected return of the note should be considered against its high cash convertibility, as liquidity is preserved and superior reinvestment opportunity could be available to the investor if the short-term note is purchased.
See attached file for the rest of the report
| Attachment | Size |
|---|---|
| FINC6014_FixedIncomeProject.pdf | 385.24 KB |
Subjects: Finance 経済, School 学校
Tags: finance, fixed income, USyd
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