Financial Risk Manager Part 1
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An investor seeks advice on how to invest USD 500,000 in a bond with a minimum rating of AA. The financial advisor is considering bonds from three companies—Company X, Company Y, and Company Z—and aims to identify the bond that not only meets the minimum rating criteria but also offers the highest yield to maturity. Here is the data collected by the advisor:
Company/Bond X Y Z Bond rating AA+ A+ AAA Annual coupon rate (%) 3.50 3.56 3.38 Time to maturity in years 5 5 5 Price (USD) 975 973 989 Par value (USD) 1,000 1,000 1,000
Assuming the bonds make semi-annual coupon payments, which bond should the financial advisor recommend to the investor?
An investor seeks advice on how to invest USD 500,000 in a bond with a minimum rating of AA. The financial advisor is considering bonds from three companies—Company X, Company Y, and Company Z—and aims to identify the bond that not only meets the minimum rating criteria but also offers the highest yield to maturity. Here is the data collected by the advisor:
| Company/Bond | X | Y | Z |
|---|---|---|---|
| Bond rating | AA+ | A+ | AAA |
| Annual coupon rate (%) | 3.50 | 3.56 | 3.38 |
| Time to maturity in years | 5 | 5 | 5 |
| Price (USD) | 975 | 973 | 989 |
| Par value (USD) | 1,000 | 1,000 | 1,000 |
Assuming the bonds make semi-annual coupon payments, which bond should the financial advisor recommend to the investor?
Explanation:
The investment advisor should purchase Bond X for the client. This decision is based on the client's requirement for a bond rated at least AA and the desire to achieve the highest yield to maturity (YTM). Among the bonds issued by Company X, Y, and Z, Bond Y does not meet the client's rating requirement as it is rated A+, which is below the AA threshold. This leaves Bond X and Bond Z as potential options.
Comparing Bond X and Bond Z, both of which have the required AA rating or higher, Bond X offers a higher annual coupon rate of 3.50% compared to Bond Z's 3.38%. Additionally, Bond X is priced at 989, while both have a par value of $1,000. The combination of a higher coupon rate and a lower purchase price results in a higher YTM for Bond X.
To confirm this, the YTM can be calculated using the formula provided in the file content, which relates the bond price, YTM, coupon rate, term to maturity, and face value of the bond. The calculation for Bond X yields an YTM of 4.06%, whereas for Bond Z, it is 3.62%. Using a financial calculator with the given inputs for Bond X (10 periods, future value of 17.5, and a present value of -$975), the YTM is calculated to be approximately 4.0575%.
Therefore, based on the client's criteria and the calculated YTMs, Bond X is the optimal choice as it satisfies the rating requirement and offers the highest yield to maturity.