MARKING SCHEME

INSTRUCTIONS: ANSWER QUESTION ONE AND ANY OTHER TWO QUESTIONS

Question 1 (30 marks)

A. Explain the meaning of force of interest and why it is an important concept in the context of
financial mathematics. You must use the idea of nominal rates of interest as a starting point in
your explanation. [3 marks]
Force of interest δ is the nominal rate of interest convertible continuously. [1]
In other words force of interest is defined as:

lim i ( p ) = δ
p→ ∞
[1]
Importance:
Financial decision making should take into account the time value of money i.e. money today is
of more value than money tomorrow. [1] The time value of money depends critically on how
interest is calculated and the frequency applied of compounding is an important factor in
determining financial value. The force of interest provides an expression of interest for every
infinitesimally small time period allowing the principle of consistency to pervade. [1]

B. With the aid of a simple example distinguish between the money rate of interest and real rate of
interest in time value of money. [3 marks]
Given a series of payments accumulated over a period, the money rate of interest is the rate at
which interest will have been earned in order to produce the total amount of cash in hand at the
end of the period.
The real rate of interest on the other hand is the rate at which interest is earned adjusted for the
effects of inflation (or deflation) in the value of currency.
Suppose KES 100 accumulates to KES 105 after one year if invested at a rate of interest 5% p.a
but the effects of inflation mean that KES 105 at the end of the year is worth only KES 104.
The money rate of interest would be 5%.
However the real rate of interest in this case would be 4% p.a.
C. An investor has invested KES 2,500,000 in the 91 days Treasury bill issue 2305/99. The results
of the auction as posted by the Central Bank of Kenya indicate a market weighted average return
of 9.506%. Calculate the total return for the investor at the end of the term. [3 marks]

The price of the tbill will be given as:

= 100 . = 97.9956
( × / )
Hence

Therefore for 2,500,000 the investor will pay 2,500,000 ∗ = 2,449,890

.

And the return in his account at the end of three months will be
2,500,000 − 2,449,890 = 50,110

D. Anna, a recently graduated entrepreneur would like to save up and invest money that she will
use to purchase her first car in 3 years. The car of her choice, a Toyota Auris 2018, currently costs
KES 950,000. Prices for cars such as this one generally increase at 2.5% per annum over the first
five years in the market but later level off. How much should she invest at the end of each year
for the 3 years if she can earn an annual rate of return 8.5% on her investment? [3 marks]

Let amount invested at the end of each year = X

Xs3 @8.5% = 950, 000(1.025)3

950, 000(1.025)3
X =
s3 @8.5%
950, 000(1.025)3
=
 (1.085)3 − 1 
 0.085 
 
950, 000 ×1.0769
=
3.2622
X = KES 313, 603.78
E. Suppose instead that Anna were to take out a loan and purchase the car immediately. She would
then require to repay the loan by making level annual payments for 5 years. How much would
the amount of each payment be if the rate of interest on loan is 14% per annum? [3 marks]

Let Y be the amount of annual payment

Ya5 @14% = 950,000
950, 000
Y =
a5 @14%
950, 000
=
1 − (1.14) −5 
 0.14 
 
950, 000
=
3.4331
Y = KES 276, 719.37

F. The force of interest, δ(t), is a function of time and at any time t, measured in years, is given by

0.06 0≤%≤4
the formula

$(%) = & 0.10 − 0.01% 4 < % ≤ 7

0.01% − 0.04 7 < %

a) Calculate, showing all working, the value at time t = 5 of KShs. 100,000 due for payment at
time t = 10.

[5 marks]
Let the PV be given by Y.

) = 100,000 × *+, -− . (0.01% − 0.04)/%0 × *+, -− . (0.10 − 0.01%)/%0

0.01% 2 0.01% 2
) = 100,000 × *+, − 1- − 0.04%0 3 × *+, − 1-0.1% − 0 3
2 2
0.01 × 51 0.01 × 24
) = 100,000 × *+, − 4 − 0.04 × 36 × *+, − 40.1 × 2 − 6
2 2
) = 100,000 × *+,7−0.255 + 0.12 − 0.20 + 0.129
) = 100,000 × *+,7−0.255 + 0.12 − 0.20 + 0.129
) = :;ℎ;. 80,654.144

b) Calculate the constant rate of discount per annum convertible monthly which leads to the
same result as in part (i).
[3 marks]
The desired rate of discount is:
 /( 2)
2×
100,000 × 1 − = 80,654.144
12
/( 2)
= 4.2923% ,. >. ?@AB*C%DEF* G@A%ℎFH

G. An annuity immediate pays KShs. 10,000 at the end of the first year. The payment increases by
3% per year to compensate for inflation. What is the present value of this annuity on the basis of
a rate of 7%, if it runs for 20 years?

[4 marks]

Then the payment at year k will be 10,000 × (1.03)IJ

In the first year the payment will be KShs. 10,000, at the end of year 2 KShs. 10,300 and so on.

I
The present value, Y, can then be expressed as:
) = ∑2IL 10,000 × (1.03)IJ × B I = ∑2IL (1.03B)I = ∑2IL M N [1]
, , .
. . .
I
)= ∑2IL M N − 1 [1]
, .
. .

This is the same expression for ordinary annuity with a different discount factor B O =
.
.
[1]

Applying the geometric series then:

1.03 2
10,000 1 − M1.07N 10,000
)= ×P − 1Q = × (14.731613 − 1)719 = :;ℎ;. 133,316.6311719
1.03 1.03 1.03
1 − 1.07

H. In less than 12 hours on 25th September 2005, Mr Bittok aged 49 then, had become a US citizen
and a millionaire, according to Register, a newspaper in Des Moines, where he lives; winning a
jackpot of $1.8 million. The lottery company approached him with two options: - a "cash" prize
that would give him an immediate lump sum of one-half of the jackpot, or an annuity, that will be
paid in 30 equal payments over 30 years, and the annual payment will be increased by a constant
amount $Q as determined by lottery officials.
(i) Assuming that the prevailing bank rate of interest is 10% per annum and is expected to
hold constant for the 30 year period, Determine the minimum annual constant increase,
$Q for which (in financial terms) Mr. Bittok would be indifferent over the two choices.
[4 marks]

The equation of value to consider is that in a minimum he should be paid what is worth his value today
>RRRR| − 30B
900,000 = 60,000>RRRR| + T @D = 0.10
D
This is simply solving for Q
19.6004 − 30 × 0.41199
900,000 = 60,000 × 19.6004 + T V W = 565,614 + 77.076T
0.03
T = $4,338.393

(ii) Suggest at least two reasons why when given a higher rate of increase than that
determined in (i) above that Mr. Bittok would still consider taking his cash prize.
[2 marks]
Mortality risk – He may not live to see the full value
Taxation risk – if taxation policy changes then the real return would be significantly affected
Bittok can still hold Kenyan citizenship and he may desire to return back to Kenya. He may
then choose the lumpsum to invest in Kenya.
Question 2

A developer currently owns a piece of land in Kileleshwa Nairobi and is considering putting up a
block of apartments. The developer would then exercise one of the following options:
Option 1: Sells the entire block at KES 350Mn once construction is complete
Option 2: Rent out the individual apartments for a period of 10 years and then sell at KES
600Million.
Option 3: Rent out the individual apartments indefinitely. The total annual rental income is
KES 40Mn.
Meetings with building contractors/ operators/ lessors/ have yielded the following information.

Maximum number of apartments that can

30
be developed on the piece of land

Total [expected] annual rental income KES 40,000,000

Total construction period 2yrs

Total construction cost KES 150,000,000

Value of land KES 100,000,000

Construction cost can be assumed be paid in two equal instalments at the beginning of each
of the 2yrs of construction. Each instalment is KES 75,000,000.

Annual rental income is considered to be payable in arrears starting year 3.

[Year 3 is the first year following completion of construction period.]
However rent increases and inflation are both ignored!

The developer would have to borrow the entire construction cost. He has a good relationship
with his banker and is able to save and borrow money at a rate of interest 15% per annum
effective. In this instance he would like to take out an Interest Only construction loan for a 10
year term.

The loan will be disbursed in two equal instalments at the beginning of each of the 2yrs of
construction. Each disbursement is equal KES 75,000,000.
 I. Determine the optimum option that the developer should exercise if this is based solely
on net present value as the decision criterion. [10 marks]

Timeline of annual cash-flows [All figures are in Mn] based on Option 3

t=0 1 2 3 4 … 8 9 10 11 12 13 …
Land value -100
Loan +75 +75
disbursement
Construction -75 -75
costs
Interest on loan -11.25 -22.50 -22.50 -22.50 -22.50 -22.50 -22.50
Loan -150
repayment
Rental income +40 +40 … +40 +40 +40 +40 +40 +40 +40

Note that the interest on loan for the first year is calculated as 15% * 75,000,000 as this is
the only amount that has been disbursed. For the second year onwards the interest is 15% *
150Mn.

Net present values for the 3 options are:

Option 1
( )
= ( −100 ) + ( −11.25v ) + −22.50v 2 a&&9 @15% + 350v 2 + ( −150v10 )
= ( −100 ) + ( −11.25 × 0.8696 ) + ( −22.50 × 0.7561× 5.4873) + ( 350 × 0.7561) + ( −150 × 0.2472 )
= 98.58

Option 2
( )
= ( −100) + ( −11.25v) + −22.50v2a&&9 @15% + ( −150v10 ) + 40v3a&&10 @15% + 600v12
= ( −100) + ( −11.25 × 0.8696) + ( −22.50 × 0.7561× 5.4873) + ( −150 × 0.2472) + ( 40 × 0.6575 × 5.7716) + ( 600 × 0.1869)
= 23.72

Option 3
( )
= ( −100 ) + ( −11.25v ) + −22.50v 2 a&&9 @15% + ( −150v10 ) + 40v3 a&&∞ @15%
= ( −100 ) + ( −11.25 × 0.8696 ) + ( −22.50 × 0.7561× 5.4873) + ( −150 × 0.2472 ) + ( 40 × 0.6575 × 7.6667 )
= −38.58

Exercise option 1 as it has the highest net present value.

IV. The developer believes that if the housing is sold in ten years’ time, he can obtain an
internal rate of return on the project of 18% per annum. Suggest reasons why the
developer may not achieve this anticipated internal rate of return.
[3 marks]
Reasons investor may not achieve the internal rate of return:
• Allowance for expenses when buying/selling which may be significant.
• There may be periods when the property is unoccupied and no rental income is received.
• Rental income may be reduced by maintenance expenses.
• Tax on rental income and/or sale proceeds

V. Identify and briefly describe any other method that can be used to appraise such a
project including disadvantage of the stated method.

[2 marks]

This could include

- Payback period: A company chooses the expected number of years required to
recover an original investment. Projects will only be selected if initial outlay can be
recovered within a predetermined period. This method is relatively easy since the
cash flow doesn't need to be discounted. Its major weakness is that it ignores the
cash inflows after the payback period, and does not consider the timing of cash
flows.

- Profitability index: This is the ratio of the present value of project cash inflow to
the present value of initial cost. Projects with a Profitability Index of greater than
1.0 are acceptable. The major disadvantage in this method is that it requires cost
of capital to calculate
 VI. Without doing any further calculations explain how the net present value would alter if
the interest rate had been greater than 15% per annum effective. [2 marks]

The net present values in each case would decrease due to an inverse relationship between
present value and interest rates.

VII. Determine which strategy would be optimal if the internal rate of return were to be used
as the decision criterion. [3 marks]
The option with the lowest internal rate of return would be used.
By trial and error option 3 has the lowest internal rate of return of approximately 12%.

Question 3
A late-stage Fin-tech Startup has borrowed KES 5,000,000 from Bank ABC. The loan is to be repaid
by level installments payable quarterly in arrears for 5 years from the date the loan is made. The
quarterly repayments are computed at a nominal rate of interest 14.5% per annum convertible
quarterly.

I. Calculate the amount of level quarterly payments. [4 marks]

Let X = amount of quarterly payment

4 Xa5(4)@ i( 4) =14.5% = 5, 000, 000

1, 250, 000
X =
a5(4)@ i( 4 ) =14.5%
4
1, 250, 000  0.145 
= recall i =  1 +  − 1 = 0.1531
1 − (1.1531) 
−5
 4 
 
 0.145 
1, 250, 000
=
3.5132
X = KES 355, 796.32
II. Calculate the total interest which will be paid over the 5 year term. [2 marks]

Total interest = Total payments – Original loan amount

= KES 355,796.32 *20 (= 5yrs * 4 payments per yr) – KES 5,000,000
= KES 7,115,924.57 – KES 5,000,000
= KES 2,115,924.57
Immediately after the 13th payment the Start-up runs into significant financial difficulty and requests
the Bank to restructure the loan - to which the Bank agrees. The restructured loan agreed on is as
follows:

- Payments will now be made ½ yearly in arrears for 4 years

- An initial grace period is allowed for 2 years during which only interest will be charged.
There shall be no repayment of principal loan amount during the grace period.
However the entire loan must be repaid in full in the 2 years following the grace period!
- Revised rate of interest is 12.5% per annum convertible half yearly
III. Draw out the loan amortization schedule following restructuring [9 marks]
First we need to know the amount of loan outstanding immediately after 13th payment
Amount of loan outstanding Y is the present value of remaining payments
13/ 20 payments have been made and therefor 7 payments remain.
We can calculate Y as follows:.
Y = 355, 796.32a7 @ i =15.31%

1 − (1.1531)−7 
Y = 355, 796.32  
 0.1531 
= 355, 796.32 × 4.122
Y = KES 1, 466,598.22
Loan amortization is now as follows:
- During the grace period only interest is paid on the loan at a rate of 12.5%/2 (=6.25%)
every half year.
- Following grace period, the amount of each payment Z is calculated as:

Za4 @ i = 6.25%
= 1, 466,598.22
1, 466,598.22
Z =
1 − (1.0625)−4 
 0.0625 
 
=1, 466, 598.22
3.445
Z = KES 425, 673.30
Interest payment Capital payment
Yr 1 payment 1 12.5% Nil
= ×1, 466, 598.22
2
= 91, 662.39
Yr 1 payment 2 91,662.39 Nil
Yr 2 payment 1 91,662.39 Nil
Yr 2 payment 2 91,662.39 Nil
Yr 3 payment 1 = 6.25% × 425, 673.30a4 @ i = 6.25%
= 425,673.30 – 91,662.39
= 91, 662.39
= 334,010.92
Yr 3 payment 2 = 6.25% × 425, 673.30a3 @ i =6.25%
= 425,673.30 – 70,786.71
= 70, 786.71 = 354,886.60
Yr 4 payment 1 = 6.25% × 425, 673.30a2 @ i = 6.25%
= 425,673.30 – 48,606.29
= 377,067.01
= 48, 606.29
Yr 4 payment 2 = 6.25% × 425, 673.30a1 @ i = 6.25%
= 425,673.30 – 25,039.61
= 400,633.70
= 25, 039.61
IV. In times of high interest rates, lending institutions may offer some variations in repayment
schemes to prevent high default rates. Suppose a loan of amount KES 2.5Mn is being amortised
with level monthly installments K over 20 years. The lender offers an alternative repayment plan
with weekly payments at 12 K 52 , starting one week from the time the loan is advanced. The
weekly payments will continue for as long as necessary with an additional final smaller payment.

Find the term of the weekly repayment scheme. Assume the nominal rate convertible monthly
is 6.5% p.a. [5 marks]

We can determine the effective rate of interest as:

D ( 2) 0.06
2 2
1+D = 1+ = V1 + W → D = 6.1678%
12 12

Therefore the nominal rate convertible weekly is given by:

D ( 2)
2
1.061678 = 1 + → D( 2)
= 5.9885132%
52
The monthly repayment is given by

1 2 ∗ 2
1−M
2,500,000 = : 1.005N = : ∗ 51.72556075 → : = 48,332
0.005
= 48,332 ∗ = 11,153.44
2Z 2
2 2
The weekly repayments =

The term of the loan Z will be obtained by solving the equation

2,500,000 = 11,153.44 ∗ >[̅ |
[
1
⎛1 − ` 0.059885132a ⎞
⎜ 1+ ⎟
2,500,000 = 11,153.44 ∗ ⎜ 52
0.059885132 ⎟
⎜ 52 ⎟

⎝ ⎠
 [
1
⎛1 − ` 0.059885132
a ⎞
⎜ 1+ ⎟
52
⎜ 0.059885132 ⎟ = 224.1440966
⎜ 52 ⎟

⎝ ⎠
Using estimation
@260 e**f; @C 5 H*>C; ghi → 224.5746069
@259 e**f; ghi → 223.8332354

Hence the term of the loan is 5 years with the last repayment being less than 11,153.54

Question 4
An investor is interested in purchasing shares in a particular company. The company pays annual
dividends, and a dividend payment of KES 3 per share has just been made. Future dividends are
expected to grow at the rate of 5% per annum compound.

I. Calculate the maximum price per share that the investor should pay to give an effective return
of 9% per annum.
[4 marks]

A reasonable assumption is that of holding the share to perpetuity. Then the

maximum price, assume to be P, per share would be the PV of such an annuity. This

= 3 × 1.05 × B % + 3 × 1.052 × B 2 % + ⋯ ..
can be expressed as:

1.05 1.05 2 1.05

=3× +3×V W +3×V W + ⋯…
1.09 1.09 1.09
1.05 1.05 1.05 2 1.05
=3× 1+ +V W +V W +⋯
1.09 1.09 1.09 1.09
1.05 1
=3× × = :li. 78.750
1.09 1 − 1.05
1.09

II. Without doing any further calculations, explain whether the maximum price paid will be
higher, lower or the same if:
i. After consulting the directors of the company, the investor increases his estimate of the rate
of growth of future dividends to 6% per annum.
 Increasing the expected rate of dividend growth, g , will increase the maximum price that the
investor is prepared to pay to purchase the share since the dividend income is expected to be higher.
[1]

ii. As a result of a government announcement, the general level of future price inflation in the
economy is now expected to be 2% per annum higher than previously assumed.

An increase in the expected rate of future price inflation is likely to lead to an increase in both
the expected rate of dividend growth (as nominal level of profits should increase in line with inflation)
and the nominal return required from the investment (as the investor is likely to want to maintain the
required real return). [1]

Thus, the maximum price that the investor is prepared to pay will be (largely) unchanged – in
fact, it will increase slightly due to (1 + g) term in numerator. [1/2]

iii. General economic uncertainty means that, whilst the investor still estimates future dividends
will grow at 5% per annum, he is now much less sure about the accuracy of this assumption.

You should consider the effect of each change separately. [4 marks]

If the investor is more uncertain about the rate of future dividend growth (whilst the expected
dividend growth is unchanged), then the required return, i, is likely to be increased to
compensate for the increased uncertainty. [1]
Thus, the maximum price that the investor is prepared to pay will reduce. [1/2]

III. An investment club invested its assets with two fund managers. On 1 January 2016 Manager A
was given 120,000,000 and Manager B was given 100,000,000. A further 10,000,000 was
invested with each manager on 1 January 2017 and again on 1 January 2018.

The values of the funds were:

31 December 2016 31 December 2017 31 December 2018
Manager A 130,000,000 135,000,000 180,000,000
Manager B 140,000,000 145,000,000 150,000,000

i. Calculate the time-weighted rates of return earned by Manager A and Manager B over
the period 1 January 2016 to 31 December 2018.

[4 marks]

The fund values before and after cash injection for both managers are:
Manager A Manager B
 1 January 2016 120,000,000 100,000,000
31 December 2016 130,000,000 140,000,000 140,000,000 150,000,000
31 December 2017 135,000,000 145,000,000 145,000,000 155,000,000
31 December 2018 180,000,000 150,000,000

Thus the TWRR for Manager A will be given as:

130 135 180
1+D = + + → D = 9.05%
120 130 135
And the TWRR for Manager B will be given as:
140 145 150
1+D = + + → D = 9.41%
100 140 145

ii.
Show that the money-weighted rate of return earned by Manager A over the period 1
January 2016 to 31 December 2018 is approximately 9.4% per annum.
[2 marks]
MWRR for Manager A will be given as:
120 ∗ 1 + D + 10 ∗ 1 + D 2 + 10 1 + D = 180

Testing for 9.4% LHS = 180.03 hence proof

iii. Without performing further calculations, explain whether the money-weighted rate of
return earned by Manager B over the period 1 January 2016 to 31 December 2018 was
higher than, lower than or equal to that earned by Manager A.
[3 marks]

Both funds increased by 50% over the three year period and received the same cash flows at the
same times.
Since the initial amount in fund B was lower, the cash inflows received represent a larger
proportion of fund B and hence the money weighted return earned by fund B over the period will
be lower, particularly since the returns were negative for the 2nd and 3rd years.
Or looking at the equation to solve
for Manager B will be given as:
100 ∗ 1 + D + 10 ∗ 1 + D 2
+ 10 1 + D = 150
proportional argument would state that Manager A equation to be as:
for Manager A will be given as:
120 ∗ 1 + D + 12 ∗ 1 + D 2
+ 12 1 + D = 180

Which then proves by inspection new MWRR lower

 iv. Based on your computations, discuss the relative performance of the two managers
[3 marks]

The money weighted rate of return is higher for fund A, whilst the time weighted return is higher
for fund B.
When comparing the performance of investment managers, the time weighted rate of return is
generally better because it ignores the effects of cash inflows or outflows being made which are
beyond the manager’s control.

In this case, Manager A’s best performance is in the final year, when the fund was at its largest,
whilst Manager B’s best performance was in the first year, where his fund was at its lowest.
Overall, it may be argued that Manager B has performed slightly better than Manager A since
Manager B achieved the higher time weighted return.
[Subtotal 12 marks]
Question 5

I. Clearly define the following terms with respect to a bond

i. Par Value
ii. Yield
iii. Maturity
iv. Duration
[5 marks]
Par Value: the face value of the bond, returned to the bondholder at maturity [1]
Maturity: The length of time until the borrower returns the par value [1]
Yield: The rate of interest that equates the present value of the coupons and value payable at
maturity to the price paid by investor today [1]
Duration is the weighted average number of years necessary to recover the initial cost of the
bond [1]

II. Distinguish between a revenue bond and a social impact bond

[2 marks]
A revenue bond is a debt instrument typically issued by a county, state or municipality that is
supported by the revenue from a specific project, such as a toll bridge, highway or local stadium.
Revenue bonds typically finance income-producing projects and are secured by a specified revenue
source.
A social impact bond (SIB) is a contract with the public sector or governing authority, whereby it pays
for better social outcomes in certain areas and passes on the part of the savings achieved to investors.
A social impact bond is not a bond, per se, since repayment and return on investment are contingent
upon the achievement of desired social outcomes; if the objectives are not achieved, investors receive
neither a return nor repayment of principal. SIBs derive their name from the fact that their investors
are typically those who are interested in not just the financial return on their investment, but also in
its social impact.

III. A fixed-interest security pays coupons of 8% per annum half yearly on 1 January and 1 July.
The security will be redeemed at par on any 1st January from 1 January 2017 to 1 January 2022
inclusive, at the option of the borrower.
An investor purchased a holding of the security on 1 May 2011, at a price which gave him a net
yield of at least 6% per annum effective. The investor pays tax at 30% on interest income and
25% on capital gains.
On 1 April 2013 the investor sold the holding to a fund which pays no tax at a price to give the
fund a gross yield of at least 7% per annum effective.
i. Calculate the price per 100 nominal at which the investor bought the security [5 marks]

To determine the optimum term, we have to first determine if there is a capital gain or loss
The investor is subject to CGT at a rate of 25% we have to perform the capital gains test to
determine there will be a capital gain on the contract
m 1−% = 0.08 ∗ 0.70 = 0.056; eℎ*C* m D; %ℎ* ?@o,@A C>%*
Since D 2
= 0.059126 > m 1 − % there will be a capital gain on contract
As the option to redeem is held by the borrower, it is rational to assume that they will delay
this to the latest possible date. Put it another way, the borrower is getting money at 5.6%
yet the market can offer 6%; The borrower will want to stick to this contract.
Hence we shall assume that its held to 1 January 2022
Note we are requested to give the PV at 1.5.11. This is 2 months away from our next coupon
payment on 1.7.11or 4 months after our prior payment on 1.1.11(for ease so as to use whole
years I will discount to 1.1.11 and then accumulate for 4 months)

Let the price paid by the investor be

@ D = 6%
q
= -0.7 ∗ 8> 2 + 100B − 0.25 100 − B 0 1+D 2
|
q
= 5.6 × 1.014782 × 7.8869 × 1.06 2 + 75B RRRR + 0.25 B RRRR

45.6985 40.2839
= = 99.319
1 − 0.25B RRRR

ii. Calculate the price per 100 nominal at which the investor sold the security [3 marks]

The return to the fund is 7% p.a. effective. It pays no taxes. To obtain the optimal term
of the bond we again perform the Capital Gains Test.
In this case
m 1−% = m = 0.08 ;DA?* %ℎ*C* >C* %>+*;; eℎ*C* m D; %ℎ* ?@o,@A C>%*
Since D 2
= 0.068816 < m there will be a capital loss on contract
We therefore assume it will be redeemed soonest possible i.e. 1 January 2017
The date is now 1.4.13 The time left is approximately 4 years to 1.1.17.
We can make computations easier by getting present value to 1.1.13 then accumulating
for the 3 months to 1.4.13
Hence the sale price per 100 nominal will be given by
 Let the price paid by the fund be r

r = -8> 2 + 100B q 0 1 + D 2 @ D = 7%
q|

= 78 × 1.017204 × 3.3872 + 100 × 0.762909 1.07 2

= 105.625

IV. In January 2019, the government of a country issued an index-linked bond with a term of
two years. Coupons were payable half-yearly in arrear, and the annual nominal coupon
rate was 6%. The redemption value, before indexing, was KES.100 per KES.100 nominal.
Interest and capital payments were indexed by reference to the value of an inflation index
with a time lag of six months. A tax-exempt investor purchased KES.100,000 nominal at
issue and held it to redemption. The issue price was KES 97 per KES100 nominal.

The inflation index was as follows:

Period July 2018 Jan 2019 Jul 2019 Jan 2020 Jul 2020 Jan 2021
Index 120 122.3 124.9 127.2 129.1 131.8

i. Set out a schedule of the investor’s cash-flows, showing the amount and month of each
cash-flow. [3 marks]

Type Timing Amount (KShs.)

Issue price January 2019 =- 0.97X100,000 = (97,000)
Interest payment July 2019 =-0.03X100,000X122.3/120 = 3,057.50
Interest payment January 2020 =-0.03X100,000X124.9/120 = 3,122.50
Interest payment July 2020 =-0.03X100,000X127.2/120 = 3,180.00
Interest payment January 2021 =-0.03X100,000X129.1/120 = 3,227.50
Capital redemption January 2021 =100,000X129.1/120 = 107,583.33

ii. Determine the annual effective real yield obtained by the investor per annum. [5 marks]
We can express all cash-flows in the January 2019 time then we have:
122.3 122.3 122.3
97,000 = 3,057.50 × × B . + 3,122.50 × × B + 3,180 × ×B .
124.9 127.2 129.1
122.3
+ 3,227.5 + 107,583.33 × × B2
131.8
97,000 = 2,993.85 × B . + 3,022.22 × B + 3,012.50 × B . + 102,823.71 × B 2

@7% → 98,232.04
We use interpolation to estimate the value:

@8% → 96,499.48
Applying interpolation formula
98,232.04 − 97,000
D = 0.07 + V W × 0.01 = 7.708%
98,232.04 − 96,499.48
END OF EXAMINATION PAPER