Investment

CONTENTS

BONDS 1

STOCKS 6

OPTIONS 10

FUTURES 16

PORTFOLIO PERFORMANCE EVALUATION 20

INTERNATIONAL INVESTING 26

BONDS

Page 480 –CFA Problems Questions #1

1. Leaf Products may issue a 10-year maturity fixed-income security, which might include a sinking fund provision and either refunding or call protection.

a) Describe a sinking fund provision.

The sinking fund provision allows the firm to repurchase a fraction of the outstanding bonds at either the market price or the sinking fund price (usually set at par), depending on the structure of the provision. The provision may be for a specific number of bonds or a percentage of the bond issue. The bonds selected for repurchase are generally selected at random.

b) Explain the impact of a sinking fund provision on:

i. The expected average life of the proposed security.

We would expect a fraction of the total bond issue to be retired before the stated maturity data under the sinking fund provision. Therefore, the sinking fund provision decreases the expected average life of the proposed security.

ii. Total principal and interest payments over the life of the proposed security.

The sinking fund provision does not affect the total principal payments that investors would receive. However, investors may receive their principal repayments earlier than expected if the firm invokes the sinking fund provision. The sinking fund provision could decrease the amount of interest payments investors would receive since an early retirement of a bond under the sinking fund provision would cut off all further coupon payments from the bond.

c) From the investor’s point of view, explain the rationale for demanding a sinking fund provision.

From the investor’s point of view, the reason for demanding a sinking fund provision is that it reduces the firm’s credit risk. The option to retire a bond issue gradually over a period of time reduces the strain on the finances of the issuing firm and makes it...