Asset Valuation

Creek manufacturing is expected to pay a dividend of $4.20 in the upcoming year. Dividends are expected to grow at 8% per year. The risk-free rate of return is 4% and the expected return on the market portfolio is 14%. The stock’s current price is $84.00. The market capitalization rate is closest to: A. 9 percent. B. 11 percent. C. 13 percent. D. 15 percent. Joan Samuels is a portfolio manager at First Bank. Samuels has 4.5 year effective duration bonds that are callable in 2011. She has modeled many interest rate changes and expects her convexity adjustment factor will be sizable. What is the most likely percentage change in her bonds if interest rates move up 125 basis points? A. -5.91 percent. B. -5.63 percent. C. -5.24 percent. D. -3.76 percent.

ahhh good question, i was stuck when i did this too… what exactly is the MARKET CAP rate???

First one I don’t know. B for the 2nd one: -4.5 * 1.25

is the market cap rate = cost of capital? it would be c 4.2/84+0.08= 0.13

yes…market cap is equal to k but how would you know this… I thought NOI/price = mkt. cap… Am I not seeing somthing here… I will see what others have to say on the second question… little bit trickier…

Did read the second one careful enough. Don’t know the exact answer though. Guessing D

Market capitalization rate is estimated by k = D1/P0 + g k= 4.2/84 + 0.08 = 0.013 C is the answer.


for the 2nd question — it clearly says Convexity factor is sizable. so given -D * delta r + C * deltar^2 and -D * deltar = -5.625 why isn’t C or D which is more towards 0 the better answer? Given convexity adjustment is considerable…

Samuels is long the bond - she’s going to be clobbered and positive convexity has to help her. Moving from an expected loss of 5.62 to 5.24 doesn’t look like much convexity. I’d go with answer D.

agreed Joey. I was just trying to make the point that -5.63 which is only the duration effect is not correct as the answer to the question. CP

Do we assume the divident of $4.2 already includes the 8% growth ? otherwise the calculation would be: k = (4.2 * 1.08)/84 + .08 = .134

it is an expected dividend. not current dividend. so you do not need the 1.08 multiplier. CP

A- B) convexity of 0 C) convexity of 24.64 D) convexity of 119.36 solved for convexity given the % changes in the price. A convexity that is sizable? My guess would be also D… But define sizable convexity…

wow… I dont think anybody got the second one right… Anwsers: C, A Reasons: 1: k = D1/P0 + g k = (4.20/84.00) +.08 =.13 or 13% Easy if you know what market cap is… 2. DP/P = -DI(Dur)+Convexity’s effect, DP/P = -(1.25)(4.5), or 5.63, +Convexity’s effect. Assuming we recognize callable bonds as having negatively convex pricing characteristics, we can estimate that a convexity adjustment factor will take that bond’s price further down than that price as strictly indicated by duration. In this case, the only loss greater than that suggested by duration (-5.63)% was that of ‘A’. Candidates are responsible to compute price change using duration. All that is required to “estimate” the correct answer here is recognizing how the direction of negative convexity will affect the bond’s price. A bit harder… I picked -5.63

I don’t think this is a very good question at all. The negative convexity would only apply at certain prices. It would depend how close you were to the call price before the 125 basis point move. If you were nowhere near the call price before the interest rates raised you wouldn’t even hit the part of the price/yeild function that demonstates negative convexity. For example, if rates were raised after the issue of the bond but before the 125 basis point raise in the question. My only guess would be that they thought you should pick up on this by their wording “She has modeled many interest rate changes and expects her convexity adjustment factor will be sizable.” Doesn’t seem to clear to me. Somebody else may have a better answer.