Ross, is an investment manager who recently dealt with a customer by the name of Michelle. After performing a Capital Asset Pricing Model (CAPM) analysis using the S&P500 as the proxy of the market portfolio, Michelle argued that her portfolio had outperformed the market. Ross uses the CAPM as an investment performance measure and finds that Michelle’s portfolio plots below the Security Market Line (SML). Ross argued that Michelle’s porfolio’s excellent performance is due to the selection of a wrong proxy of the market portfolio, not brilliant active investment management. Support Ross’s argument by explaining the likely effects of a false proxy of the market portfolio on both the market risk and the SML’s slope.
Question 2
A bond which has just been issued possess the below features :
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Coupon
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Yield-to-Maturity (YTM)
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Expiry
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Macaulay Duration
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4%
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4%
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7 years
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5 years
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Required:
(a) Determine the modified duration based upon the above data.
(b) Modified duration is a better way to determine the bond’s sensitivity to interest rate changes as compared to the expiry period of the bond. Do you agree with this statement ? Justify your stance by providing proper explanations.
(c) Determine the change’s direction in modified duration under the following situations :
(i) The bond’s coupon was 2%
(ii) The bond’s expiry was 3 years
(d) Provide the definition of convexity and discuss how modified duration and convexity are used to determine dP/dI (P : Bond price, I: Interest rate)
