Chapter 3:
More Advanced Financial Analysis
Dr Nurin Haniah Asmuni
Centre of Actuarial Studies
Faculty of Computer and Mathematical Sciences
26 April 2016
Inflation
Risk &
uncertainty
Factors Expenses
affecting
calculation of
interest rates
Currency
&
Taxes
exchange
rates
4. Currency exchange rates
Let: i d current domestic interest rate
i f current foreign interest rate
e c current exchange rate
e e expected future exchange rate
r expected return on foreign investment
e = 1 unit of domestic currency in terms of a foreign currency
(can be thought of a value in foreign currency that worth exactly
1 unit of domestic currency)
1 + 𝑖 𝑑 𝑒 𝑒 - represents $1 of investment made today in a
domestic investment for one year, and the ending balance is
converted into foreign currency
Alternatively,
1 + 𝑖 𝑓 𝑒 𝑐 - we can convert $1 into foreign currency
immediately and then invest directly in a foreign investment
Both methods will produce ending balance in foreign value at
the end of one year
Interest rate parity:
(1 i d )ee (1 i f )ec
Given any three of the four values in the above formula, we
can solve for the fourth
Examples
1. Let the domestic currency be US$ and foreign currency is
€. If €1 is worth $1.25, what is e?
2. Certificate of deposits yield 3.35% in the US and 2.31% in
Japan. The current exchange rate is 107.88 Japanese Yen
per dollar. Find the expected exchange rate one year from
today under interest rate parity.
(𝑖 𝑑 = 3.35%, 𝑖 𝑓 = 2.31%, 𝑒 𝑐 = 107.88)
5. Reflecting Risk & Uncertainty
Consider a $1000 1-year bond with 8% annual coupon maturing at
par.
P = 1000v + 80 v
= 1080v , if i = 8% , P = 1000
This is the market price if there is no risk of default.
Consider the same identical bond but the price in the market is
$940.
The $60 difference in price compensates the purchase of bond
for risk of default.
By computing yield rates on this bond ignoring the probability of
default
P = 940 , 940 = 1080v , i= 14.89%
P 80 + 1000
0 1
The excess of this rate over the risk free rate, 14.89% - 8% =
6.89%, is called risk premium.
In general, the higher the risk in investment, the higher the risk
premium.
But this computed yield rate is somewhat misleading.
14.89%
No default(0%)*
Partial default
Return (0% - 100%)
-100%
Default(100%)* *Probability of default
• To purchase a high risk bond, we need to know the probability of default(default risk)
carried by the bond.
• EPV(expected present value) of a future payment as its pv multiplied by the
probability of payment
The probability, denoted by P, can be calculated by
1080
EPV = 940 = P ( )
1.08
940 (1.08)
P = 1080 =0.94 , probability of no default
i is calculated by risk free rate. 𝑞 = 1 − 𝑝 = 0.06. (𝑞 is the probability of default)
Further analysis, it is unlikely that the bond purchaser would be
willing to pay $940 for this bond if they think that the probability
of default is as high as 6%.
Thus,
Probability of default
$60 in price
difference
Higher return to purchaser as a
compensation for assumption of risk
Thus, if an investor think that assumption for this level of risk
worth an extra 3% in the yield rate, the investor should only
be willing to invest at a yield rate of 11% instead of 8%.
Given the investor’s assumption, we can calculate the
probability of default which contributes to the price
difference of the bond
1080
940 = 𝑝 ,
1.11
𝑝 = 0.9661, 𝑞 = 0.0339
Example 9.12
The prevailing yield rate for risk-free 10 year bonds is 9%
effective. A $1000 10-year bond with annual coupons is
issued on which the coupon rate is 9%.
1. Find the price an investor would be willing to pay if the
probability of default each year is 0.005 and if the investor
requires a yield rate of 11% in compensation for the risk of
default.
2. Find the risk premium in the interest rate in this transaction.
EXERCISE: Question 33
An investment is made such that the probability is 90% that $1000
will be received at the end of one year and 10% that nothing will
be received. The effective rate of interest is 25%.
a) Find the mean of the present value of this investment (Ans: 720)
b) Find the standard deviation of the present value of this
investment (Ans: 240)
c) Find the risk premium in the interest rate (Ans: 13.89%)
Let x = pv of amount received at the end of one year
Hint: a) Calculate 𝐸(𝑥), b) Calculate 𝑆. 𝐷(𝑥) –
Where 𝑆. 𝐷 𝑥 = 𝑉𝑎𝑟(𝑥) 𝑉𝑎𝑟 𝑥 = 𝐸 𝑥 2 − 𝐸(𝑥)2
