A portfolio manager decided to purchase corporate bonds with a market value of €5 million. To finance 60 percent of the purchase, the portfolio manager entered into a 30-day repurchase agreement with the bond dealer. The 30-day term repo rate was 4.6 percent per year. At the end of the 30 days, the bonds purchased by the portfolio manager have increased in value by 0.5 percent and the portfolio manager decided to sell the bonds. No coupons were received during the 30-day period.
A. Compute the 30-day rate of return on the equity and borrowed components of the portfolio.
B. Compute the 30-day portfolio rate of return.
C. Compute the 30-day portfolio rate of return if the increase in value of the bonds was 0.3 percent instead of 0.5 percent.
D. Use your answers to parts B and C above to comment on the effect of the use of leverage on the portfolio rate of return.
E. Discuss why the bond dealer in the above example faces a credit risk even if the bond dealer holds the collateral.