Q.1 Bonds of Zello Corporation with a par value of $1,000 sell for $960, mature in 5 years, and have a 7% annual coupon rate paid semiannually.
a. Calculate each of the following yields:
i. Current yield.
ii. Yield to maturity (to the nearest whole percent, i.e., 3%, 4%. 5%, etc.).
iii. Horizon yield (also called total compound return) for an investor with a 3-year period and a reinvestment rate of 6% over the period. At the end of 3 years the 7% coupon bonds with 2 years remaining will sell to yield 7%.
b. Cite a major shortcoming for each of the following fixed-income yield measures:
i. Current yield.
ii. Yield to maturity.
iii. Horizon yield (also called total compound return).
Q.2 Carol Harrod is the investment officer for a $100 million U.S. pension fund. The fixed - income portion of the portfolio is actively managed, and a substantial portion of the fund's large capitalization U.S. equity portfolio is indexed and managed by Webb Street Advisors.
Harrod has been impressed with the investment results of Webb Street's equity index strat¬egy and is considering asking Webb Street to index a portion of the actively managed fixed-income portfolio.
a. Describe advantages and disadvantages of bond indexing relative to active bond management.
b. Webb Street manages indexed bond portfolios. Discuss how an indexed bond portfolio is constructed under stratified sampling (cellular) methods.
c. Describe the main source of tracking error for the cellular method.