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Appendix A: Example of the Investment Portfolio Summary of Observations from Investment Portfolios April–May 1997 Dr. Blood Prepared by: Richard P. White On April 11, 1997, I purchased $5,000,000 of U. S. Treasury bills, notes, and bonds. The maturity of these securities ranged from short-term to long-term. These securities are recorded on the spreadsheet on the preceding page. I tracked the prices and yields on these securities each week, using the Friday closing price through May 16, 1997. On May 16, I sold all the securities and calculated a gain or loss for each security and the entire portfolio. The spreadsheet summarizes the trade information on all the securities and the portfolio. I also prepared the following graph comparing the individual security yields to the Treasury yield curve as of May 16. The following list summarizes my observations and comments from the investment portfolio graph and the worksheet on the preceding pages. 1. The yield on the portfolio securities marks closely to the Treasury yield curve. Government security yields should approximate the yield curve. Corporate securities usually have higher yields than shown by the yield curve due to the default risk premium. 2. Differences between the securities’ yields and the yield curve are minor except in two cases: B. A 3.5% Treasury bond due November 1998 (not plotted on the graph) had a yield of 3.56%. This yield did not vary during the weeks I tracked the security. Other bonds with the same maturity had a yield of 6.14%. The yield curve suggests a yield of about 6.14%, also. I cannot explain why the bond was not steeply discounted to reflect a higher yield. It appears some restriction on that particular bond is preventing the bond from responding to market demand. a. It was interesting to observe that the spread between bid and ask was 100 basis points on this bond, compared to the usual 2 to 6 basis points on other bonds. a. Even though government bonds do not usually include a risk premium, there are other factors and restrictions an investor must consider before purchasing a government bond. 1. A 9.00% Treasury bond due November 2018 has a yield of 7.00%. This yield is greater than securities maturing at a later date. I scanned the yield quotes in the Wall Street Journal and noticed that the yields increase up to 26 years, and then decrease slightly each year 27 through 30. The yield curve in the graph does not reflect this condition. a. The yield curve is positive, or upwardly sloped. Securities with longer maturities have higher yields. This is the typical shape of the yield curve, and usually reflects a healthy economy and an accommodating Fed monetary policy. a. Because the yield curve is not linear, the yields are not proportionately allocated across the maturity range. This suggests that if maturity represents the only risk variable, some points on the curve will maximize yield better than others. a. Regardless of the coupon rate, the price of the bond will change in order to allow the security to yield a return closely equivalent to securities with the same maturity. As noted in (2) above, there are a few exceptions. It is interesting to observe the slight differences in yields of government bonds or notes with the same maturity. a. Yield to maturity is a much better measure for comparing bonds because it incorporates the total return (income and price change) into the percentage. The coupon rate is misleading by itself because it does not consider the bond’s change in price into the percentage. Yields and prices are constantly changing. Coupon rates remain the same throughout the life of the bond. a. The spreadsheet documents that 18 of the 20 securities resulted in a gain. Because there is an inverse relationship between the bond price and yield, I interpret this to mean that yields declined (interest rates weakened) during the time I held the bonds. I verified that yields decreased between the purchase and sale date for each individual security with a gain. a. Interest rate fluctuations have a greater effect on the price of securities with longer maturities. The graph below illustrates this principle. It plots the change in price between April 11 and May 16 for each of the securities in the portfolio. 1. I have inserted a linear regression trend line. The trend line is upward sloping. The upward slope indicates that as interest rates fluctuate (up or down), bond prices of longer maturities will fluctuate more than prices of shorter maturities. a. Interest received and accrued interest are not considered in the gain or loss for Treasury notes and bonds. In order to calculate the total return, this interest should be added to the price change. The investment portfolio was an excellent exercise in becoming familiar with pricing government bonds from the Wall Street Journal. It was also a valuable demonstration of many of the principles discussed in class. Summary of Observations from the Investment Portfolio The spreadsheet on the preceding page documents the trades of various investment securities in the investment portfolio. I began purchasing securities on April 11. Throughout the next five weeks, I bought and sold securities. By May 16, I had completely liquidated the entire portfolio. Over the course of the five week period, I accumulated a net gain of $130,489, or 2.61% for the period. This would approximate an annualized return of 27%. The following list summarizes my observations and comments from the investment portfolio worksheet on the preceding page. 1. One of the most interesting observations was to monitor the changes in the price of foreign bonds. Below is a graph illustrating the allocation of the loss on four foreign bonds between price changes and exchange rate changes. A. The graph illustrates the varying influence of exchange rates between currencies and countries. The dollar weakened most against the German mark, followed by Britain and then Japan. The dollar actually strengthened against the Canadian dollar. This graph demonstrates how the U.S. dollar fluctuates differently, for each currency. 1. Corporate bonds have higher yields than government bonds with the same maturity. The credit risk premium would be a major reason for the difference. The calculated yield on the Mattel corporate bond was over 9%, compared to the yield of a government bond with the same maturity of 6.55%. The difference was 245 basis points. 1. The Federal agency bonds (FNMA and GNMA) react much differently to interest rate fluctuations than government bonds with the same maturity. The following two reasons account for some of the difference. C. Future cash flows include monthly principal repayments and interest income, rather than just interest income and the entire principal balance due at maturity. C. FNMA and GNMA bonds are collateralized differently than Treasury notes and bonds. 1. An option’s price is dependent on the price of the underlying commodity and the length of time until it expires. For example, on April 25, I purchased a call option to buy 250,000 pounds of cotton at an October strike price of 73% per pound for 3.98% per pound. At that time, October cotton was selling for 74.65% per pound. One week later, I sold the options for only 3.6% per pound. When I sold the options, October futures on cotton had also decreased to 73.93% per pound. The decrease in cotton futures was a major reason for the drop in the option’s price. D. Even though the strike price and the cost of the option exceed the current price of the future commodity, the option still retains value. The reason this occurs is because there is the possibility the cotton will exceed the strike price before the expiration of the option. 1. The put option on cocoa was also fun to monitor. I purchased July cocoa put options at a strike price of $1,500 per ton for $66 per ton. At that time, July cocoa futures cost $1,466 per ton. When I sold the put options one week later, July cocoa futures dropped to $1,379 per ton. The put option increased in value to $131 per ton. E. The option increased in value because as the July cocoa futures decreased in price, the right to sale the cocoa at $1,500 became more valuable. The cocoa future price of $1,379 plus the $131 price of the put option equals $1,510. The reason this amount exceeds the strike price is because of the possibility the futures price could continue to decline further before the put option expires. 1. Options are much cheaper to buy than the commodity itself. This would make them a better instrument when leveraging money. Leveraged money, however, increases volatility. 1. The majority of the gain in the portfolio came from the foreign and domestic securities. I observed a greater variance in the prices of equity securities. Fixed income securities will fluctuate, but not with the same degree of volatility as stocks. I believe this is because risks inherent to an owner are greater than the risks to a secured debt holder. If that were not the case, why would anyone want to be an equity owner? Usually, business and market risks inherent in equity securities are greater than interest, default and liquidity risks in bonds. 1. The investment portfolio experienced many losses offset by some large gains. This demonstrates the value of diversifying a portfolio’s assets among different asset classes that behave differently. I felt more comfortable spreading the $5 million around many securities, rather than putting the entire amount into just a few securities. The investment portfolio was an excellent exercise in becoming familiar with pricing a variety of domestic and foreign investment securities. I especially enjoyed monitoring the call and put options and comparing them to their underlying commodities. It helped me gain a greater appreciation and understanding on the interrelationships of commodities and their related options. I was also able to see the effect of exchange rates on the returns of foreign securities. Microsoft Word - x_bond worksheet.doc Bond Worksheets (This is only a one-page sample; it does not represent the entire record required.) Buy Date Instrument type Issuer or Commodity Face Value or Units Price Paid / Unit Total $ Investment Coupon Rate Strike Price Maturity Date Sell Date Price Received Total Received Gain (Loss) 18-Jun T-Bond U.S. Gov. $100,000 $135.06 $135,062.50 14 ¼ Feb 02 30 Jul $134.69 $134,688 ($374.50) 18-Jun T-Note U.S. Gov. $ 50,000 $100.53 $50,265.63