EF4327 Fixed Income Securities
Problem Set 1
Semester B, 2019/2020
Instructor: Dr. DU Jintao Email: jintaodu@[Link]
Teaching Assistant: Miss ZHANG Han Email: hzhang368@[Link]
You should finish the problem set by yourself and then discuss your answers with your group members.
Your group coordinator should email your consensual answers to our TA Miss Zhang and me on behalf
of your group. The problem set must be submitted by 1 p.m. on Mar 11th.
1. Simple, long-only, bond strategies. The following exercise gets you to consider some simple,
and indeed popular, long-only bond strategies. To make the calculations simpler, I am assuming
throughout that you can trade zero coupon bonds.
Maturity 0 1 2 3 4 5
Spot rate p.a. - 3.05% 4.43% 5.38% 6.05% 6.34%
a. Given the above spot rate/zero coupon yield curve (continuously compounded), please
calculate the prices of zero-coupon bonds of all maturities.
b. What is the return earned by each zero-coupon bond over 1 year if the yield curve doesn’t
move?
c. Assume that you have a 5-year investment horizon. What is the total return you earn for
each of the following strategies if the yield curve does not move?
i. Buy and Hold – Buy the 5-year bond and hold to the maturity.
ii. Riding the Yield Curve – Buy the 5yr bond, hold for one year, then sell when it
has 4 years left to maturity, buy another 5yr bond, repeat.
iii. Bond Ladder – Start by investing 20% of your wealth in bonds of each maturity.
At the end of the first year, when the 1yr bond matures, invest the proceeds in a
new 5yr bond, repeat.
d. Please comment on the risk of these strategies (duration, VaR, expected shortfall, etc.;
make some assumptions if necessary)
2. Curve trades (flatteners/ steepeners). In a curve trade the idea is to invest in two bonds with
different maturities, where you are long one bond and short the other, in such a way so as to be
unaffected by small parallel shifts of the yield curve (i.e. to be duration-neutral), but to profit
from a change in the slope of the yield curve (either flattening or steepening, depending on your
view). You are given the following information on 2-year and 10-year bonds, both with face
value $1000:
Maturity 2 years 10 years
Coupon 2.375% 2.75%
Yield 2.5% 2.95%
a. To express the view that the yield curve will flatten (i.e. that the difference between the
10-year and 2-year bond will decrease from 0.45%), which bond do you go long, and
which bond do you go short?
b. Assuming that for the 10-year leg you are long/short (depending on your answer to
part(a)) 1 bond. How many 2-year bonds do you go short/long in order to be duration
neutral?
c. How much money do you need to invest in this strategy (i.e. borrow to fund the position)
or do you receive (which you can then lend out)?
d. Approximately how much money do you make per basis point of curve flattening?
e. What happens if the yields on both bonds move by the same large (rather than small)
amount, say ±2%? Please explain qualitatively what is driving this result.
3. Arbitrage. The following exercise helps to understand arbitrage better.
Maturity 0 1 2 3 4 5
Spot rate p.a. - 2.5% 3.2% 4.1% 3.05% 2.9%
a. Given the above spot rate/zero coupon yield curve (continuously compounded), what is the
shape of the yield curve?
b. Please explain which spot rate allows you to arbitrage.
c. Explain how to arbitrage from this case.