Debt and Money Markets (Instructor: Junho Oh)
Practice Problem Answer Key (Chapter 2)
#1. What does ‘bid-ask spread’ mean? What is the relation between bid-ask spread and liquidity?
The bid-ask spread is the difference between a bond’s bid price and ask price. The bid price is
the price a buyer is willing to pay for the bond — at this price, the buyer can purchase the
bond immediately. The ask price is the price at which a seller is willing to sell — at this price,
the seller can sell the bond immediately.
In finance, liquidity refers to how easily an asset or security can be quickly traded in the
market without affecting its price. A wide bid-ask spread indicates low liquidity, meaning the
bond is harder to trade because buyers are only willing to pay much less than what sellers are
asking.
#2. Amortization is defined as paying off a debt by regular installments according to a determined
schedule. A debt of $25,000 is to be amortized over 7 years at 7% interest. What value of
monthly payment will achieve this (in other words, what is the PMT)? We assume monthly
compounding.
Annuity formula tells us
P $25,000
n 84 months
r 7/12=0.583333% per month
A $377.32
Financial calculator: N=84, I/YR=0.583333, PV=25000, FV=0 => PMT=377.32
#3. Find the value of the accrued interest component for a 10% coupon bond if we are 30 days into
a 180-day coupon period. Assume that face value of the bond is $100.
A 180-day coupon period indicates semi-annual payments.
𝟑𝟎
× (𝟏𝟎𝟎 × 𝟎. 𝟏 ÷ 𝟐) ≅ 𝟎. 𝟖𝟑
𝟏𝟖𝟎
#4. How much would you pay for a zero coupon bond (face value=$100) maturing in two years if
prevailing market interest rates are 5%? Assume that we need to use semi-annual compounded
interest rate.
𝟏𝟎𝟎
𝑷𝒁𝑪 = 𝟐×𝟐 = 𝟗𝟎. 𝟔𝟎
(𝟏 + (𝟎. 𝟎𝟓/𝟐))
Financial calculator: I/YR=2.5, PMT=0, N=4, FV=100 → PV=90.60
#5. An 8% bond (semi-annual payments) with 18 years to maturity has a yield of 9%. Its face value
is $100. What is the price of this bond?
𝟖 𝟏 𝟏𝟎𝟎
𝑷= × [𝟏 − 𝟏𝟖×𝟐 ] + 𝟏𝟖×𝟐 = 𝟗𝟏. 𝟏𝟕
𝟎. 𝟎𝟗 (𝟏 + (𝟎. 𝟎𝟗/𝟐)) (𝟏 + (𝟎. 𝟎𝟗/𝟐))
Financial calculator: I/YR=4.5, PMT=4, N=36, FV=100 → PV=91.17
#6. A company creates a bond paying $12 per month forever. There is no face value of this bond.
The prevailing annual interest rate is 6 percent and we assume that the interest rate does not
change over time.
a) What is monthly interest rate?
b) Determine the value of the bond.
c) What if the price of the bond if it has maturity up to 30 years (no more forever payment)?
a) 6/12=0.5 %
𝑪/𝒎 𝑪 𝟏𝟐
b) Since the bond is perpetuity, 𝑷𝑷𝑬𝑹 = ∑∞
𝒌=𝟏 𝒌 = 𝒓 = 𝟎.𝟎𝟎𝟓 = $𝟐, 𝟒𝟎𝟎
(𝟏+(𝒓/𝒎))
𝑪/𝒎 𝑪 𝟏 𝟏𝟐
c) Since the bond is annuity, 𝑷𝑨𝑵𝑵 = ∑𝑻×𝒎
𝒌=𝟏 𝒌 = 𝒓 × [𝟏 − 𝑻×𝒎 ] = 𝟎.𝟎𝟎𝟓 ×
(𝟏+(𝒓/𝒎)) (𝟏+(𝒓/𝒎))
𝟏
[𝟏 − (𝟏+𝟎.𝟎𝟎𝟓)𝟑𝟎×𝟏𝟐
] = $𝟐, 𝟎𝟎𝟏. 𝟓𝟎
Alternatively, N=30×12=360, I/YR=6/12=0.5, FV=0, PMT=12 → PV=2001.50
#7. Discuss two components that affects the price of a floater.
There are two key factors that determine the price of a floater: (1) the quoted spread and (2)
any restrictions on the coupon rate (such as a cap or floor). The coupon rate of a floater is
typically equal to the reference rate (for example, the U.S. Treasury yield, SOFR, or LIBOR)
plus the quoted spread. If there are no restrictions like a cap or floor, a higher quoted spread
results in a higher price for the floater.
#8. Consider a floater with its coupon rate is equal to the reference rate. The par value is $100. We
assume that people typically use LIBOR as an interest rate for discounting.
Year (Cash flow periods) LIBOR (the reference rate) Coupon amounts ($)
0.5 5% (5%/2) × $100
1 6% (6%/2) × $100
1.5 4% (4%/2) × $100
a) What is the value of the floater at year=1?
b) What is the value of the floater at year=0.5?
c) What is the value of the floater at year=0?
$𝟏𝟎𝟎×(𝟏+(𝟒%/𝟐))
a) = $𝟏𝟎𝟎
𝟏+(𝟒%/𝟐)
$𝟏𝟎𝟎×(𝟏+(𝟔%/𝟐))
b) = $𝟏𝟎𝟎
𝟏+(𝟔%/𝟐)
$𝟏𝟎𝟎×(𝟏+(𝟓%/𝟐))
c) = $𝟏𝟎𝟎
𝟏+(𝟓%/𝟐)
What is the implication of this problem? If the coupon rate of a floater is equal to the discount
rate (i.e. quoted spread is zero), the price will be its par value.
#9. An investment company wants to create a floater and an inverse floater from a bond with the
face value of 1 million dollars, the coupon rate of 6 percent, and the maturity of 10 years as the
collateral of the inverse floater. The investment company has a plan to set the coupon rate of
the floater as (reference rate)+1.5%. The objective of the company is to make the combined
coupon rate of the floater and the inverse floater equal to a constant rate regardless of the
reference rate. Assume that the sum of the face value of the floater and the inverse floater is
equal to that of the collateral.
a) What is the face value of the inverse floater according to the plan?
b) Determine the coupon rate of the inverse floater.
c) In year 2020, the reference rate goes up to 12%. What is the coupon rate of the inverse
floater? Does it make sense? Which condition is required to solve the problem?
a) $𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎 ÷ 𝟐 = $𝟓𝟎𝟎, 𝟎𝟎𝟎, according to the assumption that the sum of the face
value of the floater and the inverse floater is equal to that of the collateral.
b) Since the floater and the inverse floater account for 50% respectively,
𝟎. 𝟓 × (𝑹𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒓𝒂𝒕𝒆 + 𝟏. 𝟓%) + 𝟎. 𝟓 × (𝑪𝒐𝒖𝒑𝒐𝒏 𝒐𝒇 𝒕𝒉𝒆 𝒊𝒏𝒗𝒆𝒓𝒔𝒆 𝒇𝒍𝒐𝒂𝒕𝒆𝒓)
= 𝟔%
𝟎. 𝟓 × (𝑪𝒐𝒖𝒑𝒐𝒏 𝒐𝒇 𝒕𝒉𝒆 𝒊𝒏𝒗𝒆𝒓𝒔𝒆 𝒇𝒍𝒐𝒂𝒕𝒆𝒓)
= 𝟔% − 𝟎. 𝟓 × (𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒓𝒂𝒕𝒆 + 𝟏. 𝟓%)
= 𝟓. 𝟐𝟓% − 𝟎. 𝟓 × 𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒓𝒂𝒕𝒆
Thus, (𝑪𝒐𝒖𝒑𝒐𝒏 𝒐𝒇 𝒕𝒉𝒆 𝒊𝒏𝒗𝒆𝒓𝒔𝒆 𝒇𝒍𝒐𝒂𝒕𝒆𝒓) = (𝟏𝟎. 𝟓% − 𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒓𝒂𝒕𝒆).
c) The coupon rate on the inverse floater would be –1.5%, which is nonsensical.
Typically, a floater includes a cap, or maximum coupon rate, to prevent such
outcomes. In this case, setting the cap at 10.5% would resolve the issue.