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Fixed Income: Practice Problems with

Solutions
Directions: Unless otherwise stated, assume semi-annual payment on bonds.

1. A 6. 0 percent bond matures in exactly 18 years and has a par value of 2000 dollars. The
bond sells for 1338. 1 dollars. What is the semiannual coupon payment?
a. 120. 0
b. 80. 288
c. 60. 0
d. 40. 144
e. 66. 906
Solution:
a. semiannual coupon: C2  12  0. 06  2000  60. 0

2. A 9. 0 percent bond matures in exactly 15 years and has a par value of 7000 dollars. The
bond sells for 6723. 1 dollars. What is the current yield?
a. 9. 0
b. 9. 5
c. 9. 370 6
d. 4. 75
e. 4. 5
Solution:
a. current yield: CY  1000.097000
6723. 1
 9. 370 6

3. A 9. 5 percent bond matures in exactly 16 years and has a par value of 10 000 dollars. The
bond sells for 14220. 0 dollars. What is the yield to maturity?
a. 3. 5
b. 4. 0
c. 5. 5
d. 4. 5
e. 5. 0
Solution:
a. calculator inputs:
N  32; PV  14220. 0; PMT  12  0. 095  10 000  475. 0; FV  10 000
b. cpt I/Y  2. 75
c. so y  5. 5
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4. A 4. 5 percent bond with a par value of 1000 dollars matures in 17 years, 170 days. The
next coupon is paid in 170 days. What is the accrued interest? Assume 183 days between
coupon payment dates.
a. 20. 902
b. 3. 196 7
c. 1. 598 4
d. 12. 049
e. 24. 098
Solution:
a. days since last coupon  183 − 170  13
b. half-year since last coupon  183−170
183
 183
13

c. so accrued interest  183−170

183
 0. 022 5  1000  1. 598 4

5. A 7. 5 percent bond with a par value of 1000 dollars matures in 15 years, 20 days. The
next coupon is paid in 20 days. The yield is 4. 5 percent. What is the dirty price? Assume
183 days between coupon payment dates.
a. 1362. 2
b. 1365. 5
c. 1358. 9
d. 1360. 5
e. 1362. 6
Solution:
a. solve for value of bond V w at first coupon payment date:w  20 days  183 20
 183
20

half years
b. calculator inputs:
N  30; I/Y  4. 5  12  2. 25; PMT  12  0. 075  1000  37. 5; FV  1000
c. cpt PV  1324. 7
d. so V  1324. 737.205  1358. 9
1. 022 5 183

6. A 9. 0 percent bond with a par value of 1000 dollars matures in 19 years, 19 days. The
next coupon is paid in 19 days. The bond sells for 1378. 2 dollars. What is the clean price?
Assume 183 days between coupon payment dates.
a. 1297. 5
b. 1335. 5
c. 1337. 8
d. 1351. 3
e. 1324. 4
Solution:
a. days since last coupon  183 − 19  164
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b. half-year since last coupon  183−19

183
 164
183
c. so accrued interest  183−19
183
 0. 045  1000  40. 328
d. then clean price is given by: CP  1378. 2 − 40. 328  1337. 8

7. A zero-coupon bond with a par value of 1000 dollars matures in 10 years, 59 days. If the
bond yields 4. 5 percent, what is the clean price? Assume 183 days in a half-year.
a. 640. 82
b. 639. 37
c. 636. 24
d. 643. 93
e. 645. 43
Solution:
a. time to maturity  20  183
59
 3719183
b. clean (or dirty) price  1000
3719  636. 24
1. 022 5 183

8. A zero-coupon bond with a par value of 1000 dollars matures in 10 years, 156 days. If the
bond sells for 464. 10, what is yield to maturity? Assume 183 days in a half-year.
a. 7. 0
b. 8. 0
c. 7. 5
d. 8. 5
e. 9. 0
Solution:
a. time to maturity:T  20  156183
 1272
61
1
1272
b. yield to maturity  2 1000
464. 10
61 −1  100  7. 5

9. The yields on a six month and one year zero-coupon bonds are 4. 0 and 9. 0 percent,
respectively. A dealer holds in inventory a 5. 0 percent treasury note with a par value of
1000 dollars and maturity of one year. What is the minimum price the dealer should ask
for the bond?
a. 1010. 5
b. 940. 24
c. 963. 13
d. 931. 84
e. 889. 76
Solution:
a. minimum price is the cost of constructing cash flow pattern using zero-coupon bonds:
25. 0d 1  1025. 0d 2
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b. so: P  25.0
 1025.0
 963. 13
1. 02 1. 045 2

10. A 7. 5 percent par treasury bond matures in exactly 13 years. A 5. 0 percent par municipal
bond matures in exactly 13 years. Suppose both bonds have the same default risk. At what
marginal tax rate would the two bonds have the same after-tax yield?
a. 34. 633
b. 36. 133
c. 33. 333
d. 37. 833
e. 39. 733
Solution:
a. since both bonds are selling at par: y treasury  7. 5 and y muni  5. 0
b. therefore: 1 − 7. 5  5. 0
c. which implies:1 −   7.5.05  0. 666 67
d. so:  1 − 0. 666 67  33. 333

11. A 10. 0 percent par municipal bond matures in exactly 13 years. For an investor at the
29. 0 percent marginal tax rate, what is the taxable-equivalent yield?
a. 7. 1
b. 7. 042 3
c. 14. 085
d. 15. 285
e. 18. 885
Solution:
a. since the muni is selling at par: y muni  10. 0
y muni
b. therefore: TEY  1−  1−0.29
10.0
 14. 085

12. A 3. 0 percent TIP bond matures in exactly 14 years. Six months ago the par value was
10 800 dollars. The annualized CPI (inflation rate) over the last six months equals 9. 5.
Assuming a coupon is paid today, what is par value of the bond?
a. 11826.
b. 10962.
c. 11313.
d. 11124.
e. 10 800
Solution:
a. inflation adjusted principal: M 1  10 8001  0.095
2
  11313.

13. A 4. 0 percent TIP bond matures in exactly 12 years. Six months ago the par value was
10 500 dollars. The annualized CPI (inflation rate) over the last six months equals 2. 5.
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Assume the coupon is paid today. What is the dollar value of the coupon paid today?
a. 425. 25
b. 215. 25
c. 212. 63
d. 430. 5
e. 210. 0
Solution:
a. inflation adjusted principal: M 1  10 5001  0.025
2
  10631.
c1
b. apply coupon rate to inflation adjusted principal: 2  10631.0.04
2
 212. 63

14. A 3. 25 percent TIP bond matures in exactly 14 years. Six months ago the par value was
10 600 dollars. The annualized CPI (inflation rate) compounded semiannually over the last
six months equals 4. 5 percent. Assume the coupon is paid today. Six months ago the bond
was selling at par and today the bond is selling at 5. 0 percent premium over par. What is
the annual rate of return compounded semiannually over the last six months?
a. 17. 048
b. 17. 298
c. 18. 048
d. 19. 298
e. 19. 788
Solution:
a. inflation adjusted principal: M 1  10 6001  0.0452
  10839.
c1
b. apply coupon rate to inflation adjusted principal: 2  10839.0.032
2
5
 176. 13
c. one plus the return over a half year equals the ratio of the begining to end of half-year
value
d. value at the end of the first half year equals the semi-annual coupon: 176. 13 plus the
price: P 1  1. 05  10839.  11380. 0
e. so: 1  R2  176. 1311380.0
10 600
 1. 090 2
f. finally: R  2  1. 090 2 − 1  100  18. 048 percent

15. A 8. 0 percent bond matures in exactly 10 years and has a par value of 10 000 dollars. The
bond sells for 11090. 0 dollars. For a 50 basis increase in the yield, determine the
percentage change in the bond’s price?
a. −3. 924 8
b. −1. 924 8
c. −3. 424 8
d. −2. 024 8
e. 0. 475 15
Solution:
a. first step, find yield to maturity y
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b. calculator inputs:
N  20; PV  11090. 0; PMT  12  0. 08  10 000  400. 0; FV  10 000
c. cpt I/Y  3. 25
d. so y  6. 5
e. second step, increase yield by 50 bps
f. new yield  6. 5 . 5  7. 0
g. so I/Y  3. 5
h. third step, compute price at new yield
i. calculator inputs:
N  20; I/Y  3. 5; PMT  12  0. 08  10 000  400. 0; FV  10 000
j. cpt PV  11090. 0
k. Δ%P  10711.−11090.0
11090.0
 100  −3. 424 8

16. A 8. 5 percent bond matures in exactly 13 years and has a par value of 7000 dollars. The
bond sells for 9321. 4 dollars. What is the approximate (effective) duration for a 20 basis
point shock (either up or down)?
a. 5. 588 8
b. 6. 588 8
c. 8. 588 8
d. 7. 588 8
e. 6. 588 8
Solution:
a. first step, find yield to maturity y
b. calculator inputs:
N  26; PV  9321. 4; PMT  12  0. 085  7000  297. 5; FV  7000
c. cpt I/Y  2. 5
d. so y  5. 0
e. second step, increase yield by 20 bps
f. new yield  5. 0 . 2  5. 2
g. so I/Y  2. 6
h. third step, compute price at new yield y 
i. calculator inputs: N  26; I/Y  2. 6; PMT  12  0. 085  7000  297. 5; FV  7000
j. so: P   9163. 1
k. fourth step, decrease yield by 20 bps
l. new yield  5. 0 −. 2  4. 8
m. so I/Y  2. 4
n. fourth step, compute price at new yield y −
o. calculator inputs: N  26; I/Y  2. 4; PMT  12  0. 085  7000  297. 5; FV  7000
p. so P −  9483. 4
q. fifth step, determine effective duration
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r. definition: ED  1
P0 |slope|
P  −P −
s. formula: ED  1
P0 2Δy
 1
9321. 4
9163. 1−9483. 4
2.002
 8. 588 8

17. A T-bill matures in exactly 241 days and has a par value of 10 000 dollars. The bond sells
for 9781 dollars. What is the discount yield?
a. 10. 0
b. 3. 316 8
c. 3. 271 4
d. 3. 344 6
e. 3. 391 1
Solution:
a. definition: annualized discount based upon 360 day year
b. so DY   360
241
 10 000−9781
10 000
 100  3. 271 4

18. A T-bill matures in exactly 326 days and has a par value of 10 000 dollars. The discount
yield equals 7. 5. What is the price?
a. 9330. 1
b. 9250. 0
c. 9320. 8
d. 9171. 8
e. 9625. 0
Solution:
a. definition: annualized discount based upon 360 day year
b. true discount as percent  7. 5 326
360
c. so price: P  10 000 − 10 000  0. 075 326
360
 9320. 8

19. A 7. 0 percent bond matures in exactly 13 years and has a par value of 1000 dollars. The
bond sells for 1141. 4 dollars. The bond is callable in 7 years for 990 dollars. What is the
yield to call?
a. 4. 0
b. 5. 0
c. 4. 5
d. 5. 5
e. 6. 0
Solution:
a. calculate the yield to maturity assuming the bond is called at the first call date
b. calculator inputs: N  14; PV  1141. 4; PMT  12  0. 07  1000  35. 0; FV  990
c. cpt I/Y  2. 25
d. so y  4. 5
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20. A 4. 0 percent bond with a par value of 1000 dollars matures in 13 years. The bond sells
for 680. 34 dollars. Assume coupons are reinvested at 7. 5 percent per year compounded
semiannually. What is the total return (over holding period of T years) compounded
semiannually on the bond?
a. 8. 024 0
b. 7. 954 9
c. 7. 869 2
d. 8. 113 1
e. 5. 280 6
Solution:
a. first step, compute future value of coupons to maturity date
b. calculator inputs:
N  26; PV  0; I/Y  7.25  3. 75; PMT  12  0. 04  1000  20. 0
c. cpt FV  855. 63
d. second step add in maturity value: FV  855. 63  1000  1855. 6
e. third step, find return compounded semiannually that converts price 680. 34 into
1855. 6
1
f. total return: TR  2 1855. 6
680. 34
213
− 1  100  7. 869 2

21. A floating rate bond has a quoted margin of 0. 5 percent, a par value of 10 000 dollars, and
maturity of 2. 0 years. The bond sells for 10073. dollars. The initial reference rate is 7. 5
percent per year compounded semiannually. The coupon rate is reset every six months.
What is the discount margin in basis points?
a. −5
b. 0
c. 10
d. 5
e. 0
Solution:
a. first step, project cash flows under the assumption that future reference rate equals the
current reference rate
b. coupon rate: CR  7. 5  0. 5  8. 0
c. coupon: C2  0.08 2
 10 000  400. 0
d. second step, compute yield to maturity
e. calculator inputs: N  4. 0; PV  10073. ; PMT  400. 0; FV  10 000
f. cpt I/Y  3. 8
g. so y  7. 6
h. third step, discount margin is difference between computed yield and reference rate
i. discount margin: 7. 6 − 7. 5  10
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22. The yields on a six month, one year, and one and a half year zero-coupon bonds are 9. 5,
5. 5, and 6. 5 percent, respectively. What is the forward price of a contract to accept
delivery of a six month T-bill with a par value of 10 000 dollars in one year?
a. 10112.
b. 9599. 0
c. 9591. 7
d. 10079.
e. 10176.
Solution:
a. method: cost of carry model
b. forward price should equal the cost of buying the spot asset and holding it to the
delivery date of one year
c. first step, value spot asset
d. spot asset is zero a coupon bond that has same maturity date (not time to maturity) as
bond underlying forward contract
e. value of spot asset: P  10 000 3  9085. 1
1. 032 5
f. second step, carry spot asset forward at spot rate to delivery date
g. forward price: F  9085. 1  1  0. 027 5 2  9591. 7

23. The yields on a six month, one year, and one and a half year zero-coupon bonds are 5. 5,
9. 5, and 8. 0 percent, respectively. What is the forward price of a contract to accept
delivery of a one year T-bill with a par value of 10 000 dollars in six months?
a. 9499. 8
b. 9154. 7
c. 9134. 4
d. 10431.
e. 10252.
Solution:
a. method: cost of carry model
b. forward price should equal the cost of buying the spot asset and holding it to the
delivery date of six months
c. first step, value spot asset
d. spot asset is zero a coupon bond that has same maturity date (not time to maturity) as
bond underlying forward contract
e. value of spot asset: P  10 0003  8890. 0
1. 04
f. second step, carry spot asset forward at spot rate to delivery date
g. forward price: F  8890. 0  1  0. 027 5  9134. 4

24. The yields on a six month, one year, and one and a half year zero-coupon bonds are 6. 0,
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6. 5, and 9. 0 percent, respectively. What is the forward rate on a contract to accept

delivery of a one year T-bill in six months?
a. 10. 793
b. 4. 516 2
c. 10. 516
d. 10. 268
e. 10. 532
Solution:
a. method: (1) construct forward contract by borrowing short term (to delivery date) and
investing long term (to maturity date) and (2) compute yield on the constructed
forward contract
Vb 1/b−a
b. formula: fa, b  Va
−1
1/2
c. forward rate (each half year): f1, 3  1. 141 2
1. 03
− 1  5. 258 2  10 −2
d. so over year the forward rate is 10. 516

25. The yields on a six month, one year, and one and a half year zero-coupon bonds are 5. 5,
4. 0, and 4. 5 percent, respectively. What is the forward rate on a contract to accept
delivery of a six month T-bill in one year?
a. 2. 751 8
b. 7. 514 7
c. 5. 503 7
d. 8. 007 1
e. 4. 003 6
Solution:
a. method: (1) construct forward contract by borrowing short term (to delivery date) and
investing long term (to maturity date) and (2) compute yield on the constructed
forward contract
Vb 1/b−a
b. formula: fa, b  Va
−1
c. forward rate (each half year): f2, 3  1. 069
1. 040 4
− 1  2. 751 8  10 −2
d. so over year the forward rate is 5. 503 7

26. The price of a six month zero-coupon bond is 96. 154. The price of a one-year 4. 5
percent coupon bond is 98. 544. Both bonds has a par value of 100 dollars. What are the
spot rates?
a. 7. 95, 6. 05
b. 8. 05, 5. 9
c. 8. 0, 6. 0
d. 8. 1, 5. 95
e. 8. 15, 6. 1
Solution:
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a. used boot-strap method to find yield on a one-year zero coupon

b. price of 1 dollar in six months: d 1  96. 154/100  0. 961 54
c. price of coupon bond: 98. 544  2. 25d 1  102. 25d 2
d. substitute for d 1 : 98. 544  2. 25  0. 961 54  102. 25d 2
e. solve for d 2 : d 2  98. 544−2. 250.961 54
102. 25
 0. 942 60
f. convert d 1 and d 2 into spot rates
g. z 1  d11 − 1  0.961
1
54
− 1  4. 0
h. z 2  1
d2
−1  1
0.942 60
− 1  3. 0

27. A 6. 0 percent par treasury bond with a par value of 100 dollars matures in exactly one
and a half years. The bond sells for 98. 599. What is the Macaully duration?
a. 1. 156 4
b. 1. 256 4
c. 1. 456 4
d. 1. 356 4
e. 1. 256 4
Solution:
a. first step, compute yield to maturity
b. calculator inputs: N  3; PV  98. 599; PMT  12  0. 06  100  3. 0; FV  100
c. cpt I/Y  3. 5
d. so y  7. 0
e. second step, compute the duration
Ct t
f. formula: D  1
P
∑ t1
N 2
1y/2 2
, where cash flow are distributed semiannually.
3.0 12 3.0100 32
g. so: D  1
 3.01
  1. 456 4
98. 599 10.035 10.035  2 10.035  3

28. A barbell promises 187 dollars in 3. 5 years and 200 dollars in 10. 0. The term structure is
a 4. 0 percent for all maturities. What is the Macaully duration of the barbell?
a. 6. 461 8
b. 6. 75
c. 6. 441 8
d. 6. 461 8
e. 1. 639 7  10 −2
Solution:
a. first step, compute price of first cash flow
b. PV  187 7.0  162. 79
1. 02
c. second step, compute price of second cash flow
d. PV  200
20.0  134. 59
1. 02
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e. third step, determine price of barbell

f. P  162. 79  134. 59  297. 39
g. fourth step, compute duration
h. D  297.1 39 162. 79  3. 5  134. 59  10. 0  6. 441 8

29. A 9. 5 percent treasury bond has a yield to maturity of 4. 0 and a duration of 11. 5 years. If
the yield changes by −93 basis points, what is your best estimate of the percentage change
in the bond’s price.
a. 10. 284
b. −10. 485
c. 10. 485
d. 10. 695
e. −10. 695
Solution:
a. formula: Δ%P ≈ − 1y/2
D
Δy
b. so: Δ%P ≈ − 11. 5
1. 02
 − 100
93
 10. 485

30. A 8. 5 percent treasury bond has a yield to maturity of 5. 0, a duration of 15. 0 years, and
a convexity of 56. 25. If the yield changes by −37 basis points, what is your best estimate
of the percentage change in the bond’s price.
a. 9. 264 9
b. 5. 491 6
c. 5. 453 1
d. 5. 414 6
e. 5. 588 5
Solution:
a. formula: Δ%P ≈ − 1y/2 D
Δy  12 CXΔy 2
2
b. so: Δ%P ≈ − 1.15.0
025
 − 1037000  1
2
 56. 25  − 1037000  5. 453 1
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Fixed Income Securities

1. True or False? Briefly explain (or qualify) your answers.

(a) The duration of a coupon bond maturing at date T is always less than the duration
of a zero-coupon bond maturing on the same date.
(b) When investing in bonds, we should invest in bonds with higher yields to maturity
(YTM) because they give higher expected returns.
(c) The phrase ”On the run” refers to junk bonds that have recently defaulted.

2. True or false? Briefly explain (or qualify) your answers.

(a) Investors expect higher returns on long-term bonds than short-term bonds because
they are riskier. Thus the term structure of interest rates is always upward sloping.
(b) Bonds whose coupon rates fall when the general level of interest rates rise are
called reverse floaters. Everything else the same, these bonds have a lower modi-
fied duration than their straight bond counterparts.

3. True, false or “it depends” (give a brief explanation):

(a) Term structure of interest rates must be always upward sloping because longer
maturity bonds are riskier.
(b) Bonds with higher coupon rates have more interest rate risk.

4. True, false (give a brief explanation): The term structure of interest rates is always
upward sloping because bonds with longer maturities are riskier and earn higher re-
turns.

5. True or false (give a brief explanation): A flat term structure (identical spot rates for
all maturities) indicates that investors do not expect interest rates to change in the
future.

6. True or false (give a brief explanation): To reduce interest rate risk, an over-funded
pension fund, i.e., a fund with more assets than liabilities, should invest in assets with
longer duration than its liabilities.

7. Which security has a higher effective annual interest rate?

(a) A three-month T-bill selling at $97, 645 with face value of $100, 000.
(b) A coupon bond selling at par and paying a 10% coupon semi-annually.

8. The Wall Street Journal quotes 6.00% for the Treasury bill with a par value of $100,000
due two months from now. What is the effective annual yield on the bill?

9. Which security has a higher effective annual interest rate?

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(a) A six-month T-bill selling at $98,058 with face value of $100,000.

(b) A coupon bond selling at par and paying a 4.2% coupon (2.1% every six months).

10. Spot rates.

You are given the following prices of US Treasury Strips (discount or zero coupon
bonds):

Maturity Price (per 100 FV)

1 96.2
2 91.6
3 86.1

(a) Compute the spot rates for years 1, 2 and 3.

(b) Now, suppose you are offered a project which returns the following cashflows:

$300m at the end of year 1

$210m at the end of year 2
$400m at the end of year 3
The project costs $600m today.

Calculate the NPV of the project using the spot rates computed above.

11. Assume that spot interest rates are as follows:

Maturity (year) Spot Rate (%)

1 3.0
2 3.5
3 4.0
4 4.5

Compute the prices and YTMs of the following bonds:

(a) A zero-coupon bond with 3 years to maturity.

(b) A bond with coupon rate 5% and 2 years to maturity.
(c) A bond with coupon rate 6% and 4 years to maturity.

Assume that spot rates and YTMs are with annual compounding, coupon payments
are annual, and par values are $100.

12. Treasury bonds paying an 8% coupon rate with semiannual payments currently sell
at par value. What coupon rate would they have to pay in order to sell at par if they
paid their coupons annually?

13. Yields on three Treasury notes are given as follows:

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Bonds and Notes

Coupon Rate Maturity Bid Asked Asked yield
7.250 Aug. 04 110:00 110:00 2.07%
10.750 Aug. 05 123:12 123:13 2.55%
5.750 Aug. 10 112:00 112:01 3.97%
5.00 Aug. 11 106:24 106:25 4.09%
8.750 Aug. 20 143:26 143:27 5.02%
6.125 Aug. 29 114:11 114:12 5.13%
Strips
Maturity Bid Asked Asked yield
Aug. 04 96:03 96:04 2.00%
Aug. 05 92:19 92:21 2.58%
Aug. 10 71:13 71:17 4.24%
Aug. 11 67:06 67:08 4.47%

Table 1: Treasury Prices and Yields, August 20, 2002

Maturity (yrs) Coupon rate (%) Yield to maturity (%)

1 0 5.25
2 5 5.50
3 6 6.00

Coupons are paid annually.

(a) What are the prices of the 1-year, 2-year, and 3-year notes?
(b) What are the spot interest rates for years 1, 2 and 3?
(c) What is the implied forward rate for year 2 to year 3?

14. Using the following data given in Table 1, answer these questions:

(a) What were the 2-, 3- and 8-year spot interest rates?
(b) What is the forward interest rate from August 2004 to August 2005? From August
2010 to August 2011?
(c) What does the slope of the term structure imply about future interest rates?
Explain briefly.
Express your answers to (a) and (b) as effective annual interest rates.

15. Forward rates.

You are given the following spot rates:

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Maturity Spot rate

1 2.9%
2 3.2%
3 3.6%
4 4.2%

(a) Compute the forward rate between years 1 and 2.

(b) Compute the forward rate between years 1 and 3.
(c) Suppose one of your 401 TAs, offers to commit to borrowing money from you
between years 3 and 4 at a rate of 6.3%. Is there any way you can profit from
this? What sort of risk are you exposed to? Is this strategy an arbitrage?

16. You are a bond trader and see on your screen the following information on three bonds
with annual coupon payments and par value of $100:

Bond Coupon rate (%) Maturity (year) YTM(%)

A 0 1 5.00
B 5 2 5.50
C 6 3 6.00

Coupon payments are annual.

(a) What are the prices of the above bonds?

(b) Construct the current term-structure of spot interest rates.
(c) Explain how you would synthetically replicate a zero-coupon bond with a maturity
of 3 years and a par value of $100.
(d) What should be the price of the bond so that there is no arbitrage?

17. You are given the following information:

Bond Coupon Rate Maturity Price

A 10% 1 106.80
B 5% 2 101.93
C 10% 3 111.31

All coupon payments are annual and par values are 100.

(a) Determine the 1-, 2- and 3-year spot interest rates from the given prices.
(b) Compute the annual forward rate from year one to year two, i.e., f2 .

18. The Wall Street Journal gives the following prices for STRIPS (with a principal of
100):
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Bond Maturity Year Price

A 1 95.92
B 2 92.01
C 3 87.00

(a) Determine the 1-, 2- and 3-year spot interest rates from the given prices.
(b) Compute the annual forward rate from year two to year three, i.e., f3 (or f2,3 ).
(c) Compute the yield to maturity of a 2-year coupon bond with a principal of 100
and a coupon rate of 4.25%. Assume annual coupon payments.

19. The Wall Street Journal gives the following prices for the STRIPS:

Maturity (years) 1 2 3
Price (% of par value) 97.56 95.18 92.86

Suppose that you have a short term liability of $10 million every year for the next
three years.

(a) Calculate the present value of the liability.

(b) Calculate the duration of your liability.
(c) Suppose that you want to set aside $20 million to pay part of the liability and
the fund will be invested in STRIPS. In order to avoid interest rate risk, what
maturity for the STRIPS should you pick?
(d) If the interest rates increase by 0.10%, how much will be the remaining short fall
for your liability?

20. The Wall Street Journal gives the following prices for the STRIPS:

Maturity (years) 1 2 3
Price (% of par value) 96.1538 92.4556 88.8996

You are holding an asset which yields a sure income of $20 million every year for the
next two years.

(a) Calculate the present value of the asset.

(b) Calculate the modified duration of the asset.
(c) If the interest rates increase by 0.10%, how much will the asset’s value change in
dollars?
(d) Suppose that you want to use an interest rate futures to hedge the interest rate
risk. The futures has a contract value of $100,000 and a modified duration of
5. Assume a flat term structure of interest rates. What will be your hedging
strategy?
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(e) Show that with the hedging position in the futures, the value of your total position
(the asset plus the futures position) is insensitive to the change in interest rate.

21. The term structure of spot interest rates is given in the table below:

Maturity (years) 1 2 3 4 5 ¿5
Interest rate (%) 3.5 3.0 4.0 4.0 4.0 4.0

You have just signed a lease on an office building with a rental payment of $1 million
per year forever. The first payment is due one year from now.

(a) What is the present value of the lease?

(b) New inflation figures imply that expected inflation will be 0.5% percent higher.
As a result, interest rates for all maturities now increase by 0.5%. What is the
PV of the lease under the new market conditions?

22. The following is a list of prices for zero-coupon bonds of various maturities. Calculate
the yields to maturity of each bond and the implied sequence of forward rates.

Maturity (Years) Price of Bond ($)

1 943.40
2 898.47
3 847.62
4 792.16

23. You have accounts receivable of $10 million due in one year. You plan to invest this
amount in the Treasury market for one year after receiving it. You would like to lock
into an interest rate today for this future investment. Current yields on Treasury
STRIPS are as follows:

Maturity Yield (%)

1 5.25
2 5.50
3 5.75

(a) Your bank quotes you a forward rate of 5.50%. Is this in line with the forward
rate implied by market interest rates?
(b) Suppose that you can buy or sell short the STRIPS at the above yields without
additional costs and the STRIPS have face value of $1,000. How can you use the
STRIPS to structure the forward investment you wanted?

24. Refer to Table 1, use the quoted yields to calculate the present value for the cash
payments on the

(a) August 2011 strip.

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(b) August 2011 note.

Assume that the first note coupon comes exactly six months after August 20, 2002, and
that principal is repaid after exactly 9 years. (This timing assumption is not exactly
right. Also, the quoted yields are rounded. Your PV will not match the Asked Price
exactly.)

25. Spot Rates and Forward Transactions.

Suppose you have the following bonds, which pay coupons at the end of each year:

Maturity (yrs) YTM (%) Coupon (%)

1 4% 4%
2 4.2% 5%
3 4.8% 5%

(a) Determine the price of each bond per $100 face value.
(b) What are the spot rates for years 1, 2 and 3?

26. Which of the following statements are correct?

With today’s Yield Curve, you can compute exactly:

(a) The price at which a 5-year T-Strip with $1, 000 face value trades today.
(b) The spot rates that will prevail in two years.
(c) The price at which a 5-year T-bond with 7% coupon and $1, 000 face value will
trade in one year.
(d) The forward rates that prevail today.
(e) The forward rates that will prevail in two years.

27. Suppose you are given the following prices for two U.S. Treasury strips.

Maturity date Price Yield to maturity

November 2012 41:25 6.83%

November 2013 38:27 6.87%

Assume for simplicity that the maturity dates are exactly 13 and 14 years from now
(November). Calculate the forward rate of interest between November 2012 and
November 2013.

28. Here are closing quotes for 4 Treasury securities on October 11, 2002.
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Coupon Maturity Asked Price Asked Yield

(Note) 6.5 Feb. 2010 119:08 3.50%

(Note) 5.0 Feb. 2011 109:20 3.65%
(Strip) 0 Feb. 2010 76:22 3.65%
(Strip) 0 Feb. 2011 73:08 3.77%

(a) Suppose you buy the Feb. 2011 note and hold it to maturity. How much would
you have to pay (approximately)? What cash flows would you receive, on what
dates?
(b) What are the spot interest rates for February 2010 and February 2011?
(c) What is the forward rate of interest between February 2010 and February 2011?
(d) Which of these securities has the shortest duration? Explain.

29. Yankee Inc. has sold the Super Coupon Absolute Marvel (SCAM) security to raise
new funds. Unlike ordinary bonds, it pays no par value/face value at the end of its
life. It only pays coupons every year as follows: $100(1 + 0.05) at the end of year one,
$100(1 + 0.05)2 at the end of year two, and so on. This security lasts for 4 years (i.e.,
makes 4 payments). The current interest rate is 5% for all maturities.

(a) What is the price today of SCAM?

(b) What is the duration today of SCAM?
(c) Yankee Inc. sold $10 million worth of SCAM. It plans to invest the proceeds in
two assets, A1 and A2, for the short run. A1 is a 12-month T-Bill, whereas A2
is a 4-year STRIPS. How much should Yankee Inc. invest in A1 and A2 to avoid
interest rate risks?

30. You manage a pension fund, and your liabilities consist of two payments as follows:

Time Payment
10 years $20 million
30 years $30 million

Your assets are $18 million. The term structure is currently flat at 5%.

(a) Compute the present value of your liabilities.

(b) Compute modified duration of your liabilities.
(c) Compute an approximate change in the present value of your liabilities, using
duration, when interest rates fall by 0.25%.
(d) Suppose that you invest the $18 million in 1-year Treasury bills (i.e., 1-year zero-
coupon bond) and in a Treasury bond with modified duration of 20. How would
you allocate your assets to avoid interest rate risk of your portfolio, which includes
both assets and liabilities?
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31. As a mid-size company, you have a pension plan which pays out $10 million a year
forever. The first payment is exactly one year from now. The term structure is currently
flat at 5%.

(a) Compute the present value of your pension liabilities.

(b) Suppose that the interest rate goes down by 0.1%. How does the value of your
liability change?
(c) Given your answer to (b), what is the modified duration of your pension liability?
(d) Suppose that the pension plan is fully funded (i.e., the value of your assets equal
the value of pension liabilities). You want to invest all your assets in bonds to
avoid any interest rate risk. What should the duration of your bond portfolio be?
(e) Suppose that this portfolio is a single zero-coupon bond. What should its maturity
and total par value be?

32. On a job interview, you were handed the following quotes on U.S. Treasuries:

Bond Maturity (years) Coupon Rate Yield to Maturity

1 1 5% 4.5%
2 2 5% 5.0%
3 3 0% 5.5%

Assume that the par value is $100 and coupons are paid annually, with the first coupon
payment coming in exactly one year from now. The yield to maturity is also quoted
as an annual rate. You are then asked the following questions:

(a) What should be the price of a bond with a maturity of 3 years and coupon rate
of 5%, given the above information?
(b) What should be the 1-year forward rate between years 2 and 3?
(c) What is the modified duration of a bond portfolio with 30% invested in bond 1
and 70% invested in bond 3?
(d) How much would the value of the portfolio in (c) change if the yields of all bonds
increased by 0.15%?

33. You have the following data on Treasury bonds. Assume that there are no taxes, only
annual coupon payments are made and the first coupon payment occurs a year from
now.

Bond Year of Maturity Coupon Face Value at T Price Today

A 1 25 100 100.00
B 2 50 500 422.61
C 3 20 300 232.28
D 10 0 1000 192.31
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(a) Calculate the following four annualized forward rates: f from 0 to 1, f from 1 to
2, f from 2 to 3, and f from 3 to 10.
(b) Is it a good investment if it costs $21 million now and yields the following risk-free
cash inflows?
Year 1 2 3
Cash Flow (in million dollars) 9 10 11

34. Which of the following investments is most affected by changes in the level of interest
rates? Suppose interest rates go up or down by 50 basis points (± 0.5%). Rank the
investments from most affected (largest change in value) to least affected (smallest
change in value).

(a) $1 million invested in short-term Treasury bills.

(b) $1 million invested in Treasury strips (zero coupons) maturing in December 2016.
(c) $1 million invested in a Treasury note maturing in December 2016. The note pays
a 5.5% coupon.
(d) $1 million invested in a Treasury bond maturing in January 2017. The bond pays
a 9.25% coupon.

Explain your ranking briefly.

35. Valerie Smith is attempting to construct a bond portfolio with a duration of 9 years.
She has $500,000 to invest and is considering allocating it between two zero coupon
bonds. The first zero coupon bond matures in exactly 6 years, and the second zero
coupon bond matures in exactly 16 years. Both of these bonds are currently selling
for a market price of $100. Suppose that the yield curve is flat at 7.5%. Is it possible
for Valerie to construct a bond portfolio having a duration of 9 years using these two
types of zero coupon bonds? If so, how? (Describe the actual portfolio.) If not, why
not?

36. Given the bond prices in the question above, you plan to borrow $15 million one year
from now (end of year 1). It will be a two-year loan (from year 1 to year 3) with
interest paid at the ends of year 2 and 3. The cash flow is as follows:

Year 1 Year 2 Year 3

Borrow $15M Pay interest Pay interest plus principal of 15M

Explain how you could arrange this loan today and “lock in” the interest rate on the
loan. What transactions today would be required? What would the interest rate be?
You can buy or sell any of the bonds listed above (in the previous question).

37. You purchased a 3 year coupon bond one year ago. Its par value is $1,000 and coupon
rate is 6%, paid annually. At the time you purchased the bond, its yield to maturity
was 6.5%. Suppose you sell the bond after receiving the first interest payment.
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(a) What is the total rate of return from holding the bond for the year if the yield to
maturity remains at 6.5% when you sell it?
(b) What if the yield to maturity becomes 6.0% when you sell it?

38. You manage a pension fund, which provides retired workers with lifetime annuities.
The fund must pay out $1 million per year to cover these annuities. Assume for
simplicity that these payments continue for 20 years and then cease. The interest rate
is 4% (flat term structure). You plan to cover this obligation by investing in 5- and
20-year maturity Treasury strips.

(a) What is the duration of the funds 20-year payout obligation?

(b) You decide to minimize the funds exposure to changes in interest rates. How
much should you invest in the 5- and 20- year strips? What will be the par value
of your holdings of each strip?
(c) After three months, you reexamine the pension funds investment strategy. Interest
rates have increased. You still want to minimize exposure to interest rate risk.
Will you invest more in 20-year strips and less in 5-year strips? Explain briefly.

Duration and Convexity.

Consider a 10 year bond with a face value of $100 that pays an annual coupon of
8%. Assume spot rates are flat at 5%.

(a) Find the bond’s price and duration.

(b) Suppose that 10yr yields increase by 10bps. Calculate the change in the bond’s
price using your bond pricing formula and then using the duration approximation.
How big is the difference?
(c) Suppose now that 10yr yields increase by 200bps. Repeat your calculations for
part (b).
(d) Given that the bond has a convexity of 33.8, use the convexity adjustment and
repeat parts (b) and (c). Has anything changed?

40. The yield to maturity of a 10-year zero-coupon bond is 4%.

(a) Suppose that you buy the bond today and hold it for 10 years. What is your
return? (Express this return as an annual rate.)
(b) Given only the information provided, can you compute the return on the bond if
you hold the bond only for 5 years? If you answered yes, compute the return. If
you answered no, explain why.
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41. Refer to Table 2.

(a) What was the quoted ask price (in dollars) for the 8.75s of 2020? Assume par
value = $10,000. You can ignore accrued interest.
(b) What cash flows would you receive if you bought this bond on August 13, 2006
and held it to maturity? Specify amounts and timing (by month).
(c) Suppose you buy $10 million (par value) of the 4.125s of 2008 and sell short
$10 million (par value) of the 3.25s of 2007. You hold each trade until the bond
matures. What cash flows would you pay or receive? Specify amounts and timing.
You can ignore any fees or margin requirements for the short sale.

Table 2: Treasury Prices and Yields, August 3, 2006

Coupon Rate Maturity Bid Asked Asked yield

Bonds and Notes:
3.25 Aug. 07 98:04 98:05 5.09%
4.125 Aug. 08 98:16 98:17 4.89
6.0 Aug. 09 103:00 103:00 4.92
5.75 Aug. 10 103:06 103:07 4.86
4.375 Aug. 12 97:11 97:12 4.88
12.5 Aug. 14 121:08 121:09 4.86
8.75 Aug. 20 136:02 136:03 5.11
6.125 Aug. 29 113:18 113:19 5.11

Strips:
Aug. 07 94:30 94:31 5.08%
Aug. 08 90:18 90:19 4.93
Aug. 09 86:10 86:10 4.91
Aug. 10 82:18 82:19 4.80
Aug. 12 74:25 74:26 4.87
Aug. 14 67:21 67:22 4.92
Aug. 16 60:20 60:21 5.05

42. Refer again to Table 2.

(a) What were the 1, 2, 3, 4, 6 and 10-year spot interest rates?

(b) What was the forward interest rate from August 2007 to August 2008? From
August 2009 to August 2010?
(c) The 8.75s of August 2020 will pay a coupon in August 2010. What was the PV
of this payment in August 2006?
(d) What did the slope of the term structure imply about future interest rates? Ex-
plain briefly.
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Express your answers to (a) and (b) as effective annual interest rates.
43. Refer again to Table 2. Use the quoted yield on the August 2012 note to calculate the
present value for the cash payments on the August 2012 note.

Assume that the first note coupon comes exactly six months after August 13, 2006.
Note: The quoted yields are rounded. Your PV may not match the Asked Price exactly.
44. In August 2006 you learn that you will receive a $10 million inheritance in August
2007. You have committed to invest it in Treasury securities at that time, but worry
that interest rates may fall over the next year. Assume that you can buy or sell short
any of the Treasuries in Table 2 at the prices listed in the table.
(a) How would you lock in a one-year interest rate from August 2007 to August 2008?
What transactions would you make in August 2006? Show how the transactions
that lock in the rate.
(b) Suppose you wanted to lock in a 5-year interest rate from August 2007 to August
2012. How does your answer to part a change?
45. Assume the yield curve is flat at 4%. There are a 3-year zero coupon bond and a 3-year
coupon bond that pays a 5% coupon annually.

(a) What are the YTMs of these two bonds?

(b) Suppose the yield curve does not change in the future. You invest $100 in each
of the two bonds. You re-invest all coupons in zero coupon bonds that mature in
year 3. How much would you have at the end of year 3?

46. The attached chart shows the fixed obligations of the Edison Mills pension plan, which
is also managed by the Renssalear Advisors.

Year Benefits ($MM)

2000 $10.60
2001 $11.24
2002 $11.91
2003 $12.62

Total $46.37

Using an assumed interest rate of 6%, the present value of this stream of fixed cash
outflows is $40 million. You are given $40 million to invest in U.S. Treasury bonds for
the pension plan. Your boss insists that you only invest in 1 year and 10 year STRIPS.
Your task is to minimize the exposure of the Edison Mills pension fund to unexpected
changes in the level of interest rates. Your performance will be evaluated after one
year.
Answer the following questions. Use the backs of this page and the next page if needed
to complete your answer.
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(a) What is duration of your obligation?

(b) Describe – step by step – how you would choose and manage the portfolio of
1-year and 10-year STRIPS to minimize the exposure to interest rate risk.

47. Bond underwriting.

Bond underwriters agree to purchase a corporate client’s new bonds at a specific price,
usually near 100% of face value, and then attempt to resell the bonds to the public.
The act of reselling takes some time. Underwriting fees increase with the maturity of
the bonds. Provide an explanation for this pattern of fees.

48. You have just been given the following bond portfolio:

Bond Maturity (yrs) Coupon rate (%) Holdings ($ million)

A 2 7.00 10
B 5 7.25 20
C 10 7.50 20
D 20 8.00 10

Coupons are paid semi-annually. The current yield curve is flat at 6%.

(a) What is duration for each of the bonds in your portfolio?

(b) What is the duration of your total portfolio?
(c) What is the percentage change in the value of your portfolio if the yield moves
up by 20 basis points?

49. A U.S. Treasury bond makes semi-annual payments of $300 for 10 years. (The investor
receives 20 $300 payments at 6-month intervals.) At the end of 10 years, the bonds
principal amount of $10,000 is paid to the investor.

(a) What is the present value of the bond if the annual interest rate is 5%?
(b) Suppose the bond is observed trading at $11,240. What discount rate are investors
using to value the bonds cash flows? (This discount rate is called the bonds “yield
to maturity.”)

50. A savings bank has the following balance sheet ($ millions, market values).

Assets Liabilities

Treasuries:$200 Deposits:$900
Floating rate mortgage loans:$300 Equity:$100
Fixed rate mortgage loans:$500

Total: $1,000 Total: $1,000

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Durations are as follows:

Treasuries 6 months
Floating rate mortgage loans 1 year
Fixed rate mortgage loans 5 years
Deposits 1 year

(a) What is the duration of the banks equity? Briefly explain what this duration
means for the banks stockholders.
(b) Suppose interest rates move from 3% to 4% (flat term structure). Use duration
to calculate the change in the value of the banks equity. Will the actual change
be more or less than your calculated value? Explain briefly.

51. Fixed Income Management:

A pension fund has the following liability:
A 20-yr annuity, that will pay coupons of 7% at the end of each year.(t=1...t=20).
The pension fund’s liability has a face value of 100. The yield curve is flat at 5%.

(a) Calculate the PV and duration of this liability.

(b) The same pension fund has the following assets:

a 1-yr discount bond with face value 100, and a 20-yr discount bond which also
has a face value of 100.

Calculate the PV and duration of the portfolio of assets.

(c) How would you change the portfolio composition of assets (keeping the PV of
assets the same), so that the NPV of the firm, defined as P VA − P VL , that is
Present Value of assets minus the Present Value of liabilities, is unaffected by
interest rate changes?
(d) After making the change above in (c), what is the change in the NPV of the firm
if interest rates increase by 10 basis points.

52. Three bonds trade in London and pay annual coupons

Bond Coupon Maturity Price

A 5% 1 100.96%
B 6.5% 3 106.29%
C 2% 3 93.84%

Prices are in decimals, not 32nds.

(a) What is each bond’s yield to maturity?

(b) What are the 1, 2 and 3-year spot rates? What are the forward rates?
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53. Assume the spot rates for year 1, year 2 and year 3 are 3.5%, 4% and 4.5%, respectively.
There are a 3-year zero coupon bond and a 3-year coupon bond that pays a 5% coupon
annually.

(a) What are the YTMs of the bonds?

(b) Calculate all 1-year forward rates.
(c) Calculate the realized returns of the two bonds over the next year if the yield
curve does not change. (In year 1 the 1-year spot rate is 3.5%, the 2-year spot
rate is 4% and the 3-year spot rate is 4.5%.)

54. A pension plan is obligated to make disbursements of $1 million, $2 million and $1

million at the end of each of the next three years, respectively. Find the durations of
the plan’s obligations if the interest rate is 10% annually.

55. A local bank has the following balance sheet:

Asset Liability
Loans $100 million Deposits $90 million
Equity $10 million

The duration of the loans is 4 years and the duration of the deposits is 2 years.

(a) What is the duration of the bank’s equity? How would you interpret the duration
of the equity?
(b) Suppose that the yield curve moves from 6% to 6.5%. What is the change in the
bank’s equity value?

The term structure is flat at 6%. A bond has 10 years to maturity, face value $100,
and annual coupon rate 5%. Interest rates are expressed as EARs.
56. (a) Compute the bond price.
(b) Compute the bond’s duration and modified duration.
(c) Suppose the term structure moves up to 7% (still staying flat). What is the bond’s
new price?
(d) Compute the approximate price change using duration, and compare it to the
actual price change.

57. Suppose Microsoft, which has billions invested in short-term debt securities, undertakes
the following two-step transaction on Dec. 30, 2009. (1) Sell $1 billion market value of
6-month U.S. Treasury bills yielding 4% (6 month spot rate). (2) Buy $1 billion of 10-
year Treasury notes. The notes have a 5.5% coupon and are trading at par. Microsoft
does not need the $1 billion for its operations and will hold the notes to maturity.
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(a) What is the impact of this two-step transaction on Microsoft’s earnings for the
first 6 months of 2010?
(b) What is the transaction’s NPV?

Briefly explain your answers.

58. The Treasury bond maturing on August 15, 2017 traded at a closing ask price of 133:16
(i.e., $133 16/32) on August 31, 2007. The coupon rate is 8.875%, paid semi-annually.
The yield to maturity was 4.63% (with semi-annual compounding).

(a) Explain in detail how this yield to maturity was calculated.

(b) Discount the bond’s cash flows, using the yield to maturity. Can you replicate
the ask price? (The replication should be close but won’t be exact.) Show your
calculations.

59. The following questions appeared in past CFA Examinations. Give a brief explanation
for each of your answers.

(a) Which set of conditions will result in a bond with the greatest volatility?
i. A high coupon and a short maturity.
ii. A high coupon and a long maturity.
iii. A low coupon and a short maturity.
iv. A low coupon and a long maturity.
(b) An investor who expects declining interest rates would be likely to purchase a
bond that has a . . . coupon and a . . . term to maturity.
i. Low, long.
ii. High, short.
iii. High, long.
iv. Zero, long.
(c) With a zero-coupon bond:
i. Duration equals the weighted average term to maturity.
ii. Term to maturity equals duration.
iii. Weighted average term to maturity equals the term to maturity.
iv. All of the above.

60. Please circle your answer to the following questions and provide a one-line explanation.

(a) Holding the one-year real interest rate constant, if the nominal one-year interest
rate where to increase by 1%, it would imply that the inflation rate over the same
period
i. Increased.
Sold to T L (#UM9TJTB4)

ii. Declined.
iii. Stayed the same.
iv. It can go either way, impossible to tell from the provided data.
(b) Consider two treasury bonds, A and B. Both have 5 years to maturity, A pays a
5% coupon rate, B pays a 7% coupon rate. Which of bonds A and B has higher
modified duration,
i. A.
ii. B.
iii. The same for A and B.
iv. It can go either way, impossible to tell from the provided data.
(c) A ten-year bond with a coupon rate of 6% and a face value of $100 is priced at
$98. Let the yield to maturity be denoted by y. Which of the following statements
is true:
i. y > 6%.
ii. y < 6%.
iii. y = 6%.
iv. It can go either way, impossible to tell from the provided data.
(d) (This may require a calculation.) Suppose the one-year spot rate r1 = 5% and
the two-year rate r2 = 6%. At time 0 you enter into a forward contract to buy,
in exactly one year from now, a one-year zero-coupon bond. Suppose that in one
year from now the term structure of interest rates changes, so that a one year rate
becomes 6%. Will you experience a profit or a loss on your forward contract?
i. Profit.
ii. Loss.
iii. No effect.
iv. It can go either way, impossible to tell from the provided data.
61. Consider two bonds (i) 3 year bond with zero coupons, and (ii) 3 year bond with 5%
annual coupon. Assume the yield curve is flat at 5.5%.

(a) Calculate the price and modified duration of each bond.

(b) Suppose the yield curve shift up by 0.1%. What are the new prices of each bond?
Check that the % change is close to MD times the yield change.
(c) Suppose the yield curve shifts up by 2%. Show that the approximation is not
very close.
(d) You have $10 million and invested 40% of them in the zero coupon bond and 60%
in the 5-year coupon bond. What is the modified duration of your portfolio?

62. You manage a pension fund that will provide retired workers with lifetime annuities.
You determine that the payouts of the fund are (approximately) level perpetuities of
$1 million per year. The interest rate is 10%. You plan to fully fund the obligation
using 5-year maturity and 20-year maturity zero-coupon bonds.
Sold to T L (#UM9TJTB4)

(a) How much market value of each of the zeros will be necessary to fund the plan if
you desire an immunized position?
(b) What must be the face value of the two zeros to fund the plan?

63. Do agree with the following statements? Explain your reason.

(a) Higher YTM means higher bond return.

(b) If the forward rates are lower than the current short term spot rate, then we
should not enter into the forward rate agreement to lend money because the rates
we get are too low.
(c) The market expects a rate cut in next month’s Fed meeting, therefore I should
load up on bonds to take advantage of the opportunity.

64. You will be paying $10, 000 a year in tuition expenses at the end of the next two years.
Bonds currently yield 8%.

(a) What is the present value and duration of your obligation?

(b) What maturity zero-coupon bond would immunize your obligation?
(c) Suppose you buy a zero-coupon with value and duration equal to your obligation.
Now suppose that rates immediately increase to 9%. What happens to your net
position, that is, to the difference between the value of the bond and that of your
tuition obligation? What if rates fall to 7%?

65. You bought a 5-year treasury with 5% annual coupon. You decide to hold it until
maturity. The yield curve is flat at 5%. The current projected inflation is 2% per year.

(a) Suppose inflation is 2% per year as forecasted. What will be your real return?
(b) Suppose inflation jumps to 3% right after you buy the bond and stay at 3% for
the next 5 years. What would your real return be?
(c) TIPS are government risk-free bond that provides protection for inflation. Let’s
look at a 5-year TIPS with 2% real coupon (and $100 principal). The way TIPS
work is that the $100 principal is expressed in real terms. Therefore in nominal
(dollar), the principal increases each year with inflation. Therefore if inflation
is 2% each year, then the principal becomes $102 (100*(1+2%))in year 1, and
$102*1.02 = $104.04 in year 2, etc. The coupon payment each year is based on
the new principal adjusted for inflation. For this 5-year TIPS, calculate the cash
flow from the bond each year if inflation is (i)2%, and (ii) 3%, respectively.
Sold to T L (#UM9TJTB4)

Fixed Income Securities Solutions

1. (a) TRUE
Coupon payments accelerate cash flows received from the investment reducing the
duration.
(b) FALSE
Higher yield to maturity (YTM) does not mean that the bond is a good invest-
ment; NPV=0 in any case.
Two good answers to this question were:
1. Bonds with longer duration have usually higher yield to maturity (YTM) as a
result of increasing yield curve.
2. Bonds with higher probability of default have higher YTM to compensate for
credit risk.
Full answer must mention at least one of these two points. Many students con-
centrated on reinvestment risk only.
(c) FALSE
“On the run” refers to a newly issued bond. These bonds are usually more liquid
and trade at a premium.

2. (a) False: yield of longer term bond also incorporates the expectation of future short
term interest rates and depending on the this factor, the term structure may be
up- or down-ward sloping.
(b) False: If interest rates rise, future coupons of such bonds fall, and so their price
(which is the present value of future coupons) falls more than the price of its
straight bond counterpart. If interest rates fall, future coupons of such bonds
rise, and so their price (which is the present value of future coupons) rises more
than the price of its straight bond counterpart. So these bonds are more interest
rate sensitive.

3. (a) False. The term structure of interest rates depends on expected future interest
rates, if short term interest rates are expected to decrease substantially, the term
structure can be inverted, flat, or downward sloping even when there is a liquidity
premium for long term interest rates.
(b) False. Bonds with higher duration are more sensitive to changes in interest rates.
If we examine coupon bonds, all things equal a bond with a higher coupon rate
will have a lower duration and thus be less sensitive to changes in interest rates.

4. False. The term structure depends on the expected path of interest rates (among other
factors): if interest rates are expected to fall, the term structure will slope downward.

5. False. If there is liquidity premium, then a flat term structure means that investors
expect interest rates to fall.
Sold to T L (#UM9TJTB4)

6. No. To minimize interest rate risks, we want MD(A)×V(A) − MD(L)×V(L) = 0. If

V(A)>V(L), we want MD(A) < MD(L). That means we should invest in assets with
shorter duration.

7. (a) Effective annual rate on 3-month T-bill:

 4
100, 000
− 1 = (1.02412)4 − 1 = .10 or 10%.
97, 645

(b) Effective annual interest rate on coupon bond paying 5% semiannually:

(1.05)2 − 1 = .1025 or 10.25%.

Therefore, the coupon bond has the higher effective annual rate.

8. The qoutes yield is calculated as

1F −P
y=
t P
where t is in fraction of year, i.e. 1/6 in this example. Using F = $100, 000 the current
 6
price is $99, 009. So the effective annual rate is $100,000
$99,009
− 1 = 6.15%

9. (a) 1 + EAR = (100/98.058)2 so EAR=4%

(b) Bond at par, so yield=coupon. So 1 + EAR = (1 + 0.042/2)2. So EAR=4.24%
The coupon bond has the higher EAR.
$100 $100 1/2 $100 1/3



10. (a) r1 = $96.2 − 1 = 3.95%, r2 = $91.6 − 1 = 4.45% r3 = $86.6 − 1 = 5.11%
96.2 91.6 86.1
(b) P V = $300M × 100
+ $210M × 100
+ $400M × 100
− $600M = $225.36
100
11. (a) Price = 1.043
= 88.90; YTM = 0.040.
5 105 5 105
(b) Price = 1.031
+ 1.035 2 = $102.87; YTM solves (1+y)1
+ (1+y) 2 = $102.87: y = 0.03488.
6 6 6 106
(c) Price = 1.031 + 1.0352 + 1.043 + 1.0454 = 105.65;
6 6 6 106
YTM solves (1+y) 1 + (1+y)2 + (1+y)3 + (1+y)4 = 105.65: y = 0.04428.

12. The effective annual yield on the semi-annual coupon bonds is 8.16%. If the annual
coupon bonds are to sell at par, they must offer the same yield, which will require an
annual coupon of 8.16%.
$100
13. (a) P1−year = 1+5.25%
= $95.01
$5 $100
P2−year = (1+5.50%)
+ (1+5.50%)2 = $99.08
$6 $6 $106
P3−year = (1+6%)
+ (1+6%)2 + (1+6%) 2 = $100

(b) The first year, is easy. It is simply the yield of the 1-year note so, r1 = 5.25%.
Then solve for r2 and r3 recursively. r2 = 5.505% and r3 = 5.7%.
Sold to T L (#UM9TJTB4)

 3  2
1 1
(c) Use the fact that 1+r3
= 1+r2
× (1 + f2,3 ) so f2,3 = 6.1%

14. (a) Spot rate at 2 years is 2.0%. At 3 years is 2.58%. At 8 years is 4.24%.
(b) Use this relation: (1 + rt−1 )t−1 (1 + ft−1,t ) = (1 + rt )t
The one year forward rate from Aug 2004 to Aug 2005 is 3.74%.
Similarly the one year forward rate from Aug 20010 to Aug 20011 is 6.33%.
(c) Under the Expectation Hypothesis, the upward slope implies that interest rates
are expected to go up. In practice, the long-term average term structure is upward
sloping. However, the August 20, 2002 slope is very steep. So interest rates are
expected to rise.

15. (a) (1 + r2 )2 = (1 + r1 )1 (1 + f1,2 ) → f1,2 = 3.5%

(b) (1 + r3 )3 = (1 + r1 )1 (1 + f1,3 )2 → f1,3 = 3.95%
(c) Let’s calculate the forward rate first. (1 +r4)4 = (1 + r3)3 (1 + f3,4 ) → f1,3 = 6.02%
So the TA is offering too high of a rate. What you need to do is as follows:
i. Enter into a contract to lend him money at 6.3% between years 3 and 4.
ii. Short a 4 year strip
iii. Use the proceeds form the shorting to buy 3 year strip. The amount should
be based on how much you enter into a contract with the TA for.
If you follow these steps you will have more than enough to cover the short position
in year 4 (since the rate you lend at is higher than the fair forward rate). Hence,
this is an arbitrage. The risks you are exposed are contract and counter-party
risk, for example the TA may go bankrupt before year 3 if he continues to enter
into contracts of this form and may not be able to honor his/her end. In that
case, you will end up with hanging position and expose to various interest rate
risks.
100
16. (a) A: 1.05 = 95.24.
5 105
B: 1.055 + 1.055 2 = 99.08.

C: 100 (coupon rate = YTM).

(b) r0,1 = 0.05.
h i0.5
105
r0,2 = 99.08−5/1.05 − 1 = 0.05513.
h i1/3
106
r0,3 = 100−6/1.05−6/1.05513 2 − 1 = 0.06041.
100
(c) Long 100 106 = 0.9434 C
6
Short 0.9434 105 = 0.05391 B
1
Short 100 [6 × 0.05513 − 5 × 0.06041] = 0.05391 A
(d) No arbitrage means that the bond in (c) should cost 0.9434 × 100 − 0.05391 ×
99.08 − 0.05391 95.24 = 83.86.
 100 ∗1/3
Note that 83.86 − 1 = 0.06041.
Sold to T L (#UM9TJTB4)

17. (a)
110
r1 = − 1 = 3.00%
106.8
5 105
101.93 = + ⇒ r2 = 4.00%
1 + r1 (1 + r2 )2
10 10 110
111.31 = + + ⇒ r3 = 6.00%
1 + r1 (1 + r2 )2 (1 + r3 )3
(b)
(1 + r2 )2
f2 = − 1 = 5.0%
1 + r1
18. (a)
100
95.92 =
1 + r1
100
92.01 =
(1 + r2 )2
100
87.00 =
(1 + r3 )3

100
r1 = − 1 = 4.25%
95.92
 100 1/2
r2 = − 1 = 4.25%
92.01
 100 1/3
r3 = − 1 = 4.75%
87.00

(b)

(1 + r3 )3
f2,3 = −1
(1 + r2 )2
= 5.76%

(c) The yield to maturity is simply 4.25% since the one year and two year spot rates
are roughly equivalent, more specifically when we calculate the present value of a
coupon bond with a coupon rate of 4.25% this bond has a current price at par.
4.25 104.25
PV = +
1 + r1 (1 + r2 )2
4.25 104.25
= + = 100
1.0425 (1.0425)2

19. (a) P V = 10 × (0.9756 + 0.9518 + 0.9286) = $28.56MM

Sold to T L (#UM9TJTB4)

(b) Duration of liability

D = 10 × (0.9756 + 2 × 0.9518 + 3 × 0.9286)/28.56 = 1.98 years
(c) To hedge interest rate risk ∆P/P = −D∆y/(1+y), so if we want ∆P (liability) =
∆P (asset), i.e. perfect hedge, then D(asset)P (asset) = D(liability)P (liability)
Leading to 20 × D(asset) = 1.98 × 28.56 → D(asset) = 2.83year To achieve
such a duration, invest x% in 2 year strips and (1-x)% in 3 year strips such as
2x + 3(1 − x) = 2.83 → x = 17%
(d) Impact on net liability
Since by investing in portfolio calculated in c, you are perfectly hedge, the change
in interest rate has no impact on your net liability. There will be some effect due
to convexity but there is not first order effect.
20. (a) P = 20(0.961538+0.924556) = $37.72.
(b) Duration is given by:
20 × 0.961538 + 20 × 0.924556 × 2
= 1.490.
37.72188
The yield is 4% (we have a flat term structure) so the modified duration is:
1.490196141
= 1.433.
1.04
(c) Asset value falls by 0.1433%, i.e. by $54,050.96.
(d) Let F be the dollar value of the futures contracts that we wish to short.
5F = 37.72188 × 1.433.
Hence F = $10.810 million so you will short 108 futures contracts. (You can only
long or short whole numbers of futures contracts.)
(e) Let the yield change by y percentage points. Portfolio value will change by
−5 × 10.8 × ∆y + 37.72188 × 1.433 × ∆y ≈ 0.
1 1
21. (a) P V1 = 1+3.5% = 0.9662, P V2 = (1+3%) 2 = 0.9426

From P V3 on, sum PV = 1/(1 + 4%)3 + 1/(1 + 4%)4 + . . .

1 1 1 1
= (1+4%) 2 ( 1.04 + 1.042 + 1.043 . . .)
1 1
= (1+4%) 2 × 0.04 = 23.1139

Therefore the total = 25.02268

(b) If you increase all rates by 0.5%, then the new values become 0.9615, 0.9335 and
20.3500. The total is 22.2446.

Maturity Price YTM Forward Rates

1 $943.40 6.00%
22. 2 $898.47 5.50% (1.0552/1.06 − 1) = 5%
3 $847.62 5.67% (1.05673/1.0552 − 1) = 6%
4 $792.16 6.00% (1.064 /1.05673 − 1) = 7%
Sold to T L (#UM9TJTB4)

23. (a) No, the rate of 5.50% is too low. To see why, use the identity that

(1 + rt )t × ft,t+1 = (1 + rt+1 )t+1

So the forward rate for year 1 to 2 should be:

1.0552
f1,2 = − 1 = 5.75%
1.0525
(b) Borrow PV of $10 million due in one year now for one year. Invest the amount for
two years. The amount you have to borrow is $10M/(1 + 5.25%) = $9, 501, 187.
In one year, you willl have enough to pay back your loan. To borrow for one
year, you can short sell the 1-year strip and to invest for 2-years, you can buy the
2-year strip.
100
24. (a) P = (1+y/2)18
So P=$67.17
100 c/2 1
(b) P = (1+y/2)18
+ y/2
(1 − (1+y/2)18
)
So P=$106.79

25. Not available but identical (different numbers) to question 000202

26. (a), (d)

27. Not available but almost identical to question 02MM03

28. (a) Assuming a par value of $100. The price is the quoted price plus accrued interests:
$109 + 20/32 + 5 ∗ 41/365 = $110.2 (Any reasonable approximation to the accrued
interest was considered correct).
You will receive $2.5 in Feb and August every year from 2003 to 2010. In Feb 2011,
you will receive $102.5 Common mistake: Most people didnt take into account
the difference between clean and dirty price
(b) You were expected to give EAR. Using the quoted yield (semi-annually com-
pounded rate): r2010 = (1 + 0.0365/2)2 − 1 = 3.68%
r2011 = (1 + 0.0377/2)2 − 1 = 3.81%
Common mistake: give the APR (-2/4), or compute it using prices without taking
correct time to maturity (-2/4).
1.03818.4 B2010 76.6875
(c) f2010,2011 = 1.03687.4
−1 = B2011
= 73.25
= 4.6%
(d) The Feb 2010 Note with 6.5 coupon rate has the shortest duration, because its
coupons (given out early) are bigger than the Feb 2011 bond and the principal is
also given earlier.

29. (a) Price = PV of cash flows = 100(1 + r)/(1 + r) + 100(1 + r)2 /(1 + r)2 + · · · =400.00
(b) Duration = (1 + 2 + 3 + 4)/4 = 2.5 years
Sold to T L (#UM9TJTB4)

(c) Put 50% in each. Then the duration of your liability = 2.5 = duration of your
assets = 0.5(1)+0.5(4)

30. (a)
20 20
PV = + = 12.28 + 6.94 = 19.22million
(1 + 5%) 0 (1 + 5%)3 0
1

(b)
12.28 ∗ 10 + 6.94 ∗ 30
D= = 17.22
19.22
D
MD = = 16.40
1+y
y = 5% because the yield curve is flat
(c) When rates drop by 0.25%, the PV of liabilities will go up by 0.25% ∗ MD ∗ P V =
0.7881 million
(d) First, you calculate the desired MD of your assets. We want:
MDasset ∗ P Vasset = MDliabilites ∗ P Vliabilities
Therefore, MDasset = 16.4∗19.22
18
= 17.51
Now we can determine the allocation of our portfolio. Suppose we invest a fraction
of x of our portfolio into 1-year bond and the rest into treasury bond, then the
MD of our portfolio will be:
1
MDportf olio = x ∗ MD1yrbond + (1 − x) ∗ MDtbond = x ∗ 1+5% + (1 − x) ∗ 20
Equating MDportf olio = 17.51, we get x = 13.05%

31. (a) Using the perpetuity formula

10M 10M
P VLiability = = = 200M
r 0.05
(b)
10M 10M
P VLiability = = = 204.0816M
r 0.049
The value of the liabilities would increase by 4.0816M.
(c)

Pnew = Pold − Pold × MD × ∆y

Pold − Pnew
→ MD =
Pold × ∆y
200 − 204.0816
= = 20.4082
200 × −0.001
(d) You should match the modified duration to neutralize first order interest rate risk.
MD=20.4082
Sold to T L (#UM9TJTB4)

(e) We must match both the modified duration and the present value of the zero
coupon bond. Let P AR be the par value of the zero coupon bond and t be the
maturity. Since the duration of a zero coupon bond is its maturity t = 21.4286.
We can then solve for the P AR value
P AR
200M =
(1.05)t
→ P AR = 200(1.05)20.4082 = 541.331M

32. (a) r1 = 4.5%, r3 = 5.5%

B2 = 100 (coupon = YTM), so 100 = 5/(1 + r1 ) + 105/(1 + r2 )2 , so r2 = 5.0126%
Therefore the price of the 5% 3-year bond is
5/(1 + 4.5%) + 5/(1 + 5.0126%)2 + 105/(1 + 5.5%)3 = 98.7382
(b) f3 = (1 + r3 )3 /(1 + r2 )2 − 1 = 6.4817%
(c) MD(bond 1) = 1/(1+4.5%) = 0.9569, MD(bond 3) = 3/(1+5.5%) = 2.8436, so
MD(portfolio) = 30%*0.9569+70%*2.8436 = 2.2776
(d) That means the portfolio will decrease in value by 0.15%*2.2776 = 0.3416%

33. (a) We have the following system of equations:

100 = (100 + 25)/(1 + f0,1 )
422.61 = 50/(1 + f0,1 ) + (500 + 50)/((1 + f0,1 )(1 + f1,2 ))
232.28 = 20/(1+f0,1 )+20/((1+f0,1 )(1+f1,2 ))+(300+20)/((1+f0,1 )(1+f1,2 )(1+
f2,3 ))
192.31 = 1000/((1 + f0,1 )(1 + f1,2 )(1 + f2,3 )(1 + f3,10 )7
The solutions are
f0,1 = 0.25,
f1,2 = 0.15,
f2,3 = 0.10,
f3,10 = 0.18.54.
(b) NP V = −21 + 9/1.25 + 10/((1.25)(1.15)) + 11/((1.25)(1.15)(1.10)) = 12

34. (b) the entire value of the treasury strip is in the principal repayment in the distant
future; it has the highest duration and is most sensitive to a change in the interest
rate.
(c) despite having the same maturity as (b), (c) has 5.5% coupon payments thatdampen
its sensitivity to interest rate changes.
(d) higher coupon payment → lower duration
(a) T-bills are only for 1 to 6 months; they have the smallest duration.

35. Since we want portfolio D = 9, we can invest x in the 6-year bond (D = 6) and (1 − x)
in 16-year bond (D = 16).
Then Dp = x ∗ 6 + (1 − x) ∗ 16, x = 70% (*)
Therefore invest 70% (350,000 or 3500 shares) in 6-year bond and 30% (150,000 or
Sold to T L (#UM9TJTB4)

1500 shares) in 16-year bond.

*: This equation holds for D here because the bonds have the same YTM.

36. Let the annual interest payment for the two-year forward loan be C. You can arrange
the loan and lock in the forward interest rate loan as follows

• Buy $15M in par value of 1-year zero, costing (15M)(943.40/1000) = $14,151,000.

• Sell $C in par value of 2-year zero, receiving $C × (898.47/1000)
• Sell $C + 15M in par value of 3-year zero, receiving $(C + 15M)(847.62/1000)
• Choose C such that proceeds from the selling of 2-year and 3-year zeros just cover
the cost of buying the 1-year zero.

Thus,

(15M)(943.40/1000) = C(898.47/1000) + (C + 15M)(847.62/1000)

which gives C = $822, 810. The CF’s of the transactions are:

Transaction CF today CF in year 1 CF in year 2 CF in year 3

Buy 1-year zero -14,151,000 15,000,000 0 0
Sell 2-year zero 739,270 -822,810 0
Sell 3-year zero 13,411,730 0 0 -15,822,810
Net 0 15,000,000 -822,810 -15,822,820

The forward interest rate for the 2-year forward loan is

f = 822, 810/15, 000, 000 = 5.4854%

which is locked in now.

37. (a) The current price of the bond is

$60 $60 $1060

P0 = + 2
+ = $986.76
1.065 1.065 1.0653
You can sell it in one year for
$60 $1060
P1 = + = $990.90
1.065 1.0652
But there is also the $60 of coupon. So the total return is

RoR = ($990.90 + $60)/$986.76 − 1 = 6.5%

(b) The bond now has the same coupon rate as the yield to maturity so it is trading
at par. So the new price P1 = $1, 000 and

RoR = ($1, 000 + $60)/$986.76 − 1 = 7.4%

Sold to T L (#UM9TJTB4)

i
i=120
P
1.04i
38. (a) D = P
i=120 1 i
= 9.21 years
1.04

(b) Need to match the duration and also the value of investment today should be
equal to the total liabilities. So have the following two equations:
V5 ∗ 5 + V20 ∗ 20 = D ∗ (V5 + V20 )
V5 + V20 = $13.59M Annuity formula
Solving gives V5 = $9.78M and V20 = $3.81M
P5 = V5 ∗ (1.04)5 = $11.9M
P20 = V20 ∗ (1.04)20 = $8.36M
(c) No. Interest rates increase, so bigger fraction of present value given early. So
duration decreases. So more in 5 year strips and less in 20 year strips.
$8 $8 $108
39. (a) P = 1.05
+ 1.05 2 + · · · + 1.0510 = $123.16
$8 1 $8 2 $108 10
D= 1.05 $123.16
+ 1.05 2 $123.16 + · · · + 1.0510 $123.16 = 7.54
(b) Using pricing equation, the price will change to Pnew = $122.28.
Recall the approximation that
∆P/P ≈ −MDy + CX × (∆y)2

MD = D/(1 + y) = 7.54/1.05 = 7.18

Usign the first two terms only we have

∆P = −P × MD × ∆y = −$123.16 × 7.18 × 10 × 10−5 = 0.88 → Pnew = $122.28

(c) Using pricing equation: Pnew = $107.02.

Using duration approximation: Pnew = $105.47.
(d) Addign the convexity term the new prices are
Pnew = $122.28, and Pnew = $107.13
So not much has changed in the first case (part b) but the approximation is not
much better for part c. In short, convexity is more important issue for large
interest rate movements and hence one has to be hedged in terms of convexity in
order to be immune to large interest rate movements.
40. (a) 4% per year
(b) No. The spot rates at t = 5 are not known at t = 0.
3
41. (a) 10000 × (136 32 %) = 13609.38
(b) $437.50 in Feb. 2007, Aug. 2007, Feb. 2008, ..., Aug. 2020
$10,437.50 in Aug. 2020.
(c) $43,750 in Feb. 2007
$-9,956,250 in Aug. 2007
$206,250 in Feb. 2008
$10,206,250 in Aug. 2008.
Sold to T L (#UM9TJTB4)

42. (a) The 1, 2, 3, 4, 6 and 10-year spot interest rates are 5.08%, 4.93%, 4.91%, 4.80%,
4.87% and 5.05%, respectively.
(b) f1,2 = 1.04932 /1.0508 − 1 = 0.0478.
f3,4 = 1.04804 /1.04913 − 1 = 0.0447.
(c) P V = 437.50/(1.04804) = 362.69.
43. P = Annuity(218.75, (1.0488)0.5, 12) + 10000/(1.0488)6 = $9, 769.56.
10
44. (a) Short 1.0508 = $9.5166 million worth of one-year strip.
Long $9.5166 million worth of two-year strip.
Cash flow at t = 1: 0.
Cash flow at t = 2: 9.5166 × (1.0493)2 = $10.478 million.
10
(b) Short 1.0508 = $9.5166 million worth of one-year strip.
Long $9.5166 million worth of six-year strip.
Cash flow at t = 1: 0.
Cash flow at t = 5: 9.5166 × (1.0487)6 = $12.659 million.
45. (a) 4%
(b) 200 × (1.04)3 = 224.97.
46. Not available but we have many other pension questions
47. Bond underwriting
If the underwriter purchases the bonds from the corporate client, then it assumes
the full risk of being unable to resell the bonds at the stipulated offering price. In
other words, the underwriter bears the risk of interest rate movement between the
time of purchase and the time of resale. For long maturity bonds, it is generally true
that its duration is also long. Thus, bonds with long maturities are more exposed
to interest rate movement risk. Therefore, the underwriter demands a larger spread
(higher underwriting fees) between the purchase price and stipulated offering price.
48. (a) Use the formula that
T
X CFt /(1 + y)t
D= t × wt where wt =
t=1
BondP rice

Durations are 1.97, 4.61, 8.35, 14.13 for A through D, respectively.

(b) You can either do this question by aggregating the cashflows as each time and
using an approach identical to what we did in part a. Here is an alternative.
To calculate the duration of a portfolio, it is easier to calculate its modified
duration first. Recall that modified duration if MD = D/(1 + y) and that
∆P/P = −MD × ∆y
Is is not have to show that the modified duration of a portfolio is simply the
weighted sum of the modified durations of the individual bonds where the weights
are proportional to the value of the bond to the total value.
Sold to T L (#UM9TJTB4)

In this case, the modified durations A through D are 1.85, 4.35, 7.88, and 13.33,
respectively. For the portfolio we have:

10 20 20 10
MDportf olio = × 1.85 + × 4.35 + × 7.88 + × 13.33 = 6.6
60 60 60 60
Hence the duration is

Dportf olio = 6.6 × 1.06 = 7

(c)
∆P/P = −MD × ∆y = 7 × 20bps = 140bps = 0.14%
49. (a) PV bond = PV semiannual payments + PV principal payment
1 1 10,000
= 300 × 0.05/2 × (1 − (1+0.05/2)20 ) + 1.02520 = $10, 779.45

Note: if 5% is an effective annual rate, the semiannual rate is 1.05 = (1 + r/2)2

so r/2 = 2.47%
1 1 10,000
Then, PV bond = 300 × 0.0247 × (1 − (1+0.0247)20 ) + 1.024720 = $10, 828.57

(b) To calculate the IRR sovle this following equation

300 300 300
0 = −11240 + (1+IRR/2)1 + (1+IRR/2)2 + · · · + (1+IRR/2)20

So: IRR/2 = 2.23%

50. (a) D = 200∗0.5+300∗1+500∗5−900∗1
100
= 20
It means that the equity has the same sensibility to interest rates as a 20 year
strip
(b) dP/P = −D/(1 + y) ∗ dy = −20/1.03 ∗ 0.01 = −0.1941. Given the $100 value,
dP = −$19.41M
So the new price is $80.58M. Because of convexity, the change will be smaller.
51. Not available but there are several other pension related question dealing with duration
matching.
105
52. (a) A: y = 100.96 − 1 = 0.040016.
6.5 6.5 106.5
B: y solves (1+y) 1 + (1+y)2 + (1+y)3 = 106.29; y = 0.042238.
2 2 102
C: y solves (1+y) 1 + (1+y)2 + (1+y)3 = 93.84; y = 0.042294.

105
(b) r0,1 = 100.96 = 1.0400.
r0,2 : consider the portfolio of +1 B, − 106.5 102
= −1.0441 C and 2×1.0441−6.5×1
105
=
−0.042017 A. The portfolio pays 0 at time t = 1, 3 and 6.5×1−2×1.0441 = 4.4118
at time t = 2. The portfolio costs 100.96 × (−0.042017) + 106.29 × 1 − 93.84 ×
1/2
1.0441 = 4.0680. Then, r0,2 = 4.4118

4.0680
= 1.041398.
h i1/3
r0,3 = 93.84−6.5/(1+r106.5
0,1 )−6.5/(1+r0,2 )
2 − 1 = 0.042323.
f0,1 = 0.040016.
f1,2 = 1.0413982/1.040016 − 1 = 0.042781.
f2,3 = 1.0423232/1.0413982 − 1 = 0.044175.
Sold to T L (#UM9TJTB4)

53. (a) Zero-coupon bond: y = 4.5%.

5 5 105 5 5 105
Coupon bond: P = 1.035 + 1.042 + 1.0453
= 101.46; y solves 1+y
+ (1+y)2
+ (1+y)3
=
101.46; y = 0.044675.
100 100
(b) Zero-coupon bond: P0 = 1.0453 = 87.63; P1 = 1.042 = 92.46; realized return =
92.46
87.63
− 1 = 0.055072.
5 105 101.91+5
Coupon bond: P1 = 1.035 + 1.04 2 = 101.91; realized return = 101.46
−1 =
0.053659.

(1) (2) (3) (4) (5)

Yrs Pmt PV of Pmt Wt of Pmt (1) × (4)
1 $1 M $0.9091 M 0.2744 0.2744
54.
2 $2 M $1.6529 M 0.4989 0.9978
3 $1 M $0.7513 M 0.2267 0.6801
Total $3.3133 M 1.0000 1.9523

Duration is 1.9523 years.

55. Not available but there is another very similar question ID:020205

56. (Assuming semiannual coupon payment: YTM per six months is (1.06)0 .5 = 1.02956.)

(a) P = Annuity(2.5, 0.02956, 20) + 100/1.0610 = $93.18.

2.5 2.5 2.5
1 1.02956 +2 +...+20 1.02956
1.029562
(b) D = 2.5
+ 2.5 2 2.5
+...+ 1.02956
= 15.8067 periods (of 6 months).
1.02956 1.02956
15.8067
MD = 1.02956
= 15.3529.
(c) ∆P = 93.18(1 − 15.3529 × (1.070.5 − 1.060.5 )) = $86.25.
(d) P = Annuity(2.5, (1.07)0.5, 20) + 100/1.0710 = $86.56.

57. (a) The net cash flow in May-June, 2010 will be −(1.04)0.5 + 0.055/2 = −$0.99230
billion.
(b) The transaction’s NPV is 1-1=0.

58. (a) There is a one-to-one mapping between a bond’s price and YTM (y). y is the
solution to P = Annuity(4.4375, y, 20) + 100/(1 + y)20 .
(b) Annuity(4.4375, 0.02315, 20) + 100/(1.02315)20 = 133.67.

59. (a) iv; (b) iv; (c) iv.

60. (a) (i) Increased. r ≈ R − i.

(b) (i) A. Bond A has a smaller coupon payment, so its value depends more heavily
on the principal repayment, which occurs far into the future. Therefore, it is more
sensitive to change in the yield.
(c) (i) y > 6%. Since the bond is sold at a discount, y > c.
(d) (i) Profit. f1,2 = 1.062 /1.05 − 1 = 0.07010 > 0.06. The price has gone up.
Sold to T L (#UM9TJTB4)

100 3
61. (a) Zero-coupon bond: P = 1.0553
= 94.79; D = 3; MD = 1.055 = 2.844.
h 1 5 +2 5 +3 105 i
5 5 105 1 2 1.0553
Coupon bond: P = +
1.055 1.0552
+ 1.0553 = 98.65; MD = 1.055 1.055 1.055
94.79
=
2.7094.
(b) Zero-coupon bond: ∆P = −2.844 × 0.001 = −0.0028436. Actual % change =
100/1.0563 −94.79
94.79
= −0.0028382.
Coupon bond: ∆P = −2.7094 × 0.001 = −0.0027094. New price = $98.38; actual
% change = 98.38−98.65
98.65
= −0.0027043.
(c) Zero-coupon bond: ∆P = −2.844 × 0.02 = −0.056872. Actual % change =
100/1.0753 −94.79
94.79
= −0.054782.
Coupon bond: ∆P = −2.7094 × 0.02 = −0.054187. New price = $93.50; actual
% change = 93.50−98.65
98.65
= −0.052228.
(d) Portfolio: MD = 2.844 × 0.4 + 2.7094 × 0.6 = 2.7631.
62. (a) The present value of the annuities is $1 M /0.1 = $10 M.
The duration is 1.10/0.10 = 11 years.
Let x = weight of 5 year zeros, and 1 − x = weight of 20 year zeros. Then
11 = 5x + 20 (1 − x)
and so x = 0.60 (in 5 year zeros), and 1 − x = 0.40 (in 20 year zeros).
5 year zeros: $10M × 0.60 = $6M market value;
20 year zeros: $10 M ×0.40 = $4M market value.
(b) Face value of 5 year zeros: $6M × (1.10)5 = $9.66M; Face value of 20 year zeros:
$4M × (1.10)20 = $26.91M.
63. (a) Depends. If the bond is held to maturity and all coupon payments are reinvested
at the YTM, then higher YTM means higher return, ceteris paribus.
(b) No. Forward rates are expectations of future spot rate; they are unrelated to the
current spot rate.
(c) No. Since the market expects a rate cut, it is already incorporated into today’s
prices.
64. (a) PV of obligation:
2
X $10, 000
PV = = $17, 832.65.
t=1
(1.08)t
Duration of obligation:
(1) (2) (3) (4) (5)
Yr Pmt PV of Pmt Wt of Pmt (1) × (4)
1 $10, 000 $9, 259.26 0.51923 0.51923
2 $10, 000 $8, 573.39 0.48077 0.96154
Total $17, 832.65 1.0000 1.48077
Duration of obligation is 1.4808 years.
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(b) Zero coupon bond with a duration of 1.4808 years would immunize the obligation.
The present value of this bond must be $17, 832.65, thus the face value (feature
redemption value) must be:

$17, 832.65 × (1.08)1.4808 = $19, 985.26.

(c) If interest rates increase to 9%, the value of the bond would be:

$19, 985.26
= $17, 590.92.
(1.09)1.4808

The tuition obligation would be:

2
X $10, 000
PV = = $17, 591.11.
t=1
(1.09)2

The net position changes by only $0.19,

If interest rates decline to 7%:
The value of the zero coupon bond would increase to:

$19, 985.26
= $18, 079.99.
(1.07)1.4808

The tuition obligation would increase to

2
X $10, 000
PV = = $18, 080.18.
t=1
(1.07)2

The net position changes by $0.19.

As interest rates change, so does the duration of the stream of tuition payments,
thus the slight net differences.

65. (a) Real return is 1.05/1.02 − 1 = 0.029412.

(b) Real return is 1.05/1.03 − 1 = 0.019417.
(c) (i) The cash flows at time t = 1, 2, 3, 4 and 5 are 5.10, 5.20, 5.31, 5.41 and 115.93,
respectively.
(ii) The cash flows at time t = 1, 2, 3, 4 and 5 are 5.15, 5.30, 5.46, 5.63 and 121.72,
respectively.