ACTSC 445/845 - Assignment 1 Due on October 10th, 2013 by the end of class

Feel free to use Excel or any other software to complete the following questions.

1. A Canadian T-bill with face value $1000 on March 3, 2014 and expiring on September 12, 2014 (193 days until maturity) is quoted at 2.3%. On the other hand, a U.S. T-Bill with the same expiration date and face value is currently quoted at 3%. (a) Does an arbitrage opportunity exist? If so, explain in detail how you would construct your portfolio so that you earn an arbitrage prot. (b) If the U.S. T-bill was quoted at a rate of r, for what value(s) of r (if any) would an arbitrage opportunity not exist?

2. (For this question, all computations must be correct to at least 8 decimal places.) Assume a non-at spot rate curve. You are given the following information on four zero coupon bonds:
Bond 1 2 3 4 Time to Maturity (in years) 1 2 3 4 Price $95.238 $89.845 $83.962 $77.732

Assume that each bond has face value F = 100. (a) Compute the annual eective spot rates s1 , s2 , s3 and s4 . In what follows, assume that you have constructed a portfolio consisting of one unit of each of the above bonds. (b) If the price of bond 1 changed instantaneously to $95.138 but the other bond prices remained the same, what is the exact percentage change in the price of your portfolio? (c) If instead the each of the bond prices decreased instantaneously by $0.10, what is the exact percentage change in the price of your portfolio? (d) For each of the two previous parts, using a suitable duration measure, calculate the approximate percentage change in the price of your portfolio. (e) Disregard the previous 3 parts. Assume now that all spot rates instantaneously increase by 10bp. Use the Fisher-Weil duration and convexity to approximate the percentage change in value of the portfolio.

3. You are given two key rates (nominal annual rates, compounded semi-annually) of 1.5% and 3% for 6 months and 2 years respectively. (a) Use linear interpolation to construct the spot rate curve from 0 to 2 years, using periods of 6 months. (b) Using this spot-rate curve, compute the value of a bond with 2% annual coupons, a face value of $100 and 1.5 years to maturity. (c) Estimate the key rate durations by using a +1bp shift (in the nominal rate). (d) Using the key rate durations, nd the approximate percentage price change of the bond above if s0.5 = 1% and s1 = 1%.

4. (Single Liability Immunization) Assume a at spot rate curve and that the current yield rate is 8%. A portfolio manager is facing a liability with cash ow L5 = $10000 at time 5 (in years). The portfolio manager can invest the amount received at time 0 in 3and 7-year zero coupon bonds. (a) Determine the asset cash ows A3 and A7 so that overall, the portfolio is guaranteed to have a non-negative surplus if there is a parallel shift in the (at) spot rate curve at time 0, immediately after the portfolio is formed. (b) Suppose there is parallel shift in the (at) spot rate curve at time 0, immediately after the portfolio is formed. The new yield rate is y . Using any graphing software, provide a plot of the surplus vs y for 0 y 16%. (c) Disregard part b). At time 1 (t = 1), suppose the yield rate is y and you rebalance your portfolio once again by matching PV and duration (at time 1). We now refer to the time-1 surplus as the dierence in time-1 values of the old asset portfolio and the new/reconstructed asset portfolio. i. If y = 9%, compute the time-1 surplus. ii. If instead y = 7%, compute the time-1 surplus. iii. Using any graphing software, plot the time-1 surplus vs y for 0 y 16%. (Submit your graphs along with a screenshot of the code or Excel spreadsheet you used to construct the graphs.)
Aside: In the single liability case, weve seen that by the Target Date Immunization Theorem, one is immunized against a one-time instantaneous change in the yield rate. As you saw (hopefully) from the last part, the time-1 surplus was non-negative. In this case, we did not assume an instantaneous change (at time 0). It turns out (for the single liability case only) that as long as no asset cash ows have been received, the surplus from reconstructing the portfolio will be non-negative. This is a further consequence of the Target Date Theorem (See s13termtest2.pdf Q1). Please note that this result must not be generalized to the multiple liability cases. In general, immunization would only protect against an instantaneous (and possibly only a small) change in the interest rate. Even if the interest rate doesnt change instantaneously, then as time goes by, we need to keep the durations and PV matched. Therefore, we need to continually rebalance.