FINS2624

PROBLEM SET 3 SOLUTIONS

Question 1.

T=4
FV = 100
C = 20
Y = 6%
New y = 7%
y = 1%

a)

= ()

= 7% 6% = 1%

20 20 20 120
= + 2
+ 3
+ = $148.51
1 + 6% (1 + 6%) (1 + 6%) (1 + 6%)4

(1 + )
= =1

1 20 20 20 120
= 1+ 2+ 3+ 4 = 3.26
(1 + 6%) (1 + 6%)2 (1 + 6%)3 (1 + 6%)4

3.26
= = = 3.08
1 + 1 + 6%

= 3.08 1% 148.51 = $4.58

= 148.51 4.58 = $143.93

Duration = 3.26 years: weighted average of the times until fixed cash flows are received.

b) Actual price, Pactual

20 1 100
= 1 4 + 144.03
0.07 1.07 1.074

( ) = 144.03 143.93 = $0.10

Implying a pricing error of 10 cents(!)

c)

The price-yield curve of a bond is a convex one as shown above. And the bonds
duration at a specific yield level is the slope of the curve at that interest rate (i.e. the
slope of the tangent line to the curve at that interest rate level).

When interest rate increases, the curve becomes flatter, and hence the duration
becomes smaller. So when you use the duration rule to calculate price changes: P/P
~= -Dy/(1+y), the duration is that at the original interest rate (6%) which is bigger
than the actual durations (which keeps changing, become smaller and smaller) over
the course of interest rate increase. And thus the estimated (negative) price change is
too big in magnitude.

So it is clear from the discussion above that the approximation error is due to convex
price-yield curve and thus negative duration-yield relationship.

Now for your own exercise, please assume interest rate decreases from 6% to 5%, and
redo a) and b). What do you find? And please follow my arguments above to explain
the findings.

d)


1+ + 0.5 ()2
I assume everyone can do this calculation.

e)

From c) we know that the approximation error of duration rule is due to the convex
price-yield curve and the change in duration when interest rate changes. You can
easily see from the price-yield curve above that the curve becomes straighter when
interest rate is higher the curve is closer to a linear line (it becomes almost a
straight line when interest rate is very high). And the straighter (or less convex) the
curve is, the smaller the change in duration due to change in interest rate, and hence
the smaller the approximation error if we use duration to estimate price change.
Question 2.

Method 1:

= +

Now,

= =
+

= =
+

Let CF = Cash Flow

The duration of the portfolio, DP:

( )
=

=1

( ) + ( )
=

=1

1 1
= ( ) + ( )

=1 =1

( ) ( )
= +

=1 =1

= +
Method 2:

Let CF = Cash Flow

=
+

=
+

1 +
=
(1 + )
=1

1
=
+
+ (1 + ) (1 + )
=1

1
(1 + ) (1 + )
= +
+
=1

1
(1 + ) (1 + )
= +
+
=1 =1

1
= ( + ) = +
+
Question 3.

y = 5%

a) Immunisation using bonds A and B

These two bonds are Zero-Coupon-Bonds (ZCB). Therefore, for Bond A and Bond B,
maturity and duration will be same.

DA = 3
DB = 6
And DX = 4

= 3 + (1 ) 6 = 4

(3 6) = 4 6

2
= = 0.67
3

, = 1 0.67 = 0.33

100
, () = = 82.27
1.054
(0.67 82.27)
, = 0.63
100

1.053
(0.33 82.27)
, = 0.37
100

1.056

b) Immunisation using Bonds B and C

Since both the bonds are ZCB, maturity = duration

= 4 = 6 + (1 ) 10

4 10 = (6 10)

= 1.5

= 1 = 0.5 ( )

(1.5 82.27)
, = 1.65
100

1.056
(0.5 82.27)
, = 0.67
100

1.0510
c) Both liabilities immunized by both Bond B and C

, = 4 + 9

100
, () = = 65.46
1.059

Now,

82.27
= = 0.56
82.27 + 64.46
64.46
= = 0.44
82.27 + 64.46

= (0.56 4) + (0.44 9) = 6.2

Now, we calculate the weight of both the bonds to match up with the liability duration of 6.2:

6 + (1 ) 10 = 6.2

6 + 10 10 = 6.2

= 0.95

= 1 = 1 0.95 = 0.05

[0.95 (82.27 + 64.46)]

, = 1.868
100

1.056
[0.05 (82.27 + 64.46)]
, = 0.119
100

1.0510
Question 4.

P/P ~= -Dy/(1+y). So the percentage price change depends on the duration.

This question essentially tests the determinants of bond duration. We know from the
lecture that, everything else equal, the bond duration: i) increases with maturity, but
at a decreasing rate; ii) decreases with coupon rate; iii) decreases with interest rate
(or more specifically yield).

a)

Bonds A, B and C have the same time-to-maturity. The coupon rate is 0% for bond A,
6% for bond B and 7% for bond C. Further bonds A and B have the same YTM of 6%,
while bond C has a YTM of 7%.
So based on the relationship between duration and coupon rate, we know that DA >
DB > DC, if everything else equal. And actually bond C even has a higher YTM, which
makes it even more obvious that its duration should be lowest.
So the percentage price change should be largest for bond A, and lowest for bond C.
Please verify this with your calculation.

b)

This is no-brainer the only difference between these two bonds is that bond D has a
longer maturity, and thus a higher duration.

c)

Everything else equal, duration increases with maturity at a decreasing rate.

So DE > DD > DC, but DE - DD < DD - DC
Hence the difference in percentage price change should be between bonds C and D.
again, please verify it.

d)

The only difference between bonds E and F is the YTM bond F has a higher YTM
(its YTM > 7%, where YTM of bend E = 7%).
The answer is clear based on the relationship btw duration and YTM.
Selected end-of-chapter questions
BKM16: 1-4, 7, 8a, 9, 12, 15, 22(a, b and c)

Question 1.

While it is true that short-term rates are more volatile than long-term rates, the
longer duration of the longer-term bonds makes their prices and their rates of return
more volatile. The higher duration magnifies the sensitivity to interest-rate changes.

Question 2.

Duration can be thought of as a weighted average of the maturities of the cash flows
paid to holders of the perpetuity, where the weight for each cash flow is equal to the
present value of that cash flow divided by the total present value of all cash flows. For
cash flows in the distant future, present value approaches zero (i.e., the weight
becomes very small) so that these distant cash flows have little impact and,
eventually, virtually no impact on the weighted average.

Question 3.

The percentage change in the bonds price is:

D 7.194
Dy = 0.005 = 0.0327 = 3.27%,
1+ y 1.10 or a 3.27% decline

Question 4.

a. YTM = 6%
(1) (2) (3) (4) (5)
Time until PV of CF
Column (1)
Payment (Discount
Column
(Years) Cash Flow Rate = 6%) Weight
(4)
1 $ $ 0.0566 0.0566
2 60.0 53.4 0.0534 0.1068
0 0
3 1,060.00 890. 0.8900 2.6700
00
Column sums $1,000.00 1.0000 2.8334
Duration = 2.833 years
b. YTM = 10%
(1) (2) (3) (4) (5)
PV of CF
Time until
(Discount Column (1)
Payment
Rate = Column
(Years) Cash Flow Weight
10%) (4)
1 $ $ 0.0606 0.0606
2 60.0 49.5 0.0551 0.1102
0 9
3 1,060.00 796. 0.8844 2.6532
39
Column sums $90 1.0000 2.8240
Duration = 2.824 years, which is less than the duration at the YTM of 6%.

Question 7.

Bond d. Investors tend to purchase longer term bonds when they expect yields to fall
so they can capture significant capital gains, and the lack of a coupon payment
ensures the capital gain will be even greater.

Question 8.

a. Bond B has a higher yield to maturity than bond A since its coupon payments
and maturity are equal to those of A, while its price is lower. (Perhaps the yield is
higher because of differences in credit risk.) Therefore, the duration of Bond B must
be shorter.

Question 9.

a.
(1) (2) (3) (4) (5)
Time until PV of CF
Column (1)
Payment (Discount Rate
Column
(Years) Cash Flow = 10%) Weight
(4)
1 $10 million $ 9.09 0.7857 0.7857
5 4 million 2.48 0.2143 1.0715
million
Column sums $11.57 1.0000 1.8572
D = 1.8572 years = required maturity of zero coupon bond.

b. The market value of the zero must be $11.57 million, the same as the
market value of the obligations. Therefore, the face value must be:
$11.57 million (1.10)1.8572 = $13.81 million
Question 12.

a. PV of the obligation = $10,000 Annuity factor (8%, 2) = $17,832.65

(1) (2) (3) (4) (5)
Time until PV of CF
Column (1)
Payment (Discount
Column
(Years) Cash Flow Rate = 8%) Weight
(4)
1 $10,000.0 $ 0.51923 0.51923
2 10,000.00 8,573.388 0.48077 0.96154
Column sums $17,832.647 1.00000 1.48077
D = 1.4808 years

b. A zero-coupon bond maturing in 1.4808 years would immunize the

obligation. Since the present value of the zero-coupon bond must be
$17,832.65, the face value (i.e., the future redemption value) must be
$17,832.65 1.081.4808 = $19,985.26

c. If the interest rate increases to 9%, the zero-coupon bond would decrease in
value to
$19,985.26
= $17,590.92
1.091.4808
The present value of the tuition obligation would decrease to $17,591.11
The net position decreases in value by $0.19
If the interest rate decreases to 7%, the zero-coupon bond would increase in value to
$19,985.26
= $18,079.99
1.071.4808
The present value of the tuition obligation would increase to $18,080.18
The net position decreases in value by $0.19
The reason the net position changes at all is that, as the interest rate changes, so does
the duration of the stream of tuition payments.
Question 15.

a. The duration of the annuity if it were to start in one year would be

(1) (2) (3) (4) (5)
PV of CF
Time until
(Discount Column (1)
Payment
Rate = Column
(Years) Cash Flow Weight
10%) (4)
1 $10, $ 0.14795 0.14795
2 10,0 8,264.463 0.13450 0.26900
00
3 10,0 7,513.148 0.12227 0.36682
00
4 10,0 6,830.135 0.11116 0.44463
00
5 10,0 0.10105 0.50526
00 6,209.213
6 10,0 5,644.739 0.09187 0.55119
00
7 10,0 5,131.581 0.08351 0.58460
00
8 10,0 4,665.074 0.07592 0.60738
00
9 10,0 4,240.976 0.06902 0.62118
00
10 10,0 3,855.433 0.06275 0.62745
00
Column sums $61,445.67 1.00000 4.72546
D = 4.7255 years
Because the payment stream starts in five years, instead of one year, we add four
years to the duration, so the duration is 8.7255 years.

b. The present value of the deferred annuity is

10,000 Annuity factor (10%,10)
= $41,968
1.10 4
Alternatively, CF 0 = 0; CF 1 = 0; N = 4; CF 2 = $10,000; N = 10; I = 10; Solve for
NPV = $41,968.
Call w the weight of the portfolio invested in the five-year zero. Then
(w 5) + [(1 w) 20] = 8.7255 w = 0.7516
The investment in the five-year zero is equal to
0.7516 $41,968 = $31,543
The investment in the 20-year zeros is equal to
0.2484 $41,968 = $10,423
These are the present or market values of each investment. The face values are equal
to the respective future values of the investments. The face value of the five-year
zeros is
$31,543 (1.10)5 = $50,801
Therefore, between 50 and 51 zero-coupon bonds, each of par value $1,000, would be
purchased. Similarly, the face value of the 20-year zeros is
$10,425 (1.10)20 = $70,123
 Question 22.

a. The price of the zero-coupon bond ($1,000 face value) selling at a yield to
maturity of 8% is $374.84 and the price of the coupon bond is $774.84.
At a YTM of 9%, the actual price of the zero-coupon bond is $333.28 and the actual
price of the coupon bond is $691.79.
Zero-coupon bond:
$333.28 $374.84
= = 0.1109 = 11.09%
Actual % loss $374.84 loss
The percentage loss predicted by the duration-with-convexity rule is:
[ ]
Predicted % loss = [(11.81) 0.01] + 0.5 150.3 0.01 = 0.1106 = 11.06% loss
2

Coupon bond:
$691.79 $774.84
= = 0.1072, or10.72%
Actual % loss $774.84 loss
The percentage loss predicted by the duration-with-convexity rule is:

Predicted % loss
= [(11.79) 0.01] + 0.5 231.2 0.012 =
0.1063, or10.63%
loss

b. Now assume yield to maturity falls to 7%. The price of the zero increases to
$422.04, and the price of the coupon bond increases to $875.91.
Zero-coupon bond:
$422.04 $374.84
= = 0.1259, or12.59%
Actual % gain $374.84 gain
The percentage gain predicted by the duration-with-convexity rule is:
= [ (11.81) (0.01) ] + 0.5 150.3 0.012 = 0.1256, or12.56%
Predicted % gain gain
Coupon bond:
$875.91 $774.84
= = 0.1304, or13.04%
Actual % gain $774.84 gain
The percentage gain predicted by the duration-with-convexity rule is:
= [ (11.79) (0.01) ] + 0.5 231.2 0.012 = 0.1295, or 12.95%
Predicted % gain gain

c. The 6% coupon bond, which has higher convexity, outperforms the zero
regardless of whether rates rise or fall. This can be seen to be a general property
using the duration-with-convexity formula: the duration effects on the two bonds
due to any change in rates are equal (since the respective durations are virtually
equal), but the convexity effect, which is always positive, always favors the higher
convexity bond. Thus, if the yields on the bonds change by equal amounts, as we
assumed in this example, the higher convexity bond outperforms a lower convexity
bond with the same duration and initial yield to maturity.