Professional Documents
Culture Documents
Fin 1 Tutorial 4 Answers
Fin 1 Tutorial 4 Answers
Finance
M.Sc. Investment & Finance
M.Sc. International Banking & Finance
And M.Sc. International Accounting & Finance
2011/2012
40901 Finance I: Tutorial/Workshop Four
SOLUTIONS
Q1. A bond was issued five years ago with a maturity of twenty years. The face value of the bond is £100
and coupon rate of interest is 10 per cent and interest is paid annually. Since the issue of the bond
interest rates have fallen and a bond with fifteen years to maturity has just been issued at par with a
coupon rate of interest of 5 per cent.
a) Determine the fair value for the bond issued five years ago.
1 1
P0 = ∑ rc B +B
(1 + r ) t
(1 + r ) n
1 1
P0 = ∑ 10 + 100
(1 + 0.05) t
(1 + 0.05)15
P0 = 10 xPVAF15|0.05 + 100 PVF15|0.05
P0 = 10 x10.3797 + 100 x0.4810
= 103.7966 + 48.1017 = 151.9037
1
b) Determine the rate of return that an investor planning to hold the bond for one year can
anticipate assuming a flat yield curve, and show the form in which this rate of return will take.
Price at the end of the year ‐ 14 years to maturity
2
c) Why is it necessary to assume a flat yield curve?
When the required yield exceeds the coupon rate of a bond it will trade at a discount and when
the required yield is below the coupon rate the bond will trade at a premium. But at the
maturity date a bond, less the interest payable, must trade at its par or nominal value (the
repayment of principal). Consequently, the price of a bond selling at a discount or premium can
be expected to move towards par value over the time to its maturity date.
If the yields curve is flat the required yield is expected to remain constant and the anticipated
capital gain in any period can be easily calculated
Pt + 1 ‐ Pt = Capital Gain or Capital Loss
Pt = rcB x PVAFn/r + B x PVFn/r
Pt + 1 = rcB x PVAFn‐1/r + B x PVFn‐1/r
and
Expected return = rcB/Pt x (Pt+1 – Pt)/Pt
(where t is the initial valuation date and t + 1 is the subsequent valuation date. Initially these
are n periods to maturity from period t and n – 1 periods form period t + 1)
When the yield curve is not flat it is possible that the required yield over the n periods to
maturity may differ from the required yield over the n – 1 periods to maturity. This requires an
adjustment to the interest rate used in the valuation equation for t +1.
Q2. a) Determine the spot rates of return on the following zero company bonds, using your calculators
Bonds Maturity Price Spot Rates
A One year 93.4579 0.070
B Two years 85.5339 0.081
C Three years 78.2908 0.085
Bond A
1 100
93.4579 = 100 y= − 1 = 0.07
(1 + rs 1 ) 93.4579
Bond B
1 100
85.5339 = 100 y= − 1 = 0.081
(1 + rs 2 ) 2 85.5339
Bond C
1 100
78.2908 = 100 y=3 − 1 = 0.085
(1 + rs 3 ) 3
78.2908
b) Value a three year bond offering a coupon rate of interest of 12 per cent on the basis of the
rates derived in (a) above.
+ (rc B + B )
1 1 1
P0 = rc B + rc B
(1 + rs 1 ) (1 + rs 2 ) 2
(1 + rs 3 ) 3
+ (12 + 100 )
1 1 1
P0 = 12 + 12 = 109.1697
(1 + 0.07) (1 + 0.081) 2 (1 + 0.085) 3
c) Develop a portfolio based on the zero coupon bonds to replicate the expected cash flows from
the three year bond with a coupon rate of interest of 12 per cent. What is the expected value of
this portfolio?
93.4579 x0.12 + 85.5339 x 0.12 + 78.2908 x1.12 = 109.1647
3
Q3. The following information is available for three coupon bonds
Time to Maturity Coupon Rate of Interest Price
1 12 106.6667
2 9 105.5810
3 13 117.4979
Determine the spot rates of return for years one to three.
Determination of spot rates in the absence of zeros (1)
A coupon bond with one period to maturity offers investors a single cash flow in the same way as a
zero and the spot rate can be evaluated as follows:
C1 (r B + B) 112
rs1 = IRR = YTM = −1 = c −1 = − 1 = 0.05
C0 P0 106.67
The price equation for a two period bond can be written as follows
rc B r B+B 9 109
P0 = + c = 105.5810 = +
(1 + rs1 ) (1 + rs 2 ) 2
(1 + 0.05) (1 + rs 2 ) 2
And as the one unknown it is possible to solve for the spot rate for period two:
109
P0 = 105.5810 = 8.5714 +
(1 + rs 2 ) 2
109
105.5810 − 8.5714 = 97.0096 =
(1 + rs 2 ) 2
109 109
(1 + rs 2 ) 2 = and (1 + rs 2 ) 2 = 1 + rs 2 = = 1.1236 = 1.06
97.0096 97.0096
rs 2 = 1.06 − 1.0 = 0.06
Determination of spot rates in the absence of zeros (2)
The spot rate for period three can be derived in the same way if the spot rate for the first and
second periods are known:
rc B rc B r B+B 13 13 113
P0 = + + c = 117.4979 = + +
(1 + rs1 ) (1 + rs 2 ) 2
(1 + rs 3 ) 3
(1 + 0.05) (1 + 0.06) 2
(1 + rs 3 ) 3
And as the one unknown it is possible to solve for the spot rate for period three:
113
P0 = 117.4979 = 12.3810 + 11.5600 +
(1 + rs 3 ) 3
113
117.4979 − 12.3810 − 11.5600 = 93.5470 =
(1 + rs 3 ) 3
113
(1 + rs 3 ) 3 = and 3 (1 + rs 3 ) 3 = 1 + rs 3 = 3 1.2079 = 1.065
93.5470
rs 2 = 1.065 − 1.0 = 0.065
4
Q4. The yield curve at the beginning of the year is flat at an interest rate of 6 per cent. Your investment
in a government four year bond with a coupon rate of interest of 5 per cent with an anticipated
holding period of one year. During the course of the year interest rates increase to 9 per cent and at
the end of the year the yield curve is again flat but at this higher rate.
a) Determine the price of the bond expected at the end at the beginning of the year and the
expected rate of return on the investment.
The initial price of the bond, its expected price at the end of the year, and its expected return.
P0 = 5 xPVAF4|0.06 + 100 xPVF4|0.06 = 5 x3.4651 + 100 x0.7921 = 96.5355
E ( P1 ) = 5 xPVAF3|0.06 + 100 xPVF3|0.06 = 5 x 2.6730 + 100 x0.8396 = 97.3250
rc B ΔP 5 0.7895
E ( R) = + = + = 0.06 = YTM
P0 P0 96.5355 96.5355
b) Determine the actual price at the end of the year and the rate of return earned over the one
year holding period on this basis. Comment on the return.
The price of the bond at the end of the year and the realised return.
P0 = 5 xPVAF4|0.06 + 100 xPVF4|0.06 = 5 x3.4651 + 100 x0.7921 = 96.5355
P1 = 5 xPVAF3|0.09 + 100 xPVF3|0.09 = 5 x 2.5313 + 100 x0.7721 = 89.8728
rc B ΔP 5 − 6.6607
E ( R) = + = + = −0.0172(a negative return)
P0 P0 96.5355 96.5355
Price
100.0000
96.5355
4 Years Years
Price
100.0000
96.5355
89.8728 Revised trajectory – assuming the required rate of
return remains at 9 per cent. A fall in the price
occurs as a result of the increase in the required
rate of return form 6 to 9 per cent
4 Years Years
5
The anticipated gain or loss may not be realised in any period as a result of changes in the
required rate of return. (The data in question assumes a significant increase in the interest rate
(required yield) that result in a capital loss that is more than sufficient to offset the positive
contribution of interest.
c) What does this indicate about investments in government bonds?
Government bonds are subject to interest rate risk just like all other bonds. So even though
there is no credit risk government bonds cannot be considered to be risk free.