Forward rates for evaluating bond prices at future times and investment returns

Contents
Option & default – free bond return from forward rates ............................................................................. 1
Callable and puttable bonds ......................................................................................................................... 2

Option & default – free bond return from forward rates

Exercise 1

Suppose that the spot rates today for the next three years are 𝑟(1) = 7%, 𝑟(2) = 8%, 𝑟(3) = 9% find
out:

a. The implied forward rates for a 1-year and a 2-year loan contracted a year from now.
b. The return of the two-year zero-coupon bond over the 1-year holding period.
c. The return of the three year bond over 1-year and 2-year holding period.

We assume that the spot-rate curves, in 1 year and 2 years from now, reflect the implied forward
curves from today.

Solution:

a. The implied forward rate for a 1-year loan contracted a year from now is given by
2
2 (1+𝑟(2)) 1.082
(1 + 𝑓(1,1))(1 + 𝑟(1)) = (1 + 𝑟(2)) ⇒ 𝑓(1,1) = 1+𝑟(1)
−1= 1.07
− 1 = 9%
The implied forward rate for a 2-year loan contracted a year from now is given by
3 3
(1 + 𝑟(3)) (1 + 𝑟(3))
(1 + 𝑓(1,2)) = 2
⇒ 𝑓(1,2) = √ − 1 = 10%
1 + 𝑟(1) 1 + 𝑟(1)
b. The return of the two-year zero coupon bond over the 1-year holding period is found as follows:
100 100 100 100 1.072
( : ) − 1 = ( : ) − 1 = − 1 = 5.03%
1 + 𝑓(1,1) [1 + 𝑟(1)]2 1 + 0.09 (1 + 0.07)2 1.09
c. 3-year bond return over the 1-year horizon:
3
100 100 1.093(1 + 𝑟(3))
( 2 : 3 ) − 1 = 2 − 1 = − 1 = 7.02%
(1 + 𝑓(1,2)) (1 + 𝑟(3)) (1 + 𝑓(1,2)) 1.12
3-year bond return over the 2-year horizon:
3
100 100 (1 + 𝑟(3)) 2
( : 3 )−1 = − 1 = (1 + 𝑟(2)) − 1 = 1.082 − 1 = 16.64%
1 + 𝑓(2,1) (1 + 𝑟(3)) 1 + 𝑓(2,1)

Exercise 2

Suppose that the market prices of three zero coupon bonds with maturities 1 year, 2 year and 3 years
are 98.05$, 96.35$, 94.53$. Compute:

a. The implied forward curve.

 b. The price of a 4% coupon default-free bond in 1 year, if the spot curve in 1 year will reflect the
actual forward yield curve. The payments are annual.

Solution:
100 100 100 100
a. 98.05 = , 96.35 = 2 , 94.53 = 3 ⇒ 𝑟(1) = − 1 = 1.98%, 𝑟(2) =
1+𝑟(1) (1+𝑟(2)) (1+𝑟(3)) 98.05

100 3 100
√ − 1 = 1.87%, 𝑟(3) = √94.53 − 1 = 1.89%
96.35

2 3
(1+𝑟(2)) (1+𝑟(3))
So we have: 1 + 𝑓(1,1) = ⇒ 𝑓(1,1) = 1.76%, 1 + 𝑓(2,1) = 2 ⇒ 𝑓(2,1) = 1.93%
1+𝑟(1) (1+𝑟(2))

Maturity Zero-rate Forward rate

1Y 1.98% 1.98%
2Y 1.87% 1.76%
3Y 1.89% 1.93%
b. The price in 1 year is:
4 104 4 104
𝑃1 = + = + = 104.1969
1 + 𝑓(1,1) ((1 + 𝑓(1,1)) ⋅ (1 + 𝑓(2,1))) 1.0176 1.0176 ⋅ 1.0193

Exercise 3

Suppose that the spot rate curve is (6%,7%,8%) for (1,2,3) years. What is the no-arbitrage futures price
of a 6% annual-coupon bond with 2 years maturity to be delivered in 1 year?

Solution:

The futures price is the bond’s price at the realized forward curve as a spot curve.
6 106 6
That means 𝐹(1,3) = 1-year futures price for a 2-year bond = + 2 = 2 +
1+𝑓(1,1) (1+𝑓(1,2)) (1+𝑟(2))
1+𝑟(1)
106 (1+𝑟(1)) 1+𝑟(1) 1.06 1.06
3 =6⋅ 2 + 106 ⋅ 3 = 6 ⋅ 1.072 + 106 ⋅ 1.083 = 94.75
(1+𝑟(3)) (1+𝑟(2)) (1+𝑟(3))
1+𝑟(1)

Callable and puttable bonds

Exercise 1 (Price of a callable and puttable bond)

Suppose we have a 3-year bond with 4% coupon, paid annually, that is callable at par in 1 year and 2
year. A. Find the price in 1 year and 2 years.

B. Find the price of a puttable bond with the same terms.

C. Find the yield-to-first put and yield-to-second put for the puttable bond. Compare that with the yield
to first year in a regular bond.

The spot rates are 4.5% for 1 year, 5.5% for 2 year, 6.5% for 3 year maturity and we assume the volatility
of the forward curve is 0.

Solution:
We use the forward curve that is 𝑓(0,1) = 4.5%, 𝑓(1,1) = 0.065, 𝑓(2,1) = 8.52%

A. Now we go backwards from year 2 through year 1 to year 0.

100+4 104
The price at time t we denote 𝑃𝑡 . So 𝑃2 = min⁡(1+𝑓(2,1) , 100) = min⁡(1.0852 , 100) = 95.8348. The bond
is not worth being called because the call price 100 is greater than 𝑃2 .
95.8348+4 99.8348 97.7415
𝑃1 = = = 93.7415 and the price at time 0 is 𝑃0 = = 92.6415
1+𝑓(1,1) 1.065 1.055

The bond is never worth being called so its price is the same as of a plain-vanilla bond.
100+4
B. We go again backwards and the price at time 2 is 𝑃2′ = max (100, 1+𝑓(2,1)) = 100. The bond is
100+4 104
worth being putted. 𝑃1′ = max ( , 100) = max ( , 100) = 100. At time 0, 𝑃0′ =
1+𝑓(1,1) 1.065
104
1.045
= 99.52.
4+100 104
C. The price of the bond is 99.52 = 1+𝑦1
= 1+𝑦 ⇒ 𝑦1 = 4.5%⁡(𝑦𝑖𝑒𝑙𝑑 − 𝑡𝑜⁡𝑓𝑖𝑟𝑠𝑡⁡𝑝𝑢𝑡).⁡
1

4 104
The yield to second put is obtained from 99.52 = + (1+𝑦 2 so 𝑦2 = 4.25%. This make this
1+𝑦2 2)
yield-to-second put greater than the spot rate for two years.

Exercise 2 (What coupon rate makes a bond worth being called)?

a. For the same bond as in exercise 1 what coupon level would make that bond callable at time 2?
b. For the bond in question what coupon level would make it callable at time 1 but not at time 2?

Solution:

a. For the bond to be callable at time 2, the value of the future cash-flows must be greater than
100+𝑐
the call price, that is > 100 ⇒ 𝑐 > 8.52%⁡
1.0852
In that case, the bond is callable at time 2.
REMARK:
100+𝑐
However, the price of time 1 would be 1.065
> 100 because 𝑐 > 8.52% so the bond is also
callable at time 1. The real question then is, when it is optimal to exercise the call option?
b. For the bond to be callable at time 1, but not at time 2, the coupon 𝑐 must fulfill the following 2
conditions:
100+𝑐
100+𝑐 +𝑐
1.0852
1.0852
< 100 and 1.065
> 100 so 𝑐 < 8.52% and 𝑐 > 4.08%

So for coupon levels 𝑐 ∈ (4.08%, 8.52%) the bond is callable.

Exercise 3 (What call price makes the bond exercisable)?

a. Suppose we have a 5% coupon payable annually, 3 years maturity which is callable in 2 years.
For what maximum call price will the bond be callable?
b. What if the coupon pays every 6 months?
c. If the coupon is 4%, what is the yield-to-call and compare to the 2-year spot rate when the
coupon payments are annually? The call price is the par value.
 The forward rates are as follows: 𝐹(0,1) = 3%, 𝐹(1,1) = 3.5%, 𝐹(1,2) = 4.5%.

Solution:

a. We must find first F(2,1) from the fact that (𝐹(2,1) + 1)(𝐹(1,1) + 1) = (𝐹(1,2) + 1)2 or
𝐹 2 (2,1)+2𝐹(1,2)−𝐹(1,1) 0.0452 +0.09−0.035
𝐹(2,1) = 𝐹(1,1)+1
= 1.035
= 0.055 = 5.5%
5+100 105
So 1+𝐹(2,1)
= 1.055 ≥ 𝑐𝑎𝑙𝑙⁡𝑝𝑟𝑖𝑐𝑒 the call price being 99.526 (that is the maximum call price for
which the bond option would be exercised in 2 years)
b. With the data available we can state that the bond call price should follow the inequality
2.5 102.5 2.5 102.5
𝑐𝑎𝑙𝑙⁡𝑝𝑟𝑖𝑐𝑒 ≤ 1 + 1+𝐹(2,1) = + 1.055 = 99.59 because there are two more
√1.055
(1+𝐹(2,1))2
coupons to be paid.
104
c. The price at time 2 is min (1.055 , 100) = 98.5781. Discounted back at time 0 the bond price is
98.5781+4
+4 4 104
1.035
1.03
= 100.10609. Now the yield to the call is given by 1+𝑦 + (1+𝑦)2 = 100.10609.
The value of 𝑦 is 3.9433%.
2
The 2-year spot rate is obtained through: (1 + 𝐹(0,1))(1 + 𝐹(1,1)) = (1 + 𝑟(2)) ⇒ 𝑟(2) =
3.2496%. The yield is obviously bigger in a callable bond, than in a regular bond, since the price is
lower.

Exercise 4 (Find the yield-to-maturity of a puttable bond given a certain price)

a. An investor buys a 3-year bond, 8% annual payment at 94.05, puttable at 97$ in 2 years. Find
the yield to maturity of this bond.
b. If the investor buys and holds the bond for two years, and after the bond is bought the interest
rate increases with 1% what is the horizon yield?
c. Is it optimal to exercise the put option if the interest rate increases?

Solution:
108 2 𝑃 +8 8
a. The put price at time 2 is max⁡(1+𝑦 , 97). The put price at time 0 is 𝑃0 = (1+𝑦) 2 + 1+𝑦. There are

two cases to treat.

108 11 108 8 8
1. If 1+𝑦 > 97 ⇔ 𝑦 < 97 = 11.34% then 𝑦⁡must satisfy (1+𝑦)3 + (1+𝑦)2 + 1+𝑦 = 94. ⇒ 𝑦 =
10.40% which fits.
108
2. If 1+𝑦 < 97 ⇔ 𝑦 > 11.34%
105 8
So 94.05 = (1+𝑦)2 + 1+𝑦 ⇒ 𝑦 = 10% which is not a solution.
So the yield to maturity is 10.40%
b. If the interest rate becomes 11.40%, the future value of the reinvested coupons is 8 ⋅
108
1.0140 + 8 = 16.912. The price after 2 years is max (1.1140 , 97) = 97.
97+16.912 113.912 113.912
The horizon yield is given by 94.05 = (1+𝑦)2
= (1+𝑦)2
⇒ (1 + 𝑦)2 = 94.05
= 10.05%
c. No. The yield to put is lower than the yield to maturity therefore the exercise should not be
done.