HEC Lausanne Homework 3 Principles of Finance

October 22, 2019

Problem 1
Prices of zero-coupon, default-free securities with face values of $1000 are summarized in the
following table:

Suppose you observe that a three-year, default-free security with an annual coupon rate of
10% and a face value of $1000 has a price today of $1183.95. Is there an arbitrage
opportunity? If so, show specifically how you would take advantage of this opportunity. If
not, why not?

Problem 2
Suppose you are given the following information about the default-free, coupon-paying yield
curve:

a. Use arbitrage to determine the yield to maturity of a two-year, zero-coupon bond.

b. What is the zero-coupon yield curve for years 1 through 4?

Problem 3
Suppose that the prices of zero-coupon bonds with various maturities are given in the
following tables. The face value of each bond is $1,000.

Maturity (year) Price ($)

1 925.93
2 853.39
3 782.92
4 715.00
5 650.00

a) Calculate the forward rate of interest for each year.

b) Suppose that you want to construct a 2-year maturity forward loan commencing in 3
years. If you buy today one 3-year maturity zero-coupon bond, how many 5-year maturity
zeros would you have to sell to make your initial cash flow equal to zero?
c) What are the cash flows on this strategy in each year?
d) What is the effective 2-year interest rate on the effective 2-year-ahead forward loan?
HEC Lausanne Homework 3 Principles of Finance
October 22, 2019
e) Confirm that the effective 2-year interest rate equals ( )( ) . You therefore
can interpret the 2-year loan rate as a 2-year forward rate for the last 2 years. Show that
the effective 2-year forward rate equals
( )
( )

Problem 4

A 12.75-year maturity zero-coupon bond selling at a yield to maturity of 8% (effective annual

yield) has convexity of 150.3 and modified duration of 11.81 years. A 30-year maturity 6%
coupon bond making annual coupon payments also selling at a yield to maturity of 8% has
nearly identical duration – 11.79 years – but considerably higher convexity of 231.2

a) Suppose the yield to maturity on both bonds increases to 9%. What will be the actual
percentage capital loss on each bond? What percentage capital loss would be predicted by
the duration-with-convexity rule?
b) Repeat part a), but this time assume the yield to maturity decreases to 7%.
c) Compare the performance of the two bonds in the two scenarios, one involving an
increase in rates, the other a decrease. Based on the comparative investment performance,
explain the attraction of convexity.
d) In view of your answer to c), do you think it would be possible for two bonds with equal
duration but different convexity to be priced initially at the same yield to maturity if the
yields on both bonds always increased or decreased by equal amounts, as in this example?
Would anyone be willing to buy the bond with lower convexity under these
circumstances?

Problem 5

A newly issued bond has a maturity of 10 years and pays a 7% coupon rate (with coupon
payments coming once annually). The bond sells at par value.

a) What are the convexity and the duration of the bond?

b) Find the actual price of the bond assuming that its yield to maturity immediately increases
from 7% to 8% (with maturity still 10 years).
c) What price would be predicted by the duration rule? What is the percentage error of that
rule?
d) What price would be predicted by the duration-with-convexity rule? What is the
percentage error of that rule?