FINA 4400: Financial Markets and Institutions

Chapter 3

End of Chapter Question #4

What is the value of a $1,000 bond with a 12-year maturity and an 8 percent coupon rate (paid semi-annually) if th
* 5%
* 6%
* 8%
* 10%

Face Value Number of Payments Periodic Coupon Payment Required Return

(FV) (N) (PMT) (YTM)
$1,000 24 40 5.00%
$1,000 24 40 6.00%
$1,000 24 40 8.00%
$1,000 24 40 10.00%

End of Chapter Question #6

What is the yield to maturity on the following bonds; all have a maturity of 10 years, a face value of $1,000 and a co
The bonds' current market values are $945.50, $987.50, $1,090.00, and $1,225.875, respectively.

Market Value Number of Payments Periodic Coupon Payment Face Value

(PV) (N) (PMT) (FV)
Bond 1 945.5 20 45 1000
Bond 2 987.5 20 45 1000
Bond 3 1090 20 45 1000
Bond 4 1225.875 20 45 1000
on rate (paid semi-annually) if the required rate of return is:

The Bond Value will be:

(PV)
$ 1,268.27
$ 1,169.36
$ 1,000.00
$ 862.01

rs, a face value of $1,000 and a coupon rate of 9 percent (paid semiannually).
5, respectively.

The yield to maurity will be:

(YTM)
9.87%
9.19%
7.69%
5.97%
Chapter 3: Duration Application

Duration is a measure of how sensitive a bond price is to changes in interest rates. It is often used to predict the change in bon
price of a bond if interest rates go up by 1%. Instead of calculating the bond's price using TVM, we can estimate the change in

As we saw in class, there are limitations to using durations in predicting bond price changes. Duration is based on a linear mod
this exercise is to demonstrate those limitations by highlighting the prediction errors, which can be see graphically in Figure 3-

For the first part of this exercise, we will calculate the "true" bond price given several scenarios of interest rates changes. Thes

For the second part of this exercise, we will calculate bond duration, both Macaulay and modified duration, and then use each
first part. These predicted prices represent the straight line in Figure 3-7, which is called the Duration Model.

In part three, you'll describe the relationship between prediction error and (1) the direction of the interest rate change and (2

Part 1: True Bond Prices after Interest Rate Changes

Inputs Scenario 1
Settlement date 1/6/2021 1/6/2021
Maturity 2/1/2028 2/1/2028
Par $ 1000 1000
Coupon 7.125% 7.125%
Frequency 2 2
Yield 2.0990% New Yield 2.5990%
Change in Yield 0.50%
$ Value of investment $ 1,328.61 New Bond Price 1290.57
Bond Price 132.861% Bond Price Change ($) (38.04)

Part 2: Calculating Duration measures and using those measures to predict or estimate bond price changes
Macualay Duration 5.75541496582698
Modified Duration 5.69563793119649 Scenario 1
Interest rate change 0.50%
Price change -37.8363
Prediction Error (0.20)

In this cell, you'll enter the formula that

you get when you rearrange the equation In this cell, you'll take the d
∆𝑃/𝑃=−𝑀𝐷×∆𝑟_𝑏 to solve for ΔP, between the true bond pric
which is the notation for the change in part 1 for each scenario and
price. If more information is need, this from the predict bond price
equation is on page 84 in the textbook. part 2 for each scenario.

Part 3:
#1. Describe the relationship between the prediction error and the direction of the interest rate change. Is this consistent w
Increase in interest rates:
Using the duration model, the relationship between the prediction error and the direction of the i
the level of interest rates, the smaller a bond’s price sensitivity to interest rate changes.
Decrease in interest rates:
Using the duration model, the relationship between the prediction error and the direction of the i
the level of interest rates, the higher a bond’s price sensitivity to interest rate changes.

#2. Describe the relationship between the prediction error and the magnitude of the interest rate change. Is this consistent
Change of 50 bps:
The amount of interest change and the prediction error for +50 and -50 is -$38.40 and $39.39, res
bonds. The formula is consistent with the Figure 3-7.
Change of 100 bps:
The amount of interest change and the prediction error for +50 and -100 is -$74.77 and $80.19, re
bonds. The formula is consistent with the Figure 3-7.
 predict the change in bond prices based on a specific change in interest rates. For example, let's say we want to know the
an estimate the change in bond price using duration.

n is based on a linear model, but the true relationship between bond prices and interest rates is not linear. The purpose of
ee graphically in Figure 3-7 in the textbook.

terest rates changes. These prices represent the points along the bold black curve in Figure 3-7.

uration, and then use each to estimate or predict what the bond price will be given the same interest rate scenarios from the
n Model.

terest rate change and (2) the size of the interest rate change.

Scenarios
Scenario 2 Scenario 3 Scenario 4 #1 50 bps increase
1/6/2021 1/6/2021 1/6/2021 #2 50 bps decrease
2/1/2028 2/1/2028 2/1/2028 #3 100 bps increase
1000 1000 1000 #4 100 bps decrease
7.125% 7.125% 7.125%
2 2 2
1.5990% 3.0990% 1.0990%
-0.50% 1.00% -1.00% These are the true
bond prices after the
1368.00 1253.84 1408.79 interest rate changes.
39.39 (74.77) 80.19

Scenario 2 Scenario 3 Scenario 4

-0.50% 1.00% -1.00%
37.836265168 -75.672530336 75.67253034
1.55 0.91 4.52

n this cell, you'll take the difference

etween the true bond price calculated in
art 1 for each scenario and subtract it
om the predict bond price estimated in
art 2 for each scenario.

ange. Is this consistent with Figure 3-7?

r and the direction of the interest change is convex. The higher
st rate changes.

r and the direction of the interest change is convex. The lower

t rate changes.

change. Is this consistent with Figure 3-7?

is -$38.40 and $39.39, respectively in the market value of

0 is -$74.77 and $80.19, respectively in the market value of

want to know the

ar. The purpose of

e scenarios from the

FINA 4400: Financial Markets and Institutions

Help Topics

THE PV FUNCTION
The present value formula, PV, "returns the present value of an investment," or "the total
amount a series of future payments is worth now." Examples include the present value
of a loan to the lender or the present value of $100 received from an investment a number
of years from now.

The syntax for this formula is:

PV(rate,nper,pmt,fv,type)

The first three variables in this function are required. Rate is the interest rate per period.
Remember that rate must be for the actual period. For example, a 10 percent annual
interest rate is equivalent to 10%/12, or 0.0083 per month.

Nper is the total number of payment periods. For example, a four year monthly loan
would have 48 periods. Pmt is the constant amount received or paid each period.

In many cases, this function can also be completed by typing in the formula for the
present value of a cash flow. See the example below.

Interest Rate 7%
Periods 3
Cash Flow 100
Present Value =C27/(1+$C$25)^c26
Present Value 81.63

THE FV FUNCTION
The future value function, FV, "returns the future value of an investment," or the total
amount a single investment or series payments will be worth in the future. Examples include the
of an investment in a CD at the bank.

The syntax for this formula is:

FV(rate,nper,pmt,pv,type)

The first three variables in this function are required. Rate is the interest rate per period.
Remember that rate must be for the actual period. For example, a 10 percent annual
interest rate is equivalent to 10%/12, or 0.0083 per month.
Nper is the total number of payment periods. For example, a four year monthly loan
would have 48 periods. Pmt is the constant amount received or paid each period; enter 0 here
if you are calculating the future value of a lump sum and place that amount under pv.

In many cases, this function can also be completed by typing in the formula for the
future value of a cash flow. See the example below.

Interest Rate 7%
Periods 3
Cash Flow 100
Present Value =C53*(1+$C$51)^c52
Present Value 122.50

THE RATE FUNCTION

Use Excel's RATE function to find the interest rate for a given payment and period.
The syntax for this formula is:
RATE(nper,pmt,pv,fv,type,guess)

The first three variables are required:

Nper is the total number of payment periods. For example, a four year monthly loan
would have 48 periods. Pmt is the constant amount received or paid each period.
pv is the the current value of the annuity (this value is entered as a negative, or outflow).

For example, suppose someone is willing to sell you a ten year annuity paying $15 each year for
What is the rate of return on this annuity?

Periods 10
Cash Flow -15
Present Value 80

Interest Rate 13%

THE (Macauley) DURATION FUNCTION

DURATION(settlement,maturity,coupon, yld, frequency, [basis])
The first five variables are requried:
Settlement is the day that the new bondholder assumes ownership of the bond.
Coupon is the securities annual coupon rate. Enter this as a percent.
Yld is the securities annual yield.
Frequency is the number of coupon payments per year. Annual frequency =1; semiannual frequ
Basis is optional, but refers to the type of day count for accrued interest.

THE (Modified Macauley) DURATION FUNCTION

MDURATION(settlement,maturity,coupon, yld, frequency, [basis])
The first five variables are requried:
Settlement is the day that the new bondholder assumes ownership of the bond.
Coupon is the securities annual coupon rate. Enter this as a percent.
Yld is the securities annual yield.
Frequency is the number of coupon payments per year. Annual frequency =1; semiannual frequ
Basis is optional, but refers to the type of day count for accrued interest.

Note: For both duration formula the security has an assumed par value of $100

ENTERING FORMULAS IN EXCEL

Select the cell in which you want to enter the formula and type an equal sign.
Enter the formula using standard formula operoters such as plus (+) and minus (-). For multiplica
Use a forward slash (/) for division; and the caret (^) for exponents.

You control the order of calculation by using parentheses to group operations that should be perf

One of the best uses of formulas is a reference to another cell. The cell that contains the formula
as a dependent cell when its value depends on the values in other cells.
For example, the formula in the cell below calculates a value depending on what is entered in the
25 50
ment," or "the total
he present value
vestment a number

st rate per period.

ercent annual

monthly loan
ach period.

mula for the

t," or the total

re. Examples include the future value

st rate per period.

ercent annual
 monthly loan
ach period; enter 0 here
ount under pv.

mula for the

and period.

monthly loan
ach period.
ative, or outflow).

paying $15 each year for $80.

ncy =1; semiannual frequency =2; quarterly frequency=4

ncy =1; semiannual frequency =2; quarterly frequency=4

d minus (-). For multiplication use (*).

ations that should be performed first.

that contains the formula is known

g on what is entered in the cell to its right.