FIN 7810 Homework 3

Qiguang Wang

1. Consider the following quoted prices on discount bonds

Maturity (year) 1/4 1/2 1 2 5

Price 0.991 0.983 0.967 0.927 0.797

(a) Calculate the holding-period return for each discount bond.

Solution:
1−B
HPR =
B
[2 points]
Therefore,
HPR1/4 = (1 − 0.991)/0.991 = 0.9082%
HPR1/2 = (1 − 0.983)/0.983 = 1.7294%
HPR1 = (1 − 0.967)/0.967 = 3.4126%
HPR2 = (1 − 0.927)/0.927 = 7.8749%
HPR5 = (1 − 0.797)/0.797 = 25.4705%

(b) Calculate EAR for each bond.

Solution:
Note that APR = HPR × n, therefore,

n
EAR = 1 + HPR1/n −1

EAR1/4 = (1 + 0.009082)4 − 1 = 3.6825%

EAR1/2 = (1 + 0.017294)2 − 1 = 3.4887%
EAR1 = (1 + 0.034126)1 − 1 = 3.4126%
EAR2 = (1 + 0.078749)1/2 − 1 = 3.8628%
EAR5 = (1 + 0.254705)1/5 − 1 = 4.6426%

(c) Assume that a bond pays three coupons: $10 coupon every six months for year
One and $20 coupon at the end of year Two. The bond matures in five years. It’s
par value is $1000. What is the price of this coupon bond?
Solution:

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 The cash flow of this coupon bond can be replicated by 10 units of B1/2 , 10 units
of B1 , 20 units of B2 , and 1000 units of B5 .
Therefore, its price is

B = (10)(0.983) + (10)(0.967) + (20)(0.927) + (1000)(0.797) = $835.04

(d) Looking at the spot interest rates implied by these discount bonds, Mr Levi wants
to lock in the rate between year Two and year Five. If he will receive $1,000 two
years from today and want to invest it for three years with the locked-in rate, what
is the total investment return in dollars from this investment?[Hint: consider the
forward rate ft and what does (1 + ft )(1 + ft+1 )(1 + ft+2 ) represent? And how
can you calculate this using discount bonds?] [6 points]
Solution:
The locked-in rate is simply (1 + f3 )(1 + f4 )(1 + f5 ) − 1, this is the forward rate
between year Two and Five. Noticing that 1 + ft = Bt−1 /Bt , we have

B2 B3 B4 B2 0.927
(1 + f3 )(1 + f4 )(1 + f5 ) − 1 = −1= −1= − 1 = 16.31%
B3 B4 B5 B5 0.797

Therefore, total return in year Five is

(1000)(1 + 0.1631) = $1, 163.1

(e) What can Mr Levi do today to lock in the investment cashflows in (d)? Assume
he can only trade on discount bonds. Numerical results required.
Solution:
The investment cash flows are as follows: -$1,000 at year Two and $1043.15 at
year Five.

Year 0 1 2 3-4 5
Sell 2-yr XB2 0 −X 0 0
Buy 5-yr −XB2 0 0 0 XB2 /B5
Total 0 0 −X 0 XBt−1 /Bt+1

Plug-in X = $1, 000, we have

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 Year 0 1 2 3-4 5
Sell 2-yr $927 0 $1,000 0 0
Buy 5-yr -$927 0 0 0 $1,163.1
Total 0 0 -$1,000 0 $1,163.1

2. Visit the U.S. Department of the Treasury website1 for latest treasury yields and their
historical values. Make sure you select Daily Treasury Yield Curve Rates.
(a) What are the yields for all treasury securities on the Oct 1, 2021? Draw the term
structure of interest rate for the same day.
Solution:

Maturity 1M 2M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 20Y 30Y

10/01/21 0.08 0.04 0.04 0.05 0.09 0.27 0.49 0.93 1.26 1.48 1.99 2.04

(b) What are the prices of a 28-day, 91-day, and 182-day T-bill on that day? Assuming
$100 face value. [Hint: you should be able to calculate the T-bill price using
the quoted yield. But pay special attention to the yield quoting convention for
treasury securities.]
Solution:
100 − B 365
Yield = ×
B Days to Maturity
Therefore, 0.08% = 100−B
B
365
28
⇒ B28−day = $99.9938. Similarly, B91−day =
$99.9900 and B182−day = $99.9750.

(c) Given these quoted yields, can you calculate the prices for the 2-year note, 5-year
note, 10-year note, and 30-year bond, assuming all of them pay 7% coupon and
have face value of $100? Explain why?
Solution: No. Since these yields are averaged across a number of different coupon
bonds, the YTMs are not equal to spot interest rates.

(d) Now assume that these yields are calculated from zero coupon treasury securities,
repeat (c) if you can. If you still cannot calculate these prices, explain why.
Treasury quoting convention is assumed.
Solution: No, the prices of above coupon bonds cannot be calculated accurately.
With zero coupon bond yields, annual spot interest rate can be calculated. Spot
interest rates (EAR) can be calculated for
• 1-month, 2mont, 3-month, 6-month (using T-bill prices and convert yields to
EAR)
1
https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

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 AP R 365/28
– for 1-month, EAR sport interest rate s28−day = (1 + 365/28 ) −1 =
0.08% 365/28
(1 + 365/28 ) − 1 = 0.08003%
– Note: T-bill yields are basically APRs.
• 1-year, 2-year, 3-year, 5-year, 7-year, 10-year, 20-year, 30-year using zero
coupon bond prices.
– For example, (1 + s2 )2 = (1 + 0.27%/2)4 and s2 = 0.27018%.
However, the cash flows of the coupon bonds occur every 6-month. Therefore we
need spot rates for
• 1-year, 2-year, 3-year, 4-year, 5-year, 6-year, ..., 28-year, 29-year, and 30-year
to discount year-end cash flows;
• 6-month, 18-month, 30-month, ..., 354-month, and 360-month intervals to
discount coupons paid out at the middle of each year.
As you can see, we are missing a lot of sport rates to correctly calculate coupon
bonds.
However, if we assume the above prices (with maturity above 1 year)
are calculated all based on 7% coupon bonds, we can conduct the fol-
lowing calculation to evaluate prices.

Using 6-month interval and adjust coupon and yield accordingly:

3.5 3.5 3.5 + 100
B2Y = + + · · · + = $113.41
1 + 0.27%/2 (1 + 0.27%/2)2 (1 + 0.27%/2)4
3.5 3.5 3.5 + 100
B5Y = + 2
+ ··· + = $129.59
1 + 0.93%/2 (1 + 0.93%/2) (1 + 2.51%/2)10
3.5 3.5 3.5 + 100
B10Y = + 2
+ ··· + = $151.13
1 + 1.48%/2 (1 + 1.48%/2) (1 + 2.69%/2)20
3.5 3.5 3.5 + 100
B30Y = + 2
+ ··· + = $210.88
1 + 2.04%/2 (1 + 2.04%/2) (1 + 2.04%/2)60
Accurately calculating a coupon bond with different coupon rates than those
traded in the market is usually very difficult. But if the bond you are trying
to price has roughly the same coupon rate as compared to those traded in the
market, then the above calculation can be used to get an approximate value for
its price.

(e) Repeat (a) for July 17, 2000.

Solution:

Maturity 1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 20Y 30Y

07/17/00 NA 6.15 6.30 6.14 6.46 6.40 6.31 6.35 6.17 6.30 5.93

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 (f) Compare term structures from (a) and (e), how do they differ?
Solution: The term structure on July 17, 2000 exhibits the so-called “inverted”
or flat yield curve, meaning that yield tend to decreases with maturity. On the
other hand, the term structure on Dec 31, 2018 looks relatively normal, and yield
increases with maturity.

(g) Use the interactive tool found here2 , how does the term structure usually look like
in the sample period from 2000 to 2017? How many major stock market recessions
can you identify? Do you notice any abnormal behavior of term structure before
market crashes?
Solution: The term structure typically is upward slopping: yields increase with
maturities. There are two major stock market recessions. One is in early 2000
after the Internet Bubble. The other is 2008 financial crisis. The term structure
became inverted prior to both recessions.

(h) On July 17, 2000, calculate the forward interest rate f2 and f3 . If the forward rate
is the market’s expectation of future 1-year spot rates, does market predict future
1-year interest rate to go up or go down based on your comparison between f2 and
f3 ? [Hint, from treasury yield, you can find out 2-year spot rate and 3-year spot
rate. However, treasury yields are not effective annual rates. But for simplicity,
you do not have to convert them to EAR; you can directly use them as spot rates
to calcualte forward rates.]
Solution:
(1 + r2 )2
f2 = − 1 = 6.78%
(1 + r1 )
(1 + r3 )3
f3 = − 1 = 6.28%
(1 + r1 )2
f2 (f3 ) is the market expectation of the 1-year spot rate one (two) year from July
17, 2000. Since f2 > f3 , the market expects that the 1-year spot rate decreases
in the future.

(i) Read this article3 , and explain in your own words why inverted yield curve predicts
a recession.
Solution: If the yield curve is inverted, it means that the forward rates are de-
creasing. This reflect the market expectation of future 1-year spot rates. And
market is believing that future short-term interest rates are decreasing. Short-
term interest rates are typically low when the market is in recessions. This is
because the Federal Reserve employs the monetary policy to stimulate the econ-
omy by making borrowing money cheaper. Fed lowers the short-term interest
rate by buying back the short-term treasury securities from investors. This drive
2
http://stockcharts.com/freecharts/yieldcurve.php
3
https://www.thebalance.com/inverted-yield-curve-3305856

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 up the prices and therefore lowers the interest rate. Consequently, if the term
structure is inverted, the market is expecting a recession and Fed intervention.

3. A bond has the par value $1000. The yield to maturity is 2% anuually. The bond pays
$20 coupon annually. The maturity of the bond is 5 years, in the end of which the
bond pays back the par value.

(a) What is the price of the bond?

Solution: B = $1, 000. In general, if yield is equal to coupon rate, then the price
is equal to the par value.

(b) What are the duration and the modified duration of this bond?
Solution:
T
1 X CFt
D= × t = 4.808
B t=1 (1 + y)t
MD = D/(1 + y) = 4.713.

(c) If the yield increases from 2% to 2.1%, what is the price change based on modified
duration?
Solution:
∂B
= −MD · ∂y = −(4.713)(0.1%) = −0.4713%.
B
δB = (−0.4713%) ∗ (1000) = −$4.713.

(d) What is the actual price change? [Hint, recalculate the price of the bond using
2.1% yield].
Solution: When y = 2.1%, B = $995.30. And the price change is -$4.7.

(e) Do (c) and (d) differ a lot?

Solution: No. They are very close.

(f) Repeat (c)-(e), assuming that the yield increased from 2% to 4%.
Solution: When y = 4%, the new price is B = $910.96 and the actual price
change is -$89.04. Using modified duration, the approximate change is -(4.713)
(2%) (1000)= -$94.26.

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(g) Can you reliably rely on (modified) duration method to estimate price changes
when the yield moves a lot? Why? [Hint: Using the fact that modified duration
is the first-order derivative of the bond price as a function of the yiled. Combine
this with Taylor expansion.]
Solution: No. Modified duration method is essentially a first-order approxima-
tion. We can apply Taylor expansion to the price B. Let y be the current yield,
and ∂y be the yield change. Then the bond price at the new yield y + ∆y is given
by:
00
0 B (y)
B(y + ∆y) = B(y) + B (y)∆y + (∆y)2 + · · ·
2
When ∆y is small, (∆y)2 and its higher power becomes extremely small compared
to ∂y. So the third component and all components afterwards can safely ignored.
Thus, the price change becomes B 0 (y)∆y = −MD · B, which is exactly what the
modified duration method does. However, when ∆y is large, then we need the
third component and possibly higher order components thereafter to achieve a
good approximation.

(h) What are the duration and the modified duration of a 4-year discount bond,
assuming a flat term structure (i.e., spot rates are equal to 2% at all matures)?
Solution: D = 4 and MD = 4/1.02 = 3.922.

(i) You can include the 4-year discount bond to your portfolio in order to hedge
interest risk. Describe your portfolio composition.
Solution: Short $x of 4-year discount bond: x · 4 = (1000)(4.808). We have
x = $1, 202. Long $1,000 of the 5-year coupon bond and short $1,202 of the
4-year discount bond.

(j) When the yield change from 2.0% to 2.1%, how much does each position in your
portfolio change in value? How much does the portfolio change in value?
Solution:
Change in the long position: -(1000)(0.1%)(-4.713) = -$4.713.
Change in the short position: -(-1200)(0.1%)(3.922) = $4.706.
They cancel out almost perfectly.

(k) Realistically, interest rates at different maturities do not move up and down at
the same time; and even when they do, they move by different amounts. Now
assume that 4-year yield increases from 2% to 2.2% whereas the 5-year yield only
increases from 2% to 2.1%. In this scenario, what is the change in value of your
portfolio based on modified duration?
Solution:
Change in the long position: -(1000)(0.1%)(-4.713) = -$4.713.
Change in the short position: -(-1200)(0.2%)(3.922) = $9.4128.
The net change is $4.6998. With non-parallel shifts in yield curves, duration
hedging becomes less effective.