Midterm Exam (27 Marks)

Submit your typewritten solutions in MS Word file. Name your file as first name_last name.doc. Show your
complete solution to get full marks and work independently. Each day of late submission will merit a deduction
of 2 points from your raw score. Deadline: Saturday November 22 11:59 am
1. (3 Marks) A pension fund projects its cash flow obligations to be constant at $5Mln for the next 10
years and then grow by 5% in perpetuity starting year 11. Assume that interest rates are constant at 4%
for the next ten years and will then increase to 6% from year 11 onwards. Determine the present value of
the pension fund obligations. (Hint: You may want to divide the cash flows into the annuity and the
growing perpetuity component.)

1.) PV of Annuity = 5,000,000 [ 1/0.04 – 1/0.04(1 + 0.04)^10] = $ 40,554,478.9

2.) PV of Growing Perpetuity = 5,000,000 / (-0.06 – 0.05) = $ 500,000,000

2. (3 Marks) You are given the following information about the prevailing spot and forward rates:

2-Year Spot Rate (r2) 5%

Forward Rate between Year 1 6%
and Year 2 (1f1)
Forward Rate between Year 1 7%
and Year 3 (1f2)

Determine the 3-Year Spot Rate. (Hint: You may need to derive the 1-year spot rate first using the
forward rate formula discussed in class.)

1.) For Year-1 Spot Rate:

a.) (1 + 0.06)^1 = (1 + 0.05)^2 / (1 + x )^1
b.) 1.06 = 1.1025 / 1 + x
c.) (1 + x) (1.06) = 1.1025
d.) 1 + x = 1.1025 / 1.06
e.) 1 + x = 1.0401
f.) x = 1.0401 – 1.0000 = 0.0401 or 4.01% is the 1-Year Spot Rate

2.) For Year-3 Spot Rate:

a. (1 + 0.07)^2 = (1 + x)^3 / (1 + 0.0401)^1
b. 1.1449 = (1 + x)^3 / 1.0401
c. (1.0401) (1.1449) = (1 + x)^3
d. 1.1908 = (1 + x)^3
e. (1.1908) ^ (1/3) = 1 + x
f. 1.0599 = 1 + x
g. x = 1.0599 – 1.0000 = 0.0599 or 5.99 % is the 3-Year Spot Rate

3. (3 Marks) The Chief Operations Officer (COO) of a manufacturing firm recommends one of the
manufacturing sites to undergo a process improvement initiative. He claims that this project will enable
the company to realize a net savings of at least $3.25 Mln. The Chief Financial Officer (CFO) of the
company tasked you to conduct a financial analysis to verify the claims of the COO. After performing
cost analysis, you estimated that the project will require an initial investment of $2 Mln today and $1
Mln in Year 1. Afterwards, the initiative will yield an annual cost savings of $850k from Year 2 to Year
10. You assume that these cost savings are realized at the end of each year.
 Years Solutions PV of Cash Flows
0 - 2000000/(1+0.05)^0 $ (2,000,000.0000)
1 -1000000/(1+0.05)^1 $ (952,380.9524)
2 850000/(1+0.05)^2 $ 770,975.0567
3 850000/(1+0.05)^3 $ 734,261.9588
4 850000/(1+0.05)^4 $ 699,297.1036
5 850000/(1+0.05)^5 $ 665,997.2415
6 850000/(1+0.05)^6 $ 634,283.0871
7 850000/(1+0.05)^7 $ 604,079.1306
8 850000/(1+0.05)^8 $ 575,313.4577
9 850000/(1+0.05)^9 $ 547,917.5788
10 850000/(1+0.05)^10 $ 521,826.2655
TOTAL $ 2,801,569.9279

a. (1 Mark) Suppose that you use a discount rate of 5%. Will the resulting net savings support the
claim of the COO?

No, the resulting net savings will not support the claim of the COO. After determining the current
value of all future cash flows generated by the project, including the initial investments, the net savings
of the project will result to $ 2,801,569.9279 approximately.

b. (1 Mark) Determine the Internal Rate of Return (IRR) of the process improvement initiative.
NPV = -2,000,000 – [ 1,000,000/(1+x) ] + [ 850,000/(1+ x)^2 ] + [ 850,000/(1+ x)^3 ] + [ 850,000/(1+ x)^4 ] +
[850,000/(1+ x)^5] + [ 850,000/(1+ x)^6 ] + [ 850,000/(1+ x)^7 ] + [ 850,000/(1+ x)^8 ] + [ 850,000/(1+ x)^9 ] +
[850,000/(1+ x)^10 ]

1.) 0 = -2,000,000 – [ 1,000,000/(1+x) ] + [ 850,000/(1+ x)^2 ] + [ 850,000/(1+ x)^3 ] + [ 850,000/(1+ x)^4 ] +

[850,000/(1+ x)^5] + [ 850,000/(1+ x)^6 ] + [ 850,000/(1+ x)^7 ] + [ 850,000/(1+ x)^8 ] + [ 850,000/(1+ x)^9 ]
+ [850,000/(1+ x)^10 ]

2.) Internal Rate of Return (IRR) = 20.2041%

c. (1 Mark) Show the NPV profile of the project.

Net Present Value of a Project

6,000,000.0000

5,000,000.0000

4,000,000.0000

3,000,000.0000
Net Present Value

2,000,000.0000

1,000,000.0000

-
0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%
(1,000,000.0000) 0.0 5.0 0.0 5.0 0.0 5.0 0.0 5.0 0.0 5.0 0.0 5.0 0.0 5.0 0.0 5.0 0.0 5.0 0.0
1 1 2 2 3 3 4 4 5 6 7 7 8 8 9 9 10
(2,000,000.0000)

(3,000,000.0000)
Discount Rates

Discount Rates Net Present Value

0.00% 4,650,000.0000
 5.00% 2,801,569.9279
10.00% 1,541,063.8580
15.00% 657,257.6798
20.00% 21,934.6061
25.00% (445,072.2202)
30.00% (795,268.3489)
35.00% (1,062,583.9954)
40.00% (1,269,893.2491)
45.00% (1,432,948.6725)
50.00% (1,562,813.9342)
65.00% (1,822,262.9272)
70.00% (1,879,972.8407)
75.00% (1,928,016.5690)
80.00% (1,968,253.5788)
85.00% (2,002,129.5249)
90.00% (2,030,780.1905)
95.00% (2,055,106.6162)
100.00% (2,075,830.0781)

4. (3 Marks) An annual coupon bond that matures in 3 years and pays a 4% coupon rate is currently
valued at 97.564. 1-year and 2-year spot rates are 3.5% and 4.5%, respectively. Compute for the implied
3-year spot rate.

 Annual Coupon Payments = 100 × (0.04/1) = 4 per year

1.) Implied Spot Rate for Year 3:

a) 97.564 = 4 / (1 + 0.035) ^ 1 + 4 / (1 + 0.045) ^ 2 + 104 / (1 + x) ^ 3
b) 97.564 = 3.8647 + 3.6629 + 104 / (1 + x)^3
c) 97.564 = 7.5277 + 104 / (1 + x) ^ 3
d) 97.564 – 7.5277 = 104 / (1 + x) ^ 3
e) 90.0364 = 104 / (1 + x) ^ 3
f) 90.0364 = 104 / (1 + x) ^ 3
g) [(1 + x) ^ 3] (90.0364 ) = 104
h) (1 + x) ^ 3 = 104 / 90.0364
i) (1 + x) ^ 3 = 1.1551
j) 1 + x = (1.1551) ^ (1/3)
k) 1 + x = 1.0492
l) x = 1.0492 – 1.0000 = 0.0492 or 4.92% is the Implied Spot Rate for Year 3

5. (3 Marks) You are interested in buying a semiannual coupon bond that matures in 2 years and pays a
nominal coupon rate of 6%. You have the following information about the relevant spot rates:

6-month spot rate (r0.5) 3%

1-year spot rate (r1) 5%
18-month spot rate (r1.5) 4.5%
2-year spot rate (r2) 6%

Determine the fair price of the bond.

 Semi-annual coupon payments = 100 × ( 0.06/2) = $ 3 per year

 YTM (in years) = 2
 Number of semi-annual periods = 4
 Years Solutions Annual Coupon Payments
1 = 3 / [1 + (0.03/2)] ^ 1 $2.9557
2 = 3 / [1 + (0.05/2)] ^ 2 $2.8554
3 = 3 / [1 + (0.045/2)] ^ 3 $2.8063
4 = 103 / [1 + (0.06/2)] ^ 4 $91.5142
TOTAL $100.1316

6. (3 Marks) A bond dealer is trading a 3% semi-annual coupon bond that has a remaining life of 4 years.
Suppose that he bought the bond at a yield-to-maturity (YTM) of 5% and immediately sold it at a YTM
of 4.75%. How much profit did he make for each 100-unit face value of the bond?

2.) Bond that is Purchased at YTM of 5%:

 Annual Coupon Payments = 100 × (0.03/2) = $1.5 per year

 YTM = 0.05/2 = 0.025
 n = 4 × 2 = 8 periods

a. Bond Price = [ 1.5 × (1 – 1/(1 + 0.025) ^ 8 / 0.025) ] + [ 100 × 1/(1 + 0.025) ^ 8) ]

b. Bond Price = 1.4692 + 82.0747
c. Bond Price = $83.5439 is the Bond Price bought at YTM of 5%

3.) Bond that is Sold at YTM of 4.75%:

 Annual Coupon Payments = 100 × (0.03/2) = $1.5 per year

 YTM = 0.0475/2 = 0.02375
 n = 4 × 2 = 8 periods

a. Bond Price = [ 1.5 × (1 – 1/(1 + 0.0238) ^ 8 / 0.0238) ] + [ 100 × 1/(1 + 0.0238) ^ 8) ]

b. [ 1.5 × (1 – 1/(50.7159) ] + [ 100 × 1/(1 + 0.0238) ^ 8) ]
c. Bond Price = 1.4704 + 82.8474
d. Bond Price = $84.3179, which is the bond price sold at YTM of 4.75%

Profit = $84.3179– $83.5439 = $0.7740 (profit) for each 100-unit face value of the bond

7. (3 Marks) Consider a semiannual coupon bond with a YTM of 5%, coupon rate of 4%, and remaining
life of 3 years.
YTM (y) 0.025 Coupon Rate 0.02 Coupon Payment Frequency 2
t DF CF DF × CF Weight Weight × t Weight × t × (t + 1)
1 0.9756 2 1.9512 2.01% 0.0201 0.0401
2 0.9518 2 1.9036 1.96% 0.0392 0.1175
3 0.9286 2 1.8572 1.91% 0.0573 0.2292
4 0.9060 2 1.8119 1.86% 0.0745 0.3726
5 0.8839 2 1.7677 1.82% 0.0909 0.5453
6 0.8623 102 87.9543 90.45% 5.4267 37.9870
Macaulay Duration
Bond Price 97.2459 2.8543
    (in Years)  
        Modified Duration 2.7847  
        Convexity 37.3984  

a. (1 Mark) Determine the Macaulay Duration of the bond.

 The D (y) or Macaulay Duration is 2.8543 (in Years)

b. (1 Mark) Determine the Modified Duration of the bond.

The D*(y) or the Modified Duration = 2.8543 / (1+(0.05/2)) = 2.7847

c. (1 Mark) If the bond has a convexity of 54.25, by how much will the bond price change if yields went
up by 0.25%?

1.) ΔP(y) = - (97.2459) [(2.7847)*(0.0025) + 0.5(54.25)*(0.0025)^2] = - 0.6935

2.) The bond price will go down by – 0.6935. Thus, the estimated bond price will be 97.2459 – 0.6935
= 96.5524

8. (3 Marks) A commercial bank has the following bond investments:

Bond Face Value Bond Price Remaining Modified Convexity

Life (in Yrs) Duration
A 1,500,000 98.65 2.35 3.25 22.56
B 2,250,000 101.45 3.24 3.78 29.76
C 1,050,000 96.55 4.01 4.23 34.56
D 2,425,000 94.56 4.17 5.04 55.67

a. What is the overall market value of the bond investments?

Bond Face Value Bond Price Market Value
A 1,500,000 98.65 1,479,750
B 2,250,000 101.45 2,282,625
C 1,050,000 96.55 1,013,775
D 2,425,000 94.56 2,293,080
Market Value 7,069,230

b. Determine the average modified duration and convexity of the bond investment.
Portfolio
Bond Modified Duration Weight × D*(y)
Allocation
A 0.2093 3.25 0.6803
B 0.3229 3.78 1.2205
C 0.1434 4.23 0.6066
D 0.3244 5.04 1.6348
Average Modified
4.1423
Duration

Portfolio
Bond Convexity Weight × C(y)
Allocation
A 0.2093 22.56 4.7223
B 0.3229 29.76 9.6094
C 0.1434 34.56 4.9561
D 0.3244 55.67 18.0579
Average
37. 3458
Convexity

c. By how much will the overall value of the bond investments change if yields went up by 0.25%?

Δ P(y) = - (7,069,230) [(4.1423)(0.25%) + (0.5)( 37.3458)(0.25%)^2] = -74,032.1975

 This means that estimated value of the fund with 0.25% increase in YTM must be 7,069,230 –
74,032.1975 = 6, 995, 197. 8025

9. (3 Marks) A pension fund has the following liability obligations to its pensioners:

Liability Market Value Modified Duration

A $4.25 Bln 6.25
B $5.75 Bln 8.05
C $3.50 Bln 7.55

1.) Market Duration of Liabilities:

Market Value Modified Duration Market Value × D*(y)
4,250,000,000 6.25 $ 26,562,500,000
5,750,000,000 8.05 $ 46,287,500,000.00
3,500,000,000 7.55 $ 26,425,000,000.00
Market Duration of
$ 99,275,000,000
Liabilities

It has $13.50 Bln available cash to invest in the following bonds:

Bond Modified Duration

D 5.25
E 11.86

2.) Market Value Duration of Bonds = (XD × 5.25) + (XE × 11.86)

Set up the system of equations to determine how much of its available cash should the pension fund
invest in the two bonds to ensure that the market value duration of assets will match the market value
duration of liabilities.

Equation (1) : XD + XE = $ 13, 500, 000, 000

Equation (2) : (XD × 5.25) + (XE × 11.86) = $ 99, 275, 000, 000