Case study 1 consists of a series of problems and a short case study from the Harvard Business

Publishing (Education). The main goal of this exercise is to solidify your understanding of interest
rates.

Problem 1 (1.5 points) - understanding how to compute duration

Consider two bonds: bond XY and bond ZW. Bond XY has a face value of $1,000 and 10 years to
maturity and has just been issued at par. It bears the current market interest rate of 7% (i.e. this
is the yield to maturity for this bond). Bond ZW was issued 5 years ago when interest rates were
much higher. Bond ZW has face value of $1,000 and pays a 13% coupon rate. When issued, this
bond had a 15-year, so today its remaining maturity is 10 years. Both bonds make annual coupon
payments.

a) (0.5 points) What is the price of Bond ZW, given that market interest rates are 7%?
Price of bond ZW：
Face value = 1000, and market Interest rate (i) = 7%, Coupon rate = 13%, Coupon Amount =
1000*13%= 130, Years to maturity (n)= 10
So use Excel function = -PV(market Interest rate, number of periods, coupon Amount, face value)
Bond price=-PV(7%,10,130,1000)= $1,421.41

b) (1.0 points) Compute the duration for both bonds (use Excel).

Formula:duration for bond ZW: =ROUND(DURATION(B9,B10,B3,B5,1),4)

Formula:duration for bond XY: =ROUND(DURATION(B9,B10,D3,D5,1),4)

Problem 2 (3.0 points) - understanding the determinants of duration

In this exercise, you are going to analyze first the relationship between interest rates and bond
prices, and then the effect of time to maturity, interest rates and coupon rates on duration.

a) (1.0 points) First, consider a 10 year bond with a coupon rate of 7% and annual coupon
payments. Draw a graph showing the relationship between the price and the interest on this
bond. The price should be on the y-axis and the interest rate on the x-axis. To compute the
various prices, consider interest rates between 2% and 12% (use 0.5% increments). So your x-axis
should go from 2%, then 2.5% … until 11.5% and then 12%.
As we know, n=10 years, coupon rate=7%, coupon payments=70, Face Value=$ 1,000.00
So, when Interest Rate=2.00%, Price=$ 1,449.13, and then:
Int Rate 2.00% Price $ 1,449.13
2.50% $ 1,393.84
3.00% $ 1,341.21
3.50% $ 1,291.08
4.00% $ 1,243.33
4.50% $ 1,197.82
5.00% $ 1,154.43
5.50% $ 1,113.06
6.00% $ 1,073.60
6.50% $ 1,035.94
7.00% $ 1,000.00
7.50% $ 965.68
8.00% $ 932.90
8.50% $ 901.58
9.00% $ 871.65
9.50% $ 843.03
10.00% $ 815.66
10.50% $ 789.48
11.00% $ 764.43
11.50% $ 740.45
12.00% $ 717.49

Is the relationship linear (i.e. is the slope constant)? Start at 7%. If interest rates go up or down
by 0.5% is the price changing by the same amount? What type of relationship do we observe
between prices and interest rates (liner, concave, convex or something else)?
Compute =PV(rate,nper,pmt,fv,type) using excel by putting rate=2.00% which increases each
round by 0.5%

nper=10 years and do absolute referencing

Pmt = $1000*7%= $70 and do it absolute referencing.

Fv as $1000 and press Enter.

Below is the graph showing int rate on x-axis and price on y-axis.

Calculating the slope from 0.5% increase form 7% we get= (965.68-1000)/(7.50%-7.00%)=-

6864.08

Calculating the slope from 0.5%decrease from 7%, we get=(1000-965.68)/(7.00%-7.50%)=-

6864.08

Likewise, we can calculate for each 0.5% increase or decrease in interest rate what effect it has on
the price

the relationship is Linear and the slope is constant.

As it is not a straightline, the relationship is not linear, i.e. slope is not constant.
Starting at 7% when the interest rates go up or down by 0.5% the price is not changing by the
same amount, as we can see in the data table and graph above
The relationship is convex to the origin.

b) (0.5 points) Now consider the same bond with 10 year maturity, a face value or $1,000, a
coupon rate of 7% (coupon is paid annually) and assume that the yield to maturity on the bond is
7%. Compute the duration of this bond.
As we know, Face Value of the Bonds = $1000, so Coupon Interest = $70, Maturity Period = 10
Years, YTM = 7%
Besides, the Coupon rate = YTM, then the duration of the Bonds = Life of The Bond
Therefore Duration of this bond = 10 Years
C) (0.5 points) Next, we are going to analyze the effect of time to maturity on the duration of the
bond. Compute the duration of a bond with a face value of $1,000, a coupon rate of 7% (coupon
is paid annually) and a yield to maturity of 7% for maturities of 2 to 18 years in 1-year increments
(so here we are going to vary the time to maturity and see how duration changes if N=2, 3 …
etc.). What happens to duration as maturity increases?
As we know, FV=$1000, coupon rate=7%, yield to maturity=7%, and n=2-18.
Therefore, duration calculated based on PV factor tables.
Maturity Duration
2 1.93
3 2.79
4 3.6
5 4.35
6 5.05
7 5.71
8 6.32
9 6.88
10 7.42
11 7.88
12 8.29
13 8.65
14 8.96
15 9.22
16 9.43
17 9.59
18 9.70

According to this table, we can know that the increase of maturity period, duration also increases,
therefore, maturity and Duration are directly proportionate.

d) (0.5 points) Next, we are going to analyze the effect of the yield to maturity on the duration of
the bond. Compute the duration of a bond with a face value of $1,000, a coupon rate of 7%
(coupon is paid annually) and a maturity of 10 years as the interest rate (or yield to maturity) on
the bond changes from 2% to 12% (consider increments of 1% - so you need to compute the
duration for various yields to maturity 2%, 3%, …, 12%) . What happens to duration as the
interest rate increases?
YTM Duration
2% 7.89
3% 7.8
4% 7.71
5% 7.61
6% 7.52
7% 7.43
8% 7.32
9% 7.23
10% 7.12
11% 7.02
12% 6.91

According to this table, when YTM increases, Duration is decreasing, therefore, YTM and duration are
inversely proportionate.

e) (0.5 points) Finally, we are going to analyze the effect of the coupon payment on the duration
of the bond. Compute the duration of a bond with a face value of $1,000, a maturity of 10 years
and a yield to maturity of 7%. Compute the duration for coupon rates ranging from 2% to 12% (in
increments of 1%). What happens to duration as the coupon rate increases?

Problem 3 (0.5 points) - understating expected value and standard deviation

You own a $1,000 face value, zero-coupon bond that has 5 years of remaining maturity. You plan
on selling the bond in one year and believe that the required yield next year will have the
following probability distribution:

Probability Required Yield

0.1 5.50%

0.1 5.75%

0.6 6.00%

0.1 6.25%

0.1 6.50%

What is your expected price when you sell the bond?

What is the standard deviation?
EXPECTED RETURN = PROBABILITY*RETURN
Face value = $ 1,000
n = 5 – 1 = 4 years
Price = Face value / ( 1+ yield)^n
792.13

Case study (5 points) - understanding the term structure of interest rates

Go to Harvard Business Publishing and buy the following case study:

HBPS case
https://hbsp.harvard.edu/import/939839

After reading the case study, answer the following questions (you also need to find Estrella’s
study from the NY Fed – a link is provided in the case study). Also, you can use other sources as
long as you cite them. To find the current yield curve (as well as historical yield curves you can go
to https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/
textview.aspx?data=yield

Please answer the following questions (your answers should be less than 1000 words or less than
2 pages):
(2 points) Estrella (NY Fed) is quite certain that the yield curve is a good predictor of future
economic activity. From the case, or the link to his FAQs, answer the following questions:
How successful is the yield curve at predicting recessions?
What matters most – the level of the term spread, the change in the spread, or the level of short
term interest rates?
Discuss why a yield curve inversion should lead to a recession.

B. (1.5 points) Dick Berner (Morgan Stanley) is a bit more skeptical about the predictive power of
the yield curve. Does he just not understand Estrella’s overwhelming evidences, or
does his skepticism rest on solid reasoning?

C. (1.5 points) How is the U.S. yield curve currently sloped? What does it affect your forecast of
economic activity?