MATH4512 Fundamental of Mathematical Finance (2021 Spring)

Suggested Solution of Assignment 1

Submission deadline of Assignment 1: 11:59p.m. of 18th Mar, 2022 (Fri)

Instruction: Please complete all required problems. Full details (including (i)
description of methods used and explanation, (ii) key formula and theorem used
and (iii) final answer) must be shown clearly to receive full credits. Marks can be
deducted for incomplete solution or unclear solution. You may earn extra score by
completing some bonus problems. Also, additional score will be given for well-
written assignment.
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deadline. Late assignment will not be accepted.
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assignment.

Problem 1 (Required, 25 marks)

The current spot rates of various maturities are given in the table below.
Term 6 months 12 months 18 months 24 months 30 months 36 months
(0.5 year) (1 year) (1.5 years) (2 years) (2.5 years) (3 years)
Spot rate 2% 2% 2.2% 2.3% 2.3% 2.5%

Term 42 months 48 months 54 months 60 months 66 months 72 months

(3.5 year) (4 years) (4.5 years) (5 years) (5.5 years) (6 years)
Spot rate 2.6% 2.7% 2.7% 2.9% 3% 3.2%
(*Note: All spot rates are quoted as annual effective interest rate)

We consider a 5-year bond. The bond has face value $1200 and coupon rates 5% payable
annually.
Questions
(a) Calculate the annual effective yield rate of the bond.
(b) Hence, calculate the modified duration and modified convexity of the bond with respect
to annual effective yield rate.
(c) Suppose that the spot rates after 30 months are increased uniformly by 0.5%, calculate
the annual effective yield rate of the bond at that time.
(😊Note: In finding the yield rate, you need to present the governing equation (with
explanation) of the yield rate. However, you don’t need to show the calculation on how to solve
those equations.)
 Solution
(a) We let 𝑖 be the annual effective yield rate of the bond. Then the yield rate must satisfy
5
1200(0.05) 1200
𝑃0 = ∑ +
(1 + 𝑖)𝑘 (1 + 𝑖)5
⏟
𝑘=1
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 (𝑢𝑠𝑖𝑛𝑔 𝑦𝑖𝑒𝑙𝑑 𝑟𝑎𝑡𝑒)
1200(0.05) 1200(0.05) 1200(0.05) 1200(0.05) 1200(0.05) + 1200
= 1
+ 2
+ 3
+ +
(1 + 0.02)
⏟ (1 + 0.023) (1 + 0.025) (1 + 0.027)4 (1 + 0.029)5
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 (𝑢𝑠𝑖𝑛𝑔 𝑡𝑒𝑟𝑚 𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒)
≈ 1317.985.
By solving the equation numerically, we have 𝑖 ≈ 0.028616.

(b) Firstly, the Macaulay duration of the bond is computed as

5 1200(0.05) 1200 𝑃0 =1317.985
𝑖=0.028616
(1 + 𝑖)𝑘 (1 + 𝑖)5
𝐷𝑀𝑎𝑐 (𝑖) = ∑ 𝑘 ( )+5 =
⏞ 4.569566.
𝑃0 𝑃0
𝑘=1
1
Thus, the modified duration is given by 𝐷𝑀𝑜𝑑 (𝑖) = 1+𝑖 𝐷𝑀𝑎𝑐 (𝑖) ≈ 4.442442.
On the other hand, the modified convexity is found to be
1200(0.05) 1200
∑5𝑘=1 𝑘(𝑘 + 1) + 5(6)
(1 + 𝑖)𝑘 (1 + 𝑖)5
𝐶𝑀𝑜𝑑 (𝑖) = = 25.11087.
(1 + 𝑖)2 𝑃0

(c) We let 𝑖 ∗ be the annual effective yield rate of the bond after 30 months. Then it is governed
by
1200(0.05) 1200(0.05) 1200(0.05) + 1200
+ +
⏟(1 + 𝑖 ∗ )0.5 (1 + 𝑖 ∗ )1.5 (1 + 𝑖 ∗ )2.5
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 (𝑢𝑠𝑖𝑛𝑔 𝑦𝑖𝑒𝑙𝑑 𝑟𝑎𝑡𝑒)
1200(0.05) 1200(0.05) 1200(0.05) + 1200
= 0.5
+ 1.5
+
(1 + 0.02 + 0.005)
⏟ (1 + 0.022 + 0.005) (1 + 0.023 + 0.005)2.5
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 (𝑢𝑠𝑖𝑛𝑔 𝑡𝑒𝑟𝑚 𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒)
∗
By solving the equation, we have 𝑖 = 0.027943.

Problem 2 (Required, 35 marks)

The following table show the information of three bonds available in the market:
Bond term Annual coupon rate Face value
(coupon frequency)
Bond A 3 years 4% 100
(semi-annual)
Bond B 5 years 5% 100
(annual)
Bond C 10 years Zero coupon 100
The current term structure is assumed to be flat and the annual effective interest rate is
currently 𝑖0 = 4.5%.
An investor has $15000 initially and would like to invest the money into these 3 bonds. You are
given that
 The investment horizon of the investor is 6 years.
 The investor thinks that the interest rate will go down in future and seeking for an
investment that can achieve a return (i.e. IRR) strictly higher than 4.5%.
 On the other hand, the investor requires that the minimum return of this investment is
𝑖𝑚𝑖𝑛 = 4.2% (< 4.5%).
Questions
(a) Suppose that the investor will choose one of the following three bond portfolios:
Capital Invested
Bond A Bond B Bond C
Portfolio 1 $4500 $6000 $4500
Portfolio 2 $10500 $3000 $1500
Portfolio 3 $1500 $4500 $9000
Which portfolio should the investor consider? Explain your answer.

(b) The investor has invested in the portfolio chosen in (a).

(i) Suppose that the interest rate has dropped immediately to 3.71% after the start of
the investment and maintains at 3.71% in the 1st year. After 1 year (i.e. at time 1), the
investor thinks that the interest rate will raise in future and would like to adjust his
portfolio.
Which of the following strategies is appropriate for the investor? Choose the best
answer and explain your answer.
(*Note: You don’t need to find the detail of the portfolio)
(A) Construct a portfolio with Macaulay duration 𝐷𝑚𝑎𝑐 = 3.
(B) Construct a portfolio with Macaulay duration 𝐷𝑚𝑎𝑐 = 5.
(C) Construct a portfolio with Macaulay duration 𝐷𝑚𝑎𝑐 = 7.

(ii) Suppose that the interest rate has raised immediately to 5.62% after the start of the
investment and maintains at 5.62% in the 1st year. After 1 year (i.e. at time 1), the
investor thinks that the interest rate will drop in future and would like to adjust his
portfolio.
Which of the following strategies is appropriate for the investor? Choose the best
answer and explain your answer.
(*Note: You don’t need to find the detail of the portfolio)
(A) Construct a portfolio with Macaulay duration 𝐷𝑚𝑎𝑐 = 3.
(B) Construct a portfolio with Macaulay duration 𝐷𝑚𝑎𝑐 = 5.
(C) Construct a portfolio with Macaulay duration 𝐷𝑚𝑎𝑐 = 7.
Solution
To faciliate the analysis, we first compute the current price and Macaulay duration of those
3 bonds. The calculation and result is shown in the following table:
Price 𝑃𝑖 𝑖
Macaulay duration 𝐷𝑀𝑎𝑐
Bond A 6 0.04 6 0.04
100 ( )
2 + 100 𝐴
1 𝑘 100 ( 2 ) 100
𝑃𝐴 = ∑ 𝑘
𝐷𝑀𝑎𝑐 = (∑ 𝑘 +3 )
(1.045)3 𝑃𝐴 2 (1.045)3
𝑘=1 (1.045)2 𝑘=1 (1.045) 2
= 98.74786 = 2.855648
Bond B 5 5
100(0.05) 100 1 100(0.05) 100
𝑃𝐵 = ∑ + 𝐵
𝐷𝑀𝑎𝑐 = (∑ 𝑘 +5 )
(1.045)𝑘 (1.045)5 𝑃𝐵 𝑘 (1.045)5
𝑘=1 𝑘=1 (1.045) 2
= 102.195 = 4.551539
Bond C 100 𝐶
𝐷𝑀𝑎𝑐 = 10 (since it is a zero-coupon bond)
𝑃𝐶 = = 64.39277
(1.045)10
(a) The current safety margin is
𝑆𝑎𝑓𝑒𝑡𝑦 𝑚𝑎𝑟𝑔𝑖𝑛 = ⏟ 15000(1.045)6 − ⏟
15000(1.042)6 ≈ 334.0635 > 0
𝐹𝑉 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑇𝑎𝑟𝑔𝑒𝑡 𝑣𝑎𝑙𝑢𝑒
Since the investor believes that the interest rate will drop, he should choose a
portfolio with Macaulay duration > 𝐻 = 6 (since safety margin is fairly far from 0, so
this strategy is safe).
Using the given information, the Macaulay duration of the three portfolios is
 Portfolio 1
1
4500 6000 4500
𝐷𝑀𝑎𝑐 = (2.855648) + (4.551539) + (10) ≈ 5.67731
15000 15000 15000
<6
 Portfolio 2
2
10500 3000 1500
𝐷𝑀𝑎𝑐 = (2.855648) + (4.551539) + (10)
15000 15000 15000
≈ 3.909261 < 6
 Portfolio 3
3
1500 4500 9000
𝐷𝑀𝑎𝑐 = (2.855648) + (4.551539) + (10)
15000 15000 15000
≈ 7.651026 > 6
So the investor should choose portfolio 3 since it is the only portfolio with 𝐷𝑀𝑎𝑐 > 6.

(b) The investor chooses portfolio 3. We let 𝑁𝑖 be the number of bond 𝑖 (𝑖 = 𝐴, 𝐵, 𝐶),
then we have
1500 4500
𝑁𝐴 = ≈ 15.1902, 𝑁𝐵 = ≈ 44.03347,
98.74786 102.195
9000
𝑁𝐶 = ≈ 139.7672.
64.39277
We let 𝑖 be the annual effective interest rate during the first year, then the
investment value at time 1 is
 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐼(𝑖) = { }
𝑣𝑎𝑙𝑢𝑒
𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
𝑐𝑜𝑢𝑝𝑜𝑛
⏞4
⏞ 1 2 100
= 15.1902 2(1 + 𝑖)2 + 2 + ∑ 𝑘 +
(1 + 𝑖)2
𝑘=1 (1 + 𝑖)2
⏟ ( )
𝐵𝑜𝑛𝑑 𝐴
𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
𝑐𝑜𝑢𝑝𝑜𝑛 ⏞4
5 100
+ 44.03347 ⏞
5 +∑ +
(1 + 𝑖)𝑘 (1 + 𝑖)4
𝑘=1
⏟ ( )
𝐵𝑜𝑛𝑑 𝐵
100
+ 139.7672 ( ).
⏟ (1 + 𝑖)9
𝐵𝑜𝑛𝑑 𝐶
(i) When 𝑖 = 3.71%, then the safety margin is
𝑆𝑎𝑓𝑒𝑡𝑦 𝑚𝑎𝑟𝑔𝑖𝑛 = ⏟𝐼(0.0371)(1.0371)5 − ⏟ 15000(1.042)6 ≈ 585.3663.
𝐹𝑉 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑇𝑎𝑟𝑔𝑒𝑡 𝑣𝑎𝑙𝑢𝑒
Since the safety margin is far above from 0, so the investor may consider
some active strategy. Since the investor believes that the interest rate goes
up, then he can choose a portfolio with 𝐷𝑀𝑎𝑐 < 𝐻 ′ = 5 in order to enhance
the IRR (by enhancing the future value of investment) in the remaining
period. So the answer is (A) (i.e. choose a portfolio with 𝐷𝑚𝑎𝑐 = 3)

(ii) When 𝑖 = 5.62%, then the safety margin is

5 6
𝑆𝑎𝑓𝑒𝑡𝑦 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝐼(0.0562)(1.0562)
⏟ − 15000(1.042)
⏟ ≈ 2.990095.
𝐹𝑉 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑇𝑎𝑟𝑔𝑒𝑡 𝑣𝑎𝑙𝑢𝑒
Since the safety margin is close to 0, so the investor should consider to immunize the
portfolio in order to maintain the IRR to be at least 𝑖𝑚𝑖𝑛 = 4.2%. So he should choose a
portfolio with 𝐷𝑀𝑎𝑐 = 𝐻 ′ = 5 and the answer is (B).

Problem 3 (Required, 40 marks)

There are 3 bonds (Bond A, Bond B and Bond C) in a market:
 Bond A: It is a 2 years zero coupon bond.
 Bond B: It is a 5 years zero coupon bond.
 Bond C: It is a 8 years zero coupon bond.
The term structure is assumed to be the flat and the annual effective interest rate is currently
𝑖0 = 3%.
Questions
(a) A company is facing two liabilities 𝐿1 = 43709.08 and 𝐿2 = 15988.36 to be repaid at
the end of 3rd year and at the end of 7th year respectively. To fulfill the debt obligation,
 the company invests capital into these three bonds and create a bond portfolio which
can immunize against future change in interest rate. Based on the immunization
strategies learnt in Topic 1, suggest a feasible immunization strategy and find all feasible
portfolios under immunization strategy.

(b) Suppose that the company also has another liability 𝐿3 = 11073.87 to be repaid at the
end of 11th year. To fulfill the debt obligation, the company invests capital into these
three bonds and create a bond portfolio which can immunize against a small change in
interest rate. Based on the immunization strategies learnt in Topic 1, suggest a feasible
immunization strategy and find all feasible portfolios under immunization strategy.
(*Note for Problem 3: For each part, you need to give a brief explanation on the feasibility of
each possible immunization strategy.)

Solution
(a) The company can consider full immunization since the portfolio can be immunized
against any change of future interest rate.
To execute the full immunization, one should execute the full immunization on each
liability. For each liability, construct a bond portfolio which 𝐷𝑚𝑎𝑐 = 𝑇𝐿 , where 𝑇𝐿
denotes the repayment date of the liability.
For Liability 1, we let 𝑃𝐴,1 , 𝑃𝐵,1 and 𝑃𝐶,1 be the capital invested in Bond A, Bond B and
Bond C in the portfolio respectively. Then the unknowns must satisfy
43709.08
𝑃𝐴,1 + 𝑃𝐵,1 + 𝑃𝐶,1 =
⏟ = 40000
⏟(1.03)3
𝑃𝑉𝐴𝑠𝑠𝑒𝑡
𝑃𝑉𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑃𝐴,1 + 𝑃𝐵,1 + 𝑃𝐶,1 = 40000
2𝑃𝐴,1 + 5𝑃𝐵,1 + 8𝑃𝐶,1 ⇒ { .
2𝑃𝐴,1 + 5𝑃𝐵,1 + 8𝑃𝐶,1 = 120000
= ⏟
3
⏟𝑃𝐴,1 + 𝑃𝐵,1 + 𝑃𝐶,1 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
𝐷𝑀𝑎𝑐
{ 𝐴𝑠𝑠𝑒𝑡
𝐷𝑀𝑎𝑐
By taking 𝑃𝐶,1 = 𝑡1, we deduce that
40000 80000
𝑃𝐵,1 = − 2𝑡1 , 𝑃𝐴,1 = 𝑡1 + .
3 3
20000
Here, 0 ≤ 𝑡1 ≤ 3 in order that 𝑃𝐴,1 , 𝑃𝐵,1 and 𝑃𝐶,1 ≥ 0.
For Liability 2, we let 𝑃𝐴,2 , 𝑃𝐵,2 and 𝑃𝐶,2 be the capital invested in Bond A, Bond B and
Bond C in the portfolio respectively. Then the unknowns must satisfy
15988.36
𝑃𝐴,2 + 𝑃𝐵,2 + 𝑃𝐶,2 =
⏟ = 13000
⏟(1.03)7
𝑃𝑉𝐴𝑠𝑠𝑒𝑡
𝑃𝑉𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑃𝐴,2 + 𝑃𝐵,2 + 𝑃𝐶,2 = 13000
2𝑃𝐴,2 + 5𝑃𝐵,2 + 8𝑃𝐶,2 ⇒ { .
2𝑃𝐴,2 + 5𝑃𝐵,2 + 8𝑃𝐶,2 = 91000
= ⏟
7
⏟𝑃𝐴,2 + 𝑃𝐵,2 + 𝑃𝐶,2 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
𝐷𝑀𝑎𝑐
{ 𝐴𝑠𝑠𝑒𝑡
𝐷𝑀𝑎𝑐
By taking 𝑃𝐶,2 = 𝑡, we deduce that
 65000 26000
𝑃𝐵,2 =
− 2𝑡2 , 𝑃𝐴,2 = 𝑡2 − .
3 3
26000 32500
Here, 3 ≤ 𝑡2 ≤ 3 in order that 𝑃𝐴,2 , 𝑃𝐵,2 and 𝑃𝐶,2 ≥ 0.
Therefore, the required portfolio is that the investor invests PA,1 + 𝑃𝐴,2 in bond A,
𝑃𝐵,1 + 𝑃𝐵,2 in bond B and 𝑃𝐶,1 + 𝑃𝐶,2 in bond C.

(b) The company can consider Redington’s immunization which the company can fulfill
the debt obligation under small change in interest rate.
We let 𝐹𝐴 , 𝐹𝐵 and 𝐹𝐶 be the face values of bond A, bond B and bond C in the
𝐴 𝐹 𝐹
𝐵 𝐶 𝐹
portfolio and let 𝑃𝐴 = (1.03)2
, 𝑃𝐵 = (1.03)5
and 𝑃𝐶 = (1.03)8
be the amount of capital
invested in each of these bonds. Then 𝑃𝐴 , 𝑃𝐵 and 𝑃𝐶 must satisfy
43709.08 15988.36 11073.87
𝑃𝐴 + 𝑃𝐵 + 𝑃𝐶 =
⏟ + + = 61000
𝑃𝑉𝐴𝑠𝑠𝑒𝑡
⏟(1.03)3 (1.03)7 (1.03)11
𝑃𝑉𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
43709.08 15988.36 11073.87
2𝑃𝐴 + 5𝑃𝐵 + 8𝑃𝐶 3 ( (1.03)3 ) + 7 ( (1.03)7 ) + 11 ( (1.03)11 )
= = 4.901639
⏟𝑃𝐴 + 𝑃𝐵 + 𝑃𝐶 ⏟ 61000
𝐴𝑠𝑠𝑒𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
𝐷𝑀𝑎𝑐 𝐷𝑀𝑎𝑐
43709.08 15988.36 11073.87
2(3)𝑃𝐴 + 5(6)𝑃𝐵 + 8(9)𝑃𝐶 3(4) ( (1.03)3 ) + 7(8) ( (1.03)7 ) + 11(12) ( (1.03)11 )
>
⏟ (1.03)2 (𝑃𝐴 + 𝑃𝐵 + 𝑃𝐶 ) ⏟ (1.03)2 (61000)
𝐴𝑠𝑠𝑒𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
{ 𝐶𝑀𝑜𝑑 𝐶𝑀𝑜𝑑
By some calculation, the above conditions are simplied into
𝑃𝐴 + 𝑃𝐵 + 𝑃𝐶 = 61000
{ 2𝑃𝐴 + 5𝑃𝐵 + 8𝑃𝐶 = 299000
6𝑃𝐴 + 30𝑃𝐵 + 72𝑃𝐶 > 2264000
By solving the first two equation and take 𝑃𝐶 = 𝑡, we have
𝑃𝐴 = 2000 + 𝑡, 𝑃𝐵 = 59000 − 2𝑡, 𝑃𝐶 = 𝑡,
where 0 ≤ 𝑡 ≤ 29500 in order that 𝑃𝐴 , 𝑃𝐵 , 𝑃𝐶 are all non-negative.

Substitute the result in the last inequality, we get

6(2000 + 𝑡) + 30(59000 − 2𝑡) + 72𝑡 > 2264000 ⇒ 𝑡 > 26777.78.
Therefore, the immunized portfolio consists of (1) Bond A with value 𝑃𝐴 = 2000 + 𝑡,
(2) Bond B with value 𝑃𝐵 = 59000 − 2𝑡 and (3) Bond C with value 𝑃𝐶 = 𝑡, where
26777.78 ≤ 𝑡 ≤ 29500 .

Bonus Problem 1 (Optional, 20 marks)

We consider a 𝑛𝑇-year coupon bond which pays coupons every 𝑇 years. The bond has face
value 𝐹 and the coupon rate over a coupon period is 𝑟 (i.e. the amount of each coupon
payment is 𝑟𝐹). The annual effective yield rate of the bond is 𝑖.
Question
Derive the formula for the Macaulay duration and Modified convexity of the bond (with respect
to annual effective interest rate 𝑖). Express your answer in terms of 𝑛, 𝑇, 𝑟, 𝐹 and 𝑖.
(Hint: The following formula will be useful.
𝑛
1 1 − (1 + 𝑖)−𝑛
∑ =
(1 + 𝑖)𝑘 𝑖
𝑘=1
𝑛
𝑘 1 1 − (1 + 𝑖)−(𝑛−1) 𝑛 1 + 𝑖 − (1 + 𝑖)−(𝑛−1) 𝑛
∑ 𝑘
= (1 + − 𝑛
) = 2
−
(1 + 𝑖) 𝑖 𝑖 (1 + 𝑖) 𝑖 𝑖(1 + 𝑖)𝑛
𝑘=1
𝑛 𝑛 𝑛
𝑘2 1 𝑛2 + 2𝑛 + 1 𝑘 1
∑ = (1 − + 2 ∑ + ∑ )
(1 + 𝑖)𝑘 𝑖 (1 + 𝑖)𝑛 (1 + 𝑖)𝑘 (1 + 𝑖)𝑘
𝑘=1 𝑘=1 𝑘=1
The derivation of these formula can be found in the appendix A)
Solution
We let 1 + 𝑗 = (1 + 𝑖)𝑇 ⇔ 𝑗 = (1 + 𝑖)𝑇 − 1.

Firstly, the bond price can be expressed as

𝑛 𝑛
𝑟𝐹 𝐹 1 𝐹
𝑃0 = ∑ + = 𝑟𝐹 ∑ +
(1 + 𝑖)𝑘𝑇 (1 + 𝑖)𝑛𝑇 (1 + 𝑗)𝑘 (1 + 𝑖)𝑛𝑇
𝑘=1 𝑘=1
1 − (1 + 𝑗)−𝑛 𝐹 1 − (1 + 𝑖)−𝑛𝑇 𝐹
= 𝑟𝐹 + = 𝑟𝐹 + .
𝑗 (1 + 𝑖)𝑛𝑇 (1 + 𝑖)𝑇 − 1 (1 + 𝑖)𝑛𝑇
Then the Macaulay duration (with respect to effective interest 𝑖) can be expressed as
𝑟𝐹 𝐹
∑𝑛𝑘=1 𝑘𝑇 + 𝑛𝑇 𝑇
𝑛
𝑘 𝐹
(1 + 𝑖)𝑘𝑇 (1 + 𝑖)𝑛𝑇
𝐷𝑀𝑎𝑐 = = [𝑟𝐹 ∑ + 𝑛 ]
𝑛 𝑟𝐹 𝐹 𝑃 (1 + 𝑗) 𝑘 (1 + 𝑖) 𝑛𝑇
∑𝑘=1 + 0
𝑘=1
(1 + 𝑖)𝑘𝑇 (1 + 𝑖)𝑛𝑇
𝑇 1 + 𝑗 − (1 + 𝑗)−(𝑛−1) 𝑛 𝐹
= [𝑟𝐹 ( 2
− 𝑛
)+𝑛 ]
𝑃0 𝑗 𝑗(1 + 𝑗) (1 + 𝑖)𝑛𝑇
(1 + 𝑖)𝑇 − (1 + 𝑖)−(𝑛−1)𝑇 𝑛 𝑛𝐹𝑇
𝑟𝐹𝑇 ( 𝑇 2 − 𝑇 𝑛𝑇 )+
((1 + 𝑖) − 1) ((1 + 𝑖) − 1)(1 + 𝑖) (1 + 𝑖)𝑛𝑇
=
1 − (1 + 𝑖)−𝑛𝑇 𝐹
𝑟𝐹 𝑇 +
(1 + 𝑖) − 1 (1 + 𝑖)𝑛𝑇
Finally, the modified convexity of the bond can be compute as
𝑟𝐹 𝐹
∑𝑛𝑘=1 𝑘𝑇(𝑘𝑇 + 1) + 𝑛𝑇(𝑛𝑇 + 1)
(1 + 𝑖)𝑘𝑇 (1 + 𝑖)𝑛𝑇
𝐶𝑀𝑜𝑑 =
(1 + 𝑖)2 𝑃0
𝑘2 𝑘 𝐹
𝑟𝐹𝑇 2 ∑𝑛𝑘=1 + 𝑟𝐹𝑇 ∑𝑛𝑘=1 + 𝑛𝑇(𝑛𝑇 + 1)
(1 + 𝑗) 𝑘 (1 + 𝑗) 𝑘 (1 + 𝑖)𝑛𝑇
=
(1 + 𝑖)2 𝑃0
 1 𝑛2 + 2𝑛 + 1 𝑘 1
𝑟𝐹𝑇 2 ( 𝑗 (1 − + 2 ∑𝑛𝑘=1 + ∑𝑛𝑘=1 ))
(1 + 𝑗)𝑛 (1 + 𝑗)𝑘 (1 + 𝑗)𝑘
=
(1 + 𝑖)2 𝑃0
1 + 𝑗 − (1 + 𝑗)−(𝑛−1) 𝑛 𝐹
𝑟𝐹𝑇 ( 2 − 𝑛 ) + 𝑛𝑇(𝑛𝑇 + 1)
𝑗 𝑗(1 + 𝑗) (1 + 𝑖)𝑛𝑇
+
(1 + 𝑖)2 𝑃0
1 𝑛2 + 2𝑛 + 1 1 + 𝑗 − (1 + 𝑗)−(𝑛−1) 𝑛 1 − (1 + 𝑗)−𝑛
𝑟𝐹𝑇 2 ( 𝑗 (1 − + 2 ( − ) + ))
(1 + 𝑗)𝑛 𝑗2 𝑗(1 + 𝑗)𝑛 𝑗
=
(1 + 𝑖)2 𝑃0
1 + 𝑗 − (1 + 𝑗)−(𝑛−1) 𝑛 𝐹
𝑟𝐹𝑇 ( 2 − 𝑛 ) + 𝑛𝑇(𝑛𝑇 + 1)
𝑗 𝑗(1 + 𝑗) (1 + 𝑖)𝑛𝑇
+
(1 + 𝑖)2 𝑃0

Bonus Problem 2 (Optional, 25 marks)

There are 3 bonds available in the market. The information of these 3 bonds is summarized in
the following table:
Time to Annual coupon Face value
maturity rate
(Frequency)
Bond A 2 years Zero coupon 100
Bond B 4 years 6% (annual) 100
Bond C 8 years 3% (annual) 100

We assume that the term structure is flat and the annual effective interest rate is currently 5%.
An investor has $10000 currently and wishes to invest his wealth for 5 years. The investor
decides to invest the capital into these 3 bonds. To minimize the potential interest rate risk,
the investor constructs the portfolio such that the internal rate of return of the investment can
be maintained at 5% (or at least 5%). Determine the best portfolio. Provide full justification to
your answer.
Solution
To facilitate the analysis, we first compute the Macaulay duration and modified convexity
for each of the bond. The result is summarized in the following table:
Macaulay Modified
duration Convexity
𝑫𝑴𝒂𝒄 (𝒊𝟎 ) 𝑪𝑴𝒐𝒅 (𝒊𝟎 )
Bond A 2 5.442177
Bond B 3.679271 16.20898
Bond C 7.163723 56.31203
(*For example, the bond price, Macaulay duration and modified convexity of bond B are
computed by
4 100(0.06) 100
(1.05) 𝑘 (1.05)4
𝐵 (𝑖 )
𝐷𝑀𝑎𝑐 0 = ∑𝑘 +4 ≈ 3.679271.
𝑃𝐵 (𝑖0 ) 𝑃𝐵 (𝑖0 )
𝑘=1
100(0.06) 100
∑4𝑘=1 𝑘(𝑘 + 1) ( ) + 4(5) ( )
𝐵 (𝑖 ) (1.05) 𝑘 (1.05)4
𝐶𝑀𝑜𝑑 0 = ≈ 16.20898.
(1.05)2 𝑃𝐵 (𝑖0 )
Also note that the annual effective yield rate of bond B is 𝑖0 = 5% since the term structure
is assumed to be flat.)

To achieve the investment goal, the investor can consider a bond portfolio with Macaulay
duration equals 𝐻 = 5 since the IRR of the portfolio will be at least 5% for any level of
future interest rate.

We let 𝑃𝐴 , 𝑃𝐵 and 𝑃𝐶 be the amount of capital invested in each of the bond. Then 𝑃𝐴 , 𝑃𝐵 and
𝑃𝐶 must satisfy
𝑃𝐴 + 𝑃𝐵 + 𝑃𝐶 = 10000
⏟
𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴 𝐵 𝐶
𝐷𝑀𝑎𝑐 𝐷𝑀𝑎𝑐 𝐷𝑀𝑎𝑐
𝑃𝐴 ⏞ + 𝑃𝐵 ⏞ 𝑃𝐶 ⏞
(2) (3.679271) + (7.163723) = 5
𝑃
⏟𝐴 + 𝑃𝐵 + 𝑃𝐶 𝑃𝐴 + 𝑃𝐵 + 𝑃𝐶 𝑃𝐴 + 𝑃𝐵 + 𝑃𝐶
{ 𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝑃𝐴 + 𝑃𝐵 + 𝑃𝐶 = 10000
⇒{
2𝑃𝐴 + 3.679271𝑃𝐵 + 7.163723𝑃𝐶 = 50000
Write 𝑃𝐶 = 𝑡, we deduce that
30000 − 5.163723𝑡
𝑃𝐵 = , 𝑃𝐴 = ⏟ 2.074979𝑡 − 7864.89.
⏟ 1.679271
≥0 𝑤ℎ𝑒𝑛 𝑡≥3790.347
≥0 𝑤ℎ𝑒𝑛 𝑡≤5809.762
Here, we require that 3790.347 ≤ 𝑡 ≤ 5809.762 in order that 𝑃𝐴 , 𝑃𝐵 , 𝑃𝐶 ≥ 0.

In order to maximize the IRR, one should choose the portfolio with highest convexity among
those portfolios with 𝐷𝑀𝑎𝑐 = 5.

Given the value of 𝑡, the Modified convexity of the portfolio is found to be

𝐴 𝐵 𝐶
𝐶𝑀𝑜𝑑 𝐶𝑀𝑜𝑑 𝐶𝑀𝑜𝑑
𝑃𝐴 ⏞ 𝑃𝐵 ⏞ 𝑃𝐶 ⏞
𝐶𝑀𝑜𝑑 = (5.442177) + (16.20898) + (56.31203)
𝑃𝐴 + 𝑃𝐵 + 𝑃𝐶 𝑃𝐴 + 𝑃𝐵 + 𝑃𝐶 𝑃𝐴 + 𝑃𝐵 + 𝑃𝐶
30000 − 5.163723𝑡
5.442177(2.074979𝑡 − 7864.89) + 16.20898 ( ) + 56.31203𝑡
= 1.679271
10000
17.76216𝑡 + 246769.6
= .
10000
Since the convexity is increasing with respect to 𝑡, so the convexity is maximized when 𝑦 =
5809.762. Hence, we conclude that the best portfolio is the portfolio which the investor
invests 𝑃𝐴 = 4190.244 in bond A and 𝑃𝐶 = 5809.762 in bond C (no investment on bond B
since 𝑃𝐵 = 0).