Test 3

Q1. Convexity is the change in duration.

a) True
b) False

Feedback: No, the curvature of a function, represented by its second derivative, is equal to
the change in slope of the function, given by the first derivative. For example, the duration of
the zero coupon bond is constant, but its convexity is definitely not zero.

Q2. The dollar convexity is the change of the negative of the dollar duration.

a) True
b) False

Feedback: Correct, the dollar convexity of a zero coupon bond is equal to (T-t)2xPz.

Q3. Calculate the convexity of a 5-year zero coupon bond.

Feedback: The convexity of the zero coupon bond is square of its maturity, i.e. 5x5=25.

Q4. Use the following discount factors when needed:

t Z(0, t)
0.25 0.9840
0.50 0.9680
0.75 0.9520
1.00 0.9360
1.25 0.9190
1.50 0.9040
1.75 0.8880
2.00 0.8730
2.25 0.8587
2.50 0.8445
2.75 0.8308
3.00 0.8175
3.25 0.8047
3.50 0.7924
3.75 0.7806
4.00 0.7691

Calculate the convexity of a 3-year fixed rate bond paying 4% coupon on a semiannual basis.

Feedback: 8.378 - First calculate the price of the bond, which is 92.436. Then, multiply all
present values of each cash flow divided by the price (wi) times the square of the time of each
cash flow (ti). Sum of these products gives convexity of the bond.
Q5. Use the discount curve from question 4. Calculate the convexity of the following
portfolio:
i. 2 units of a 1.5-year fixed rate bond paying 6% quarterly.
ii. 4 units of a 1.75-year floating rate bond paying float + 80 bps semiannually [Note:
semiannual spread is 40 bps]. You know that the reference rate was 7% three months ago.
iii. 6 units of a 2-year zero coupon bond.
iv. 1 units of a 1.5-year floating rate bond with no spread paid semiannually.

Feedback: 2.0857 - First, you need to calculate the price of each component and the value of
the whole portfolio. These prices are: 1.5-year bond - 98.89, 1.75-year floating rate bond -
103.3412 (101.844 float + 1.497 spread), 2-year zero bond - 87.3, 1.5-year floating bond -
100. Thus, the total value of the portfolio is: 1234.95. Next you need to calculate the
convexities of each component: 1.5-year bond: 2.136, 1.75-year floating bond - 0.08 (0.0625
float, 1.2697 spread), 2-year zero bond - 4, 1.5-year floating bond - 0.25. Weighting each
component's convexity with its weight in the portfolio the convexity of the portfolio is:
2.0857.

Q6. Calculate annualized expected returns (including convexity) for a 30-year zero coupon
bond, when E[dr] = 0 and E[dr2] = 0.0000007 (on a daily basis). Give your answer in per
cent.

[Note: there are 252 working days in a year.]

Feedback: 7.938 - The expected return is: (- Duration x E[dr] + 1/2 x Convexity x E[dr2] ) x
252. Since the Convexity of the zero coupon bond is 900, the answer follows.

Q7. Suppose you hold a bond and interest rates suddenly fall. Duration says that bond prices
will raise a given amount. If Convexity is included in this estimate:

a) the bond price will go up even more than what Duration predicts.
b) the bond price will go below what Duration predicts.
c) the bond price will go up exactly what Duration predicts.
d) the bond price can go up more or less than what Duration predicts.

Feedback: Convexity is positive so the bond price will go up even more than what Duration
predicts.

Q8. Suppose you observe the following data: 1-month yield = 5%, 5-year yield = 8%, 10-year
yield = 10%, The Term Spread is [?]% and the Butterfly Spread is [?]%.

Feedback: Term spread = long yield - short yield = 10% - 5% = 5%

Butterfly spread = 2 x medium yield - (short yield + long yield) = 2 x 8% - (10% + 5%) = 1%

Q9. You currently hold a 7-year fixed rate bond paying 5% annually. You would like to
hedge against changes in the level and the slope of the yield curve and you plan to use a 1-
year zero coupon bond and a 7-year zero coupon bond. Use the following table to compute
the adequate positions in the hedging instruments.
 maturity β1 β2 Z(t, T)
1 1.1150 -0.2540 0.9800
2 0.9940 -0.3010 0.9600
3 0.9640 -0.1470 0.9300
4 0.9330 0.0080 0.8900
5 0.9300 0.1620 0.8500
6 0.9260 0.3160 0.8100
7 0.9270 0.4230 0.7700
8 0.9270 0.5300 0.7300

The position in the short term bond and the long term bond should be:

a) -0.2533 and -1.7865

b) 0.2367 and 1.2541
c) -0.2411 and 1.3277
d) -0.4651 and -1.1231

Feedback: The price of the coupon bond is P= 107.95, price of the short bond is 98 and price
of the long bond is 77. Factor durations of the coupon bond are: 5.6689 and 2.2647, for the
short bond: 1.115 and -0.254, and for the long bond: 6.489 and 2.961. Using the formula for
portfolio immunization yields the answer.

Q10. How many securities do you need to hedge three factors?

a) 2
b) 3
c) 4
d) It depends.

Feedback: To hedge three factors you need three securities, because the three factors
generate a system of equations with three unknowns. In order to solve it you must include a
security for each of these unknowns.