7. The following is a list of prices for zero-coupon bonds of various maturities. Calculate the yields to maturity of each bond and the implied sequence of forward rates. Maturity (Years) Price of Bond 1 $943.40 2 898.47 3 247.62 4 792.16 4. _Maturity Price YTM Forward Rate 1 $943.40 6.00% 2 $898.47 5.50% — (1.055°/1.06)— 1 = 5.0% 3 $847.62 5.67% —(1.0567°/1.055") — 1 = 6.0% 4 $792.16 6.00% — (1.06°/1.0567°) — 0% 9, Consider the following $1,000 par value zero-coupon bonds: Bond Years to Maturity YTM(%) A 1 5% 8 2 6 c 3 65 D 4 7 According to the expectations hypothesis, what is the expected 1-year interest rate 3 years from now? 5 ‘The expected price path of the 4-year zero coupon bond is shown below. (Note that we discount the face value by the appropriate sequence of forward rates implied by this year's yield curve.) Beginning Expected Price 1 $792.16 2 S000 5839.60 1.05 «1.06 «1.07 3 51,000 __ 5881.68 1.06 «1.07 934.58 Expected Rate of Return ($839.69/8792.16) 1 = 6.00% ($881.68/8839.69) — 1 5.00% (8934.58/8881.68) ~ 1 = 6.00% ($1,000.00/8934.58) — 1 = 7.00%10, The term structure for zero-coupon bonds is currently: Maturity (Years) YT™ (%) 1 1% 2 3 6 Next year at this time, you expect it to be: Maturity (Years) YT™M (%) 1 5% 2 3 ‘a. What do you expect the rate of return to be over the coming year on a 3-year zero-coupon bond? 'b, Under the expectations theory, what yields to maturity does the marker expect to observe on. 1- and 2-year zeros at the end of the year? Is the market's expectation of the return on the 3-year bond greater or less than yours? 8. A 3-year zero coupon bond with face value $100 will sell today at a yield of 6% and aprice of, $100/1.06" =$83.96 ‘Next year, the bond will have a two-year maturity, and therefore a yield of 6 (from next year's forecasted yield curve). The price will be $89.00, resulting i holding period return of 6%. b. The forward rates based on today’s yield curve are as follows: Year Forward Rate 2 057/104) T= 6.01% 3 Co6'/1.08") Using the forward rates, the forecast for the yield curve next year is: Maturity _YTM 1 601% 2 (1.0601 « 1.0803)" — = 7.02% ‘The market forecast is for a higher YTM on 2-year bonds than your forecast. Thus, the market predicts a lower price and higher rate of rewrn,UL “The yield to maturity on 1-year zero-coupon bonds is currently 7%; the YIM on 2-year zeros is 8%. The Treasury plans to issue a 2-year maturity coupon bond, paying coupons once per year with a coupon rate of 9%. The face value of the bond is $100. b c. At what price will the bond sell? What will the yield to maturity on the bond be? If the expectations theory of the yield curve is correct, what is the market expectation of the price that the bond will sell for next year? Recalculate your answer to (c) if you believe in the liquidity preference theory and you believe that the liquidity premium is 1%. 9 107 S108 $100.90 Ty E(HPR) > 6%17. The current yield curve for default-free zero-coupon bonds is as follows: Maturity (Years) YTM (%) 1 10% 2 " 3 2 What are the implied I-year forward rates? ». Assume that the pure expectations hypothesis of the term structure is correct. If market expectations are accurate, what will be the pure yield curve (that is, the yields to maturity on 1- and 2-year zero coupon bonds) next year? If you purchase a 2-year zero-coupon bond now, what is the expected total rate of return over the next year? What if you purchase a 3-year zero-coupon bond? (Hint: Compute the current ‘and expected future prices.) Ignore taxes 1. What should be the current price of a 3-year maturity bond with a 12% coupon rate paid annually? If you purchased it at that price, what would your total expected rate of return be ‘over the next year (coupon plus price change)” Ignore taxes. We obtain forward rates from the following table: Maturity _YTM Forward Rate Price (for parts ¢. d) Tyear 10% '$1,000/1,10 = $909.09 Zyears 11% (111/110) ~1= 12.01% — $1,000/1.117 = $811.62 Byears 12% © (1.12°/1.11°)—1 = 14.03% — $1,000/1-12* = $711.78, We obtain next year’s prices and yields by discounting each zero"s face value at the forward rates for next year that we derived in part (a): Maturity’ Price YT T year ‘$1,000/1.1201 = $892.78 12.01% 2years — $1,000/(1.1201 = 1.1403) = $782.93 13.02% Note that this year’s upward sloping yield curve implies, according to the expectations hypothesis, a shift upward in next year’s curve. Next year, the 2-year zero will be a 1-year zero, and will therefore sell at a price of: $1,000/1.1201 = $892.78. Similarly, the current 3-year zero will be a 2-year zero and will sell for: $782.93 Expected total rate of return: $892.78 9-year bond: =1=1.1000~1 = 10.00% Pyearbond: $311.62 3-year bond: — $782-93_1 1 1000-1 = 10.00% $711.78d. The current price of the bond should equal the value of each payment times the present value of $1 to be received at the “maturity” of that payment. The present value schedule can be taken directly from the prices of zero-coupon bonds calculated above, Current price = ($120 x 0.90909) + ($120 x 0.81162) + ($1,120 x 0.71178) = $109.0908 + $97,3944 + $797.1936 = $1,003.68 Similarly, the expected prices of zeros one year from now can be used to calculate the expected bond value at that time: Expected price 1 year from now = ($120 x 0,89278) + ($1,120 x 0.78293) = $107.1336 + $876.8816 = $984.02 Total expected rate of return = $120 + ($984.02 - $1,003.68) $1,003.68 18, Suppose that the prices of zero-coupon bonds with various maturities are given in the followin; table. The face value of each bond is $1,000. = 0.1000 = 10.00% Maturity (Years) Price $925.93 853.39 782.92 715.00 650.00 weuns 4. Calculate the forward rate of interest for each year. b, How could you construct a 1-year forward loan beginning in year 32 Confirm that the rate on that loan equals the forward rate c. Repeat (b) for a 1-year forward loan beginning in year 4psec Tr yr Foreard years) rate 1 S059 800% 2 $853.39 825% 8.50% 3 S7a292 850% 9.00% 4 $715.00 8.75% 9.50% 3 $650.00 9.00% — 10.00% For each 3-year zero issued today, use the proceeds to buy: $782,92/8715.00 = 1.095 four-year zeros ‘Your cash flows are thus as follows: Time __Cash Flow 0 3 -$1,000 The 3-year zero issued at time 0 matures; the issuer pays out $1,000 face value 4 481,095 The 4-year zeros purchased at time 0 mature; roceive face value ‘This is a synthetic one-year loan originating at time 3. The rate on the synthetic loan is 0.095 = 9.5%, precisely the forward rate for year 3 ‘Chapter 13 - ne Term Structure of Interest Rates ©. For each 4-year zero issued today, use the proceeds to buy: $715.00/8650.00 = 1.100 five-year zeros Your cash flows are thus as follows: Time ___Cash Flow 0 $0 4 -$1,000 ‘The 4-year zero issued at time 0 matures; the issuer pays out $1,000 face value 5 +$1,100 ‘The 5-year zeros purchased at time 0 mature; receive face value This isa synthetic one-year loan originating at time 4. The rate on the synthetic, Joan is 0.100 = 10.0%, precisely the forward rate for year 4.19, Continue to use the data inthe preceding problem. Suppose that you want to construct a 2-year maturity forward loan commencing in3 years 4, Suppose that you buy today one 3-year maturity zero-coupon bond. How many 5-year matu- rity zeros would you have to sell to make your initial cash flow equal to zero? a What are the cash flows on tis strategy in each year? . Whats he effective 2-year interest rate onthe effective 3-year-ahead forward loan? . Confirm thatthe effective 2-year interest rate equals (1 +f, X (I +f) ~ 1. You therefore can interpret the 2-year loan rate as a 2-year forward rate for the last 2 years. Alternatively, show that the effective 2-year forward rate equals. (1+ y)° (1+) For each three-year zero you buy today, issue '$782.92/S650.00 = 1.2045 five-year zeros ‘The time-0 cash flow equals zero Your cash flows are thus as follows ‘Time Cash Flow 0 30 3 $81,000.00 The 3-year zero purchased at time 0 matures; receive $1,000 face value 5 $1,204.50 The 5-year zeros issued at time 0 mature, issuer pays face value a synthetic two-year loan originating at time 3. The effective two-year interest rate on the forward loan is: $1,204, 50/S1,000 ~ 1 = 0.2045 = 20.45% and 5 xe 9.5% and 10%, respectively. 1.095 1.10= 1.2045 = 1 + (ewo-year forward rat on the 3-year ahead forward loan) ‘The 5-year YTM is 9.0%. The 3-year YTM is 8.5%. Therefore, another way to derive the 2-year forward rate fora loan starting a time 3 is Coy) 1 HO 1 = 02046 = 20.46% (ry) 108s [Note: there isa slight discrepancy here due to rounding error in the YTM caleulations above} £O=Briefly explain why bonds of different maturities have different yields in terms of the expecta- tions and liquidity preference hypotheses. Briefly describe the implications of each hypothesis when the yield curve is (1) upward-sloping and (2) downward-sloping. Which one of the following statements about the term structure of interest rates is true? ‘a. The expectations hypothesis indicates a flat yield curve if anticipated future short-term rates. exceed current short-term rates. ‘b. The expectations hypothesis contends that the long-term rate is equal to the anticipated short- term rate. . The liquidity premium theory indicates that, all else being equal, longer maturities will have lower yields. 4. The liquidity preference theory contends that lenders prefer to buy securities at the short end. of the yield curve. ‘The following table shows yields to maturity of zero-coupon Treasury securities. Term to Maturity (Years) Yield to Maturity (%) 350% 450 5.00 5.50 6.00 6.60 Calculate the forward I-year rate of interest for year 3. Deseribe the conditions under which the calculated forward rate would be an unbiased est ‘mate of the 1-year spot rate of interest for that year. © Assume that a few months earlier. the forward I-year rate of interest for that year had been significantly higher than itis now. What factors could account for the decline inthe forward rate? ‘The 6-month Treasury bill spot rate is 4%, and the 1-year Treasury bill spot rate is 5%. What is the implied 6-month forward rate for 6 months from now? oA ‘The tables below show, respectively, the characteristics of two annual-pay bonds from the same issuer with the same priority in the event of default, and spot interest rates. Neither bond’s price is consistent with the spot rates. Using the information in these tables, recommend either bond A ‘or bond B for purchase, Bond Characteristics Bond A. Bond 8 Coupons ‘Annual ‘Annual ‘Coupon rate 10% 6% Yield to maturity 10.65% 10.75% Spot Interest Rates ‘Term (rears) Spot Rates Ze 3 n6. Sandra Kapple is a fixed-income portfolio manager who works with large institutional clients, Kapple is meeting with Maria VanHusen, consultant tothe Star Hospital Pension Plan, to discuss ‘management ofthe fund’s approximately $100 million Treasury bond portfolio. The current U.S. ‘Treasury yield curve is given in the following table. VanHusen states, “Given the large differential between 2- and 10-year yields, the portfolio would be expected to experience a higher return over 10-year horizon by buying 10-year Treasuries, rather than buying 2-year Treasuries and rein- g the proceeds into 2-year Tsbonds at each maturity date.” Maturity Yield Maturity Yield ‘year 2.00% 6 years 4.15% 2 290 7 430 3 350 8 445 4 3.80 9 4.60 5 4.00 10 470 4a, Indicate whether VanHusen's conclusion is correct, based on the pure expectations hypothesis, +b, VanHusen discusses with Kapple alternative theories of the term structure of interest rates and «gives her the following information about the U.S. Treasury market: Maturity (years) 203 4 5 6 7 8 9 1 Liquidity premium (%6) 5555657590 1.10-1.20-1.50 1.60 Use this additional information and the liquidity preference theory to determine what the slope of the yield curve implies about the direction of future expected short-term interest rates, 7. A portfolio manager at Superior Trust Company is structuring a fixed-income portfolio to meet the objectives of a client. The portfolio manager compares coupon U.S. Treasuries with zero- coupon stripped U.S. Treasuries and observes a significant yield advantage forthe stripped bonds: Coupon Zero-Coupon Stripped Term US. Treasuries US. Treasuries 3 years 5.50% 5.20% 1 675 728 10 725 7.60 30 775 220 Briefly discuss why zero-coupon stripped U.S. Treasuries could yield more than coupon U.S. ‘Treasuries withthe same final maturity10. ‘The shape of the U.S. Treasury yield curve appears to reflect two expected Federal Reserve reductions inthe federal funds rte. The current short-term interest rate is 5%. The first red tion of approximately 50 basis points (bp) is expected 6 months from now and the second reduction of approximately 50 bp is expected 1 year from now, The current U.S, Treasury term, premiums are 10 bp per year foreach of the next 3 years (out through the 3-year benchmark), However, the market also believes thatthe Federal Reserve reditetions will be reversed in 3 Single 100-bp increase in the federal funds rate 2¥4 years from now. You expect liquidity prem: ‘ums to remain 10 bp per year for each of the next 3 years (out through the 3-year benchmark), Describe or draw the shape of the Treasury yield curve out through the 3-year bench- ‘mark, Which term structure theory supports the shape of the U.S. Treasury yield curve you've described? USS. Treasuries represent a significant holding in many pension portfolios. You decide to ana lyze the yield curve for U.S. Treasury notes. ‘a Using the data in the table below, calculate the 5-year spot and forward rates assuming ‘annual compounding. Show your calculations. US. Treasury Note Yield Curve Data Par Coupon Calculated Calculated Yearsto Maturity Yield to Maturity __SpotRates___—_Forward Rates, 1 500 500 5.00 2 520 521 5.42 3 600 605 715 4 7.00 716 1056 5 7.00 ? > 1b. Define and describe each of the following three concepts: i. Short rate fi. Spot rate tik, Forward rate Explain how these concepts are related, . You are considering the purchase of a zero-coupon U.S. Treasury note with 4 years to matu: rity. On the basis of the above yield-curve analysis, calculate both the expected yield to ‘maturity and the price forthe security. Show your calculations, ie are shown in the following exhibit. ‘The spot rates of interest for five U.S, Treasury sect Assume all securities pay interest annually. Spot Rates of Interest ‘Term to Maturity, Spot Rate of Interest 1 year 13.00% 2 1200, 3 11.00 4 10.00 5 9.00 ‘4, Compute the 2-yeat implied forward rate For a deferred loan beginning in 3 years 1s. Compute the price of a S-year annusl-pay Treasury security with a coupon rate of 9% by using the information inthe exhibit.1. Expectations hypothesis: The yields on long-term bonds are geometric averages of present and expected future short rates. An upward sloping curve is explained by expected future short rates being higher than the current short rate. A downward-sloping yield curve implies expected future short rates are lower than the current short rate. Thus bonds of different maturities have different yields if expectations of future short rates are different from the current short rate. Liquidity preference hypothesis: Yields on long-term bonds are greater than the expected return from rolling-over short-term bonds in order to compensate investors in long-term bonds for bearing interest rate risk. Thus bonds of different maturities ean have different yields even if expected future short rates are all equal to the current short rate. An upward sloping yield curve can be consistent even with expectations of falling short rates if liquidity premiums are high enough. If, however, the yield curve is downward sloping and liquidity premiums are assumed to be positive then we can conclude that future shor rates are expected to be lower than the current short rate, 3. a. (Itya)'=(Itys (+f) (1.055)* = (1.05)'(1+ £4) 1.2388 = 1.1576 (1+ £4) =f 070) 01% '. The conditions would be those that underlie the expectations theory of the term structure: risk neutral market participants who are willing to substitute among maturities solely on the basi of yield differentials. This behavior would rule out liquidity or term premia relating to risk. ©. Under the expectations hypothesis, lower implied forward rates would indicate lower expected future spot rates for the corresponding period. Since the lower ‘expected future rates embodied in the term structure are nominal rates, ether lower ‘expected future real rates or lower expected future inflation rates would be ‘consistent with the specified change in the observed (implied) forward rate. The given rates are annual rates, but each period isa half-year. Therefor, the per period ‘spot rates are 2.5% on one-year bonds and 2% on six-month bonds. The semiannual forward rate is obtained by solving for fin the following equation: _ 10s? ef =1.030 This means that the forward rate is 0.030 = 3.0% semiannually, or 6.0% annually.The present value of each bond’s payments can be derived by discounting each cash flow by the appropriate rate from the spot interest rate (i, the pure yield) curve: = $10,, S10 S110, 105” 1.08 1.17 <8, $5,818 se 105” 1.08" "1.11 Bond A sels for $0.13 (ie., 0.13% of par value) less than the present value ofits stripped payments, Bond B sells for $0.02 less than the present value of is stripped payments. Bond A is more attractively priced. Bond A: PV = 898.53 Bond B: PV Based on the pure expectations theory, Vanusen’s conclusion is incorrect. According to ths theory, the expected return over any time horizon would be the sane, regardless of the maturity strategy employed. b. According tothe liquidity preference theory, the shape ofthe yield curve implies that short-term interest rates are expected to rise inthe future, This theory asserts that forward rates reflect expectations about future intrest rates plus a liquidity premium that increases with maturity. Given the shape ofthe yield curve and the liquidity premium data provided, the yield curve would stil be positively sloped (at least through maturity of eight yeas) after subtracting the respective liquidity premiums: 2.90% - 3.50% —| 3.80% 4.00% ~ 0.95% 4.15% —0.90% = 3.25% 430% — 1.10% = 3.20% 4AS%— 1.20% = 3.25% 4.60% — 1 50% = 3.10% 4.70% — 1.60% = 3.10% The coupon bonds can be viewed as portfolios of stripped zeros: each coupon can stand alone as an independent zero-coupon bond. Therefore, yields on coupon bonds reflect yields on payments with dates comesponding to each coupon, When the yield curve is upward sloping, coupon bonds have lower yields than zeros with the same maturity because the yields to maturity on coupon bonds reflect the yields on the earlier interim coupon payments.(Chapter 15 - The Term Structure of Interest Rates 8. 9, The following table shows the expected short-term interest rate based on the projections of Federal Reserve rate cuts the term premium (which increases ata rate of 0.10% perl2 months), the forward rate (which is the sum of the expected rate and term premium), and the YTM, which is the geometric average of the forward rates. 7 Expected Term Forward Forwardrate. == YTM ime short rate wemium rate (annual) (semi-annual) _ (semi-annual) 0 5.00% 0.00% 5.00% 2.500% 2.500% 6 months 4.50 0.0 455 2.275 2.387 12months 4.00 0.10 4.10 2.050 2.275 18months 4.00 0.15 415 2.075 2.25 24months — 5.00 0.20 5.20 2.600 2.300 30-months 5.00 025 5.25 2.625 2354 This analysis is predicated on the liquidity preference theory ofthe term structure, which asserts that the forward rate in any period is the sum of the expected short rate plus the liquidity premium, a. Five-year Spot Rate: sion= 57, _S10_,_S7_,_$70_, $1070. ) T+y,) (ty) (+ ys) sio=-5% ,_1_,_$10_,_$70_, $1070 (1.05) "(1.0521)" * (1.0605)° © (1.0716)" » (1+ y.) $1,070 (ys) $1,000 = $66.67 + $63.24 + $58.69 +$53,08 + $758.32 = S407 _ $1,070 © $758.32 Five-year Forward Rate: (ley)? sys = VAI -1= 7.13% (1.0713) (1.0716)* =1.0701-1=7.01%10, eld to maturity isthe singe discount rate that equates the present value of a cof cash flows toa curent price. Is the internal rate of return. ‘The spot rate fora given perio is the yield to maturity on a zero-coupon bond that ‘matures atthe end ofthe period. A spot rate isthe discount rate for each period. ‘Spot rates are used to discount each cash flow of a coupon bond in order to calculate a curent price. Spot rates are the rates appropriate for discounting future cash flows of different maturities, {A forward rate isthe implicit rate that links any two spot rates. Forward rates are directly related to spot rates, and therefore to yield to maturity. Some would argue (as inthe expectations hypothesis) that forward rate are the market expectations of future interest rates. A forward rate represents a break-even rate that inks two spot rates, Itis important to note that forward rates Tink spot rates, not yields to maturity. Yield to maturity is not unique for any particular maturity. In other words, two bonds withthe same maturity but different coupon rates may have different yields to maturity, In contrast, spot rates and forward rates for each date are unique. ‘The 4-year spot rate is 7.16%, Therefore, 716% is the theoretical yield to maturity for the zero-coupon U.S. Treasury note. The price of the zero-coupon note discounted at 7.16% is the present value of $1,000 to be received in 4 years. Using annual compounding $1,000 (1.0716) ‘The two-year implied annually compounded forward rate fora deferred loan beginning in 3 years is calculated as follows: yy [Oty] 1.07] 5 [i] Assuming a par value of $1,000, the bond price is aleulated as follows: 10607 = 107%