IPM

ANALYTICAL PROBLEM SET 3

LECTURES PROFESSOR ROBERT KOSOWSKI

TUTORIALS JOE TAN

This APS has two parts. Part 1 and Part 2.

Part 1. PURPOSE AND DESCRIPTION:

This APS is designed to cover the readings for lecture 5 of the IPM Course (see course
outline).

SECTION A

(Questions related to Bond Predictability Appendix, IPM 4)

Q1. (1 Point)
In the expression , 1+ refers to
(a) the simple log return
(b) the gross simple return
(c) the simple net return
(d) the log return

Q2. (1 Point)
If a 2 year zero-coupon bond with a face value of $1, trades at a current market price of
$0.95, then the log price is equal to

(a) 0
(b) 1
(c) -1
(d) -0.05129
Q3. (1 Point)
The log yield to maturity of the 2-year bond in the previous example is closest to
(a) 10%
(b) 5%
(c) 2.5%
(d) 1%

Q4. (1 Point)
If the price of a 3 year zero-coupon bond is 0.9 and the log price of a 2-year zero
coupon bond is 0.95, then the implied log forward rate between year 2 and 3 is

(a) 5%
(b) 1%
(c) 0.05%
(d) 0.1%

Cochrane (2005, Chapter 20, pages 426-432) related questions:

Q5. (1 Point)

Table 20.9 in Cochrane (2005, p. 428) can be used to test the following prediction of the
Expectation hypothesis

a) The expectation hypothesis predicts a coefficient of zero when regressing the change
in one-year yields on long-term bonds on the forward-spot spread.

b) The expectation hypothesis predicts a coefficient of zero when regressing one-year

excess return on long-term bonds on the forward-spot spread.

c) The expectation hypothesis predicts a coefficient of zero when regressing the change
in one-year yields on the excess return on long-term bonds.

d) The expectation hypothesis predicts a coefficient of 1 when regressing one-year

excess return on long-term bonds on the forward-spot spread.
Q6. (1 Point)
Find the (Macaulay) duration of a 6% coupon bond making annual coupon payments if it
has 3 years until maturity and has a yield to maturity of 6%. The duration is closet to

(a) 2.70
(b) 2.83
(c) 2.95
(d) 2.97

Q7. (1 Point)
Refer to the previous question: what is the duration if the yield to maturity is 10%?
The duration is closest to

(a) 2.82
(b) 2.88
(c) 2.89
(d) 2.90

Q8. (1 Point)
An insurance company must make payments to a customer of $10 million in 1 year and
$4 million in 5 years. The yield curve is flat at 10%. If it wants to fully fund and immunize
its obligation to this customer with a single issue of a zero-coupon bond, what maturity
bond must it purchase? The required maturity is closest to

(a) 1 year
(b) 2 years
(c) 3 years
(d) 4 years

Q9. (1 Point)
Refer to the previous question, what must be the face value and the market value of that
zero-coupon bond? The face value is closest to

(a) $11 million

(b) $12 million
(c) $14 million
(d) $16 million

Q10. (1 Point)
Currently, the term structure is as follows: 1-year bonds yield 7%, 2-year bonds yield
8%, 3-year bonds and longer-maturity bonds all yield 9%. An investor is choosing
between 1-, 2-, and 3-year maturity bonds all paying annual coupons of 8%, once a
year. Which bond should you buy if you strongly believe that at year-end the yield curve
will be flat at 9%?

(a) 1-year maturity bond

(b) 2-year maturity bond
(c) 3-year maturity bond

Use the following information when answering questions the next three questions.

You will be paying $10,000 a year in tuition expenses at the end of the next 2 years.
Bonds currently yield 8%.

Q11. (1 Point)
What is the present value and duration of your obligation? The duration is closest to
(a) 1 year
(b) 1.5 years
(c) 2 years
(d) 4 years

Q12. (1 Point)
What maturity zero-coupon bond would immunize your obligation? What should be the
face-value of the bonds? The face value should be closest to

(a) $15,000
(b) $17,000
(c) $19,000
(d) $20,000

Q13. (1 Point)
Suppose you buy a zero-coupon bond with value and duration equal to your obligation.
Now suppose that rates immediately increase to 9%. What happens to your net position,
that is, to the difference between the value of the bond and that of your tuition
obligation? What if rates fall to 7%? The net position changes in absolute value by

(a) $0.19
(b) $1.19
(c) $2.19
(d) $3.19

(Use the following when answering the next two questions)

A 30-year maturity bond making annual coupon payments with a coupon rate of 12%
has a duration of 11.54 years and convexity of 192.4. The bond currently sells at a yield
to maturity of 8%. Use a financial calculator or spreadsheet to find the price of the bond
if its yield to maturity falls to 7% or rise to 9%. What prices for the bond at these new
yields would be predicted by the duration rule?

Q14. (1 Point)
Use a financial calculator or spreadsheet to find the price of the bond if its yield to
maturity falls to 7% or rise to 9%. What prices for the bond at these new yields would be
predicted by the duration rule? What is the percentage error of the bond prices for the
duration rule compared to the actual price. The percentage error is closest to

(a) 7%
(b) 5%
(c) 3%
(d) 1 %

Q15. (1 Point)
What prices for the bond at these new yields would be predicted by the duration-with-
convexity rule? What is the percentage error of the bond prices for the duration-with-
convexity rule compared to the actual price. The percentage error is closest to

(a) 0.7%
(b) 0.5%
(c) 0.3%
(d) 0.1 %

SECTION B:

Q16. (3 Points)

What is the definition of Macaulay duration D, modified duration D^{∗} and convexity for
bonds?

Q17. (3 Points)
Assume that on January 7, 2009, a 5-year zero-coupon US Treasury bond (with face value 100)
with a yield to maturity of 3% has a duration of 5, a modified duration of 4.854 and a convexity
of 28.278. Its price is 86.261. You know that as the yield to maturity changes to 4% (2%) its price
falls (rises) to 82.193 (90.573).

The duration-convexity formula is given by

Supposed the yield to maturity changes by Δy=1% from 3% to 4%. What is the actual percentage
capital loss on the bond? What percentage capital loss would be predicted by the duration-with-
convexity formula?

Q18 (3 Points)
Now assume that another coupon-paying US Treasury bond with the same yield to maturity,
longer maturity, the same modified duration as the zero coupon bond but higher convexity
exited in the market. What would be the relative magnitude of the percentage gain on the
coupon bond compared to the zero coupon bond if (a) yields to maturity increased from 3% to
4% and (b) yields to maturity decreased from 3% to 2%? Based on the comparative investment
performance explain the attraction of convexity.
Part 2. PURPOSE AND DESCRIPTION:

This APS is designed to cover the readings for lecture 6 of the IPM Course (see course
outline).

SECTION A

BKM Chapter 19 related questions:

(Questions 1-3 are related)

Q1. (1 Point)
If the margin requirement is 10% of the futures price times the multiplier of $250, how
much must you deposit with your broker to trade the March S&P500 contract if the
futures price is $1,477.20?

a. $18,005
b. $ 23,405
c. $ 26,560
d. $ 36,930

Q2. (1 Point)
If the March futures price were to increase to 1,500 what percentage return would you
earn on your net investment if you entered the long side of the contract at the price
shown in the figure?

a. 5.53%
b. 12.43%
c. 15.43%
d. 18.34%

Q3. (1 Point) If the March futures price falls by 1%, what is your percentage return
a. – 1%
b. -2%
c. – 10%
d. -11%

(Questions 4-6 are related)

Q4. (1 Point)
A hypothetical futures contract on a non-dividend-paying stock with current price $150
has a maturity of 1 year. If the T-bill rate is 6%, what should the futures price be?

a. 159
b. 164
c. 178
d. 188

Q5. (1 Point)
What should the futures price be if the maturity of the contract is 3 years?

a. 177.45
b. 178.65
c. 179.85
d. 180.68

Q6. (1 Point)
What if the interest rate is 8% and the maturity of the contract is 3 years?

a. 185.58
b. 186.50
c. 188.35
d. 188.96

Q7. (1 Point)
Examine the following statements:

i. All else equal, the futures price on a stock index with a high dividend yield should be
higher than the futures price on an index with a low dividend yield.
ii. All else equal, the futures price on a high-beta stock should be higher than the futures
price on a low-beta stock.
iii. The beta of a short position in the S&P 500 futures contract is negative

State whether the above statements can be described as:

a. all false
b. one false
c. all correct
d. one correct
e. not enough information to provide an answer

(Questions 8-9 are related)

Q8. (1 Point)
The multiplier for a futures contract on the stock market index is $250. The maturity of
the contract is 1 year, the current level of the index is 1,000, and the risk-free interest
rate is 0.5% per month. The dividend yield on the index is 0.2% per month. Suppose
that after 1 month, the stock index is at 1,020.

Find the cash flow from the mark-to-market proceeds on the contract. Assume that the
parity condition always holds exactly.

a. $4,292.50
b. $4,392.50
c. $5,430.50
d. $5,560.50
Q9. (1 Point)
Find the holding-period return if the initial margin on the contract is $15,000.

a. 29.28%
b. 30.58%
c. 30.60%
d. 30.86%

Q10. (1 Point)
It is now January. The current interest rate is 5%. The June futures price for gold is
$346.30, whereas the December futures price is $360.00. Is there an arbitrage
opportunity here? If so, how would you exploit it?

a. No arbitrage opportunity
b. Short the December contract and take a long position in the June contract
c. Long the December contract and take a short position in the June contract
d. Long the December contract and invest in the riskless rate
e. Short the June contract and invest in the riskless rate

BKM Chapter 23 related questions:

(Questions 11-12 are related)

Donna Doni, CFA, wants to explore potential inefficiencies in the futures market. The
TOBEC stock index has a spot value of 185.00 now. TOBEC futures contracts are
settled in cash and underlying contract values are determined by multiplying $100 times
the index value. The current annual risk-free interest rate (APR) is 6.0%.

Q11. (1 Point)
Calculate the theoretical price of the futures contract expiring 6 months from now, using
the cost-of-carry model. The index pays no dividends.

a. 185.50
b. 190.55
c.191.50
d. 192.00
The total (round-trip) transaction cost for trading a futures contract is $15.00.

Q12. (1 Point)
Calculate the lower bound for the price of the futures contract expiring 6 months from
now.

a. 189.55
b. 190.40
c. 190.55
d. 190.60

(Questions 13-15 are related)

Q13. (1 Point)
Consider the futures contract written on the S&P 500 index and maturing in 6 months.
The interest rate is 3% per 6-month period, and the future value of dividends expected
to be paid over the next 6 months is $15. The current index level is 1,425. Assume that
you can short sell the S&P index.

i. Suppose the expected rate of return on the market is 6% per 6-month period. What is
the expected level of the index in 6 months?

a. 1,495.50
b. 1,595.50
c. 1,655.50
d. 1,795.50

Q14. (1 Point)
What is the theoretical no-arbitrage price for a 6-month futures contract on the S&P500
stock index?

a. 1156.75
b. 1278.75
c. 1355.75
d. 1452.75

Q15. (1 Point)
Suppose the futures price is 1,422. Is there an arbitrage opportunity here? If so, how
would you exploit it?

a. Buy futures, short index, sell T-bills

b. Buy futures, short index, buy T-bills
c. Sell futures, short index, buy T-bills
d. Sell futures, buy index, sell T-bills

(Question 16-19 are related)

You manage a $13.5 million portfolio, currently all invested in equities, and believe that
you have extraordinary market-timing skills. You believe that the market is on the verge
of a big but short-lived downturn; you would move your portfolio temporarily into T-bills,
but you do not want to incur the transaction costs of liquidating and re-establishing your
equity position. Instead you decide to temporarily hedge your equity holdings with S&P
500 index futures contracts.

Q16. (1 Point)
Should you be long or short the contracts?

a. Long
b. Short

Q16. (1 Point)
If your equity holdings are invested in a market-index fund, into how many contracts
should you enter? The S&P 500 index is now at 1,350 and the contract multiplier is
$250.

a. 35
b. 40
c. 45
d. 55

Q16. (1 Point)
How does your answer to (b) change if the beta of your portfolio is 0.6?

a. 15
b. 17
c. 21
d. 24

Q17. (1 Point)
Yields on short-term bonds tend to be more volatile than yields on long-term bonds.
Suppose that you have estimated that the yield on 20-year bonds changes by 10 basis
points for every 15-basis-point move in the yield on 5-year bonds. You hold a $1 million
portfolio of 5-year maturity bonds with modified duration 4 years and desire o hedge
your interest rate exposure with T-bond futures, which currently have modified duration
9 years and sell at F0=$95. How many futures contracts should you sell?

a. 2
b. 4
c. 6
d. 7

Q18. (1 Point)
The U.S. Yield curve is flat at 5% and the euro yield curve is flat at 8%. The current
exchange rate is $0.85 per euro. What will be the swap rate on an agreement to
exchange currency over a 3-year period? The swap will call for the exchange of 1 million
Euros for a given number of dollars in each year.

a. $0.8044 million per year

b. $0.8142 million per year
c. $0.8332 million per year
d. $0.8456 million per year

Q19. (1 Point)
Firm ABC enters a 5-year swap with firm XYZ to pay LIBOR in return for a fixed 8% rate
on notional principal of $10 million. Two years from now, the market rate on 3-year
swaps is LIBOR for 7%; at this time, firm XYZ goes bankrupt and defaults on its swap
obligation.

What is the market value of the loss incurred by ABC as a result of the default?

a. $245,365
b. $248,865
c. $251,465
d. $262,432

BKM Chapter 25 related questions:

Q20. (1 Point)
If the current exchange rate is $1.75/£ , the 1-year forward exchange rate is $1.85/£,
and the interest rate on British government bills is 8% per year, what risk-free dollar-
denominated return can be locked in by investing in by investing in the British bills?

a. 13.45%
b. 14.17%
c. 15.67%
d. 16.34%

Q21. (1 Point)
You are a U.S. investor considering purchase of one of the following securities. Assume
that the currency risk of the Canadian government bond will be hedged, and the 6-
month discount on Canadian dollar forward contracts is -0.75% versus the U.S. dollar
Bond Maturity Coupon Price

U.S. government 6 months 6.50% 100.00

Canadian 6 months 7.50% 100.00

government

Calculate the expected price change required in the Canadian government bond which
would result in the two bonds having equal total returns in U.S. dollars over a 6-month
horizon. Assume that the yield on the U.S. bond is expected to remain unchanged.
a. 0.15%
b. 0.20%
c. 0.21%
d. 0.25%

Q22. (1 Point)

What do the terms contango and backwardation refer to in the context of commodities pricing?

Q23. (1 Point)

Consider a currency swap agreement to exchange dollars for pounds for one period only. Next
year, for example, one might exchange S million dollars for 1 million pounds. What is the fair
swap rate if the current exchange rate is $2 per pound and the one year US and UK interest
rates are given by rUS and rUK? (4 marks)

Q24. (1 Point)

Due to effect of increased ethanol production, extreme weather and increased global demand,
wheat prices have dramatically increased recently rising above $10 per bushel. What should be
the wheat futures price for delivery in 12 months time if the spot price today is $11, the 12-
month interest rate r is 3% and storage costs are estimated to be 5%? (4 marks)

Q25. (5 Points)

You are responsible for a pension plan that will pay Mr Workalot £ 5000 once a year for a10-
year period. The first payment will come in exactly 5 years. You have studied interest rate risk
and would therefore like to immunize your position.
 (i) What is the duration of the obligation of the fund to Mr Workalot. The current
interest rate is 5% per year. Note that the duration of an annuity that starts to pay in
one year’s time is given by
 =1 +  – (1 + ) - 1
where  is the number of payments and  is the annuity’s yield per payment period.

(ii) If the plan uses 1-year and 20-year zero coupon bonds to construct the immunized
position, how much money ought to be placed in each bond? The bonds’ face value is
assumed to be £1000.

(iii) What will be the face value of the holdings in each zero coupon bond?

(iv) Duration measures the effect of small changes in yields on the bond price. What is
the effect of issuer call provisions on the relationship between bond price and yield?

(v) Assume that a pension fund holds a large government bond portfolio and is
concerned about an interest rate increase of 5 basis points. Outline how the pension
fund could hedge interest rate risk using interest rate futures. What variables
determine the hedge ratio?

Q26. (1 Point)

Your role as Treasurer of USB (United Short Bread) is to optimally manage the firm’s funds. Your
CEO has instructed you to optimally invest £ 1 million and allowed you to use non-UK
government cash equivalents provided that you hedge the currency risk to British pounds by
using forward currency contracts.

Suppose you observe the following information:

Interest Rates
3-Month Cash Equivalents (expressed as APR)
US Government 3%
Japanese government 1%

Exchange Rates
Currency Units per British £
Spot 3-Month forward
US Dollar 1.95 1.94
Japanese YEN 200 198

(i) Calculate the British pound value of the hedged investment at the end of 3 months for each
of the two cash equivalents in the table above. Show all calculations. Because the interest rates
are for 3 month periods, assume they are quoted as bond equivalent yields (APR), annualized
using simple interest.

(ii) What theory of interest rates is most consistent with your findings above?

(iii) Based on the theory estimate the implied interest rate (bond equivalent yield) on a 3 month
UK government cash equivalent?

(iv) What does uncovered interest parity imply for the  $ exchange rate? Actual interest rates
in the UK are currently significantly above Japanese interest rates ?

(v) What regression specification would you use to test uncovered interest rate parity and what
choices are available for the independent variable in such a regression?