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IM Problem Set 6

This document contains a problem sheet with questions about bond pricing and portfolio management. It includes true/false questions and multi-part problems involving calculating bond prices, yields, durations, and forming bond portfolios to fund future payments under different interest rate scenarios. Specifically, it asks the student to calculate bond prices and yields at different maturities, order bonds by duration, compute the price and sensitivity of a 5-year bond under different yield assumptions, and determine the composition of a bond portfolio that can fund future payments even if rates change.

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Moe Eltayeb
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139 views

IM Problem Set 6

This document contains a problem sheet with questions about bond pricing and portfolio management. It includes true/false questions and multi-part problems involving calculating bond prices, yields, durations, and forming bond portfolios to fund future payments under different interest rate scenarios. Specifically, it asks the student to calculate bond prices and yields at different maturities, order bonds by duration, compute the price and sensitivity of a 5-year bond under different yield assumptions, and determine the composition of a bond portfolio that can fund future payments even if rates change.

Uploaded by

Moe Eltayeb
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Investment Management Problem Sheet 6 Autumn Term 2016

True-false

1. If interest rates rise, bond prices fall.


2. The value of a portfolio that has zero duration is unaffected by small interest rate
changes.
3. If a bond is trading above par (i.e. its market value exceeds its face value) then its
interest or running yield is higher than its yield to maturity.
4. The price of a five year bond with a 3% coupon should be exactly half way between
the price of two other five year bonds, one with zero coupon, and one with and a 6%
coupon.

5. In general, you get a higher rate of return from long-dated bonds than from short-
dated bonds.

6. If forward rates are higher than spot rates, yields on longer-dated bonds are higher
than yields on shorter-dated bonds.

7. The dirty price of a bond tends to be more variable than the clean price.

Problems

1. The table below lists the prices of zero-coupon bonds of various maturities, expressed as a
price per $1000 of principal. Calculate the yields to maturity of each bond and the
sequence of implied forward rates.

Maturity Price of bond


(years) ($)
1 943.40
2 898.47
3 847.62
4 792.16
Assuming that the pure expectations hypothesis is valid, calculate the expected price path
of the four-year bond as time passes. What is the rate of return of the bond in each of the
four years?

2. The yield-to-maturity on one-year and two-year zero-coupon bonds is currently 7% and


8%, respectively. The Treasury plans to issue a two-year bond that pays an annual coupon
of 9% of face value. The face value of the bond is 100.
a. At what price will the bond sell?
b. What will be the yield-to-maturity of the bond?
c. If the pure expectations hypothesis for the term structure of interest rates is correct,
what is the market expectation of the price that the bond will sell for next year?
d. Repeat the calculation in (c) assuming the liquidity preference hypothesis holds with a
liquidity premium of 1%.

3. Without doing any detailed computations, and assuming that the term structure is flat
at 5%, put the following bonds in order of increasing duration:

(a) a perpetual 5% coupon bond

(b) a perpetual 3% coupon bond

(c) a 25 year zero coupon bond

(d) a 10 year floating rate bond that pays LIBOR

(e) a 5 year 5% coupon bond

(f) a 5 year 6% coupon bond

4. A 5 year bond with a coupon of 7%, that pays interest annually, has its next coupon
due in 12 months. It yields 5% per annum.

(a) compute the price of the bond.

(b) compute the duration of the bond. Use this to compute approximately how the price of
the bond will change if yields rise to 6%.

(c) Compute the convexity of the bond. Use this to obtain a more precise estimate of the
change in the price which will occur if the yield rises to 6%.

5. Firm XYZ is required to make a $5M payment in 1 year and a $4M payment in 3
years. The yield curve is flat at 10% APR with semi-annual compounding. Firm XYZ
wants to form a portfolio using 1-year and 4-year U.S. strips to fund the payments. How
much of each strip must the portfolio contain for it to still be able to fund the payments
after a shift in the yield curve?

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