Department of Statistics, The Chinese University of Hong Kong

RMSC2001 Introduction to Risk Management

Tutorial 5
TA: Ryan Fong1 & Yulin Zhu2
October 2024
Notes passed down from Leo Wang Zexian.

If you have any questions about the course or find any typos in the tutorial notes, please feel free to contact
me.

1 Introduction
Unless otherwise specified, here we assume that there is NO credit risk for bonds.

Definition 1 Bond terminologies. A bond can be represented by a series of cash flows:

• (Price) The bond buyer pays P initially, i.e., c(0) = −P .

• (Coupon) The bond issuer gives c regularly (say, m payments each year), i.e.,

c(t) = c for t = 1/m, 2/m, . . . , T − 1/m.

• (Face value) At the maturity T , the bond issuer gives back the principal/face value F plus the
coupon, i.e.,
c(T ) = c + F.

We say that a bond is a zero if c = 0 and F = 1. In contrary, we say that a bond is a coupon bond if
c > $0.

LRemark More about bonds.

• Coupon c can be calculated using annual coupon rate rc and the face value F by
rc
c=F · .
m

• Bonds are also known as fixed-income debt financing instruments.

Exercise 1 Replicate coupon bond by zeros. Suppose that Yau would like to buy 200 coupon bonds with
principal $100, an annual coupon rate of 7%, a 3-year maturity, and semi-annual coupon payments. How-
ever, there is no such coupon bond available in the market. Using zeros with face values $100 and maturities
up to 3 years, propose a portfolio at time 0 for him that replicates the cash flows of his desired 200 coupon
bonds.

Solution. The following portfolio replicates the cash flows of his desired 200 coupon bonds: long 7 zeros
with maturity T = 0.5, long 7 zeros with maturity T = 1, long 7 zeros with maturity T = 1.5, long 7 zeros
with maturity T = 2, long 7 zeros with maturity T = 2.5, and long 207 zeros with maturity T = 3.

Note that each of the 7 zeros replicates the cash flows from the coupons, and the 200 zeros with maturity

1
[email protected]
2
[email protected]

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T = 3 replicate the cash flow from the principal.

2 Zero Bond
Definition 2 Zeros and related rates.

• (Price) Denote the price of a zero at time t with maturity T by B(t, T ).

• (Zero rate) We say that R(0, T ) is the zero rate if it is the interest rate s.t.

B(0, T )a(T ) = 1,

where a(T ) is the accumulative function, based on the specification of the type of interest rate, i.e.,

– (Annual Compounding) a(T ) = [1 + R(0, T )]T ;

– (k-times-per-year compounding) a(T ) = [1 + R(0, T )/k]kT ;
– (Continuous) a(T ) = exp{R(0, T ) · T }.

• (Forward rate) We say that F (0, t, T ) is the forward rate s.t. under annual compounding assump-
tion,
[1 + R(0, T )]T = [1 + R(0, t)]T [1 + F (0, t, T )]T −t

LRemark More about zeros.

• The price of a zero satisfies B(0, T ) ≤ B(t, T ) ≤ B(T, T ) = 1 for t ∈ [0, T ].

• The price of a zero with dollar sign $ are stated as if the principal is $100. For example, the price of
a zero = $99 implies that B(0, T ) = 0.99.

• A zero rate curve is a graph of zero rates against maturities T , i.e., with points (x, y) = (T, R(0, T )).

Exercise 2 Zero rates.

Suppose that there is a zero bond with price $90 and maturity T = 3. Find the zero rate if

1. the interest is compounded annually;

2. the interest is compounded quarterly;

3. the interest is compounded continuously.

Solution.

B(0, T )a(T ) = 0.9a(T ) = 1,

where a(T ) depends on the type of interest rate. Hence, we have
p
1. 0.9a(T ) = 0.9[1 + R1 (0, 3)]3 = 1 ⇒ R1 (0, 3) = 3 1/0.9 − 1 = 3.51%;
p
2. 0.9a(T ) = 0.9[1 + R2 (0, 3)/4]3×4 = 1 ⇒ R2 (0, 3) = 4( 12 1/0.9 − 1) = 3.53%;

3. 0.9a(T ) = 0.9 exp{3 · R3 (0, 3)} = 1 ⇒ R3 (0, 3) = log(1/0.9)/3 = 3.57%.

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3 Coupon Bond
Assume that there are m payments each year in t ∈ [0, T ] with coupon value c for a coupon bond.

Definition 3 Price of coupon bond. The initial price of a coupon bond can be calculated by

mT  
X i
P = c · B 0, + F · B(0, T ). [Updated]
m
i=1

Note that the zero bond price B(0, t) with maturity t is the discount factor of the coupon bond at time t.

Exercise 3 Fair price of coupon bond by zeros. Continued from Exercise 1. Suppose that the current
interest rate is 4% p.a. compounded semiannually. Compute the fair price of each coupon bond.

Solution.
First, note that the present value of our constructed portfolio in Exercise is
100 100 100 100 100 100
PV = 7 · +7· 2
+7· 3
+7· 4
+7· 5
+ 207 · = $21680.43
1.02 1.02 1.02 1.02 1.02 1.026
Since this portfolio replicates the cash flows of 200 coupon bonds, the fair price of each coupon bond is
1
P = · 21680.43 = $108.40
200

4 Yields
Recall that zero rate is the annualized rate of return of zero coupon bond, the Yield-to-Maturity (YTM) (of
a coupon bond) is the single internal rate of return (IRR) that sets the present value of the cash flows equal to
the bond price.

Definition 4 Yield. We say that y is the Yield to Maturity (YTM) if we can represent

mT
X CFi
P = P (y) =
ay (i/m)
i=1

where

• (Annual Compounding) ay (t) = (1 + y)t ;

• (k-times-per-year compounding) ay (t) = (1 + y/k)kt ;

• (Continuous) ay (t) = eyt

LRemark More about yield.

   
higher above
• If a bond has price than its face value, we say that it is selling par.
lower below

• Since the yield y determines the price P and vice versa, we may denote P = P (y) to regard the
coupon bond price as a function of yield y. Note that P (y) is decreasing with y. (Why?)

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• We say that a bond is at par if its price equals its principal. The yield (y) is equal to its coupon rate (c)
if and only if the bond is selling at par, i.e.,
mT  
X i
y=c ⇔ F =P = CFi · B 0,
m
i=1

Exercise 4 Yield. Suppose that you invest in a 10-year U.S. Treasury Note sold at par (with face value
$1000), with an annual coupon rate of 8% and semi-annual coupon payment.

1. What is the yield of this Treasury Note?

2. Assume that the coupon payments are reinvested at YTM and you plan to hold the bond for 3 years.
What is the future value of coupon payments at the end of the third year? [Hint: use the formula
for the future value of an annuity.]

3. At the end of the third year, if you sell the Treasury Note, what is your capital gain? Assume a flat
yield curve. [Hints: capital gain = sales price − purchase price, and a flat yield curve means the
yields are the same for all maturities.]

4. Immediately after the bond is issued, the market yield falls to 6%. Suppose that you still want to
hold the bond for 3 years, what are the future values of coupon payments and capital gain? Compare
the results with the answers in 2 and 3.
Solution.

1. We can find the yield as follows:

19
X $40 $1040
$1000 = + ⇒ y = 8% .
(1 + y/2)t (1 + y/2)40
t=1

We can also get this result without calculation: because the bond is sold at par, the coupon rate
must be equal to its yield, i.e., y = c = 8%

2.
1.046 − 1
 
5
F V (C) = $40 + $40(1 + y/2) + · · · + $40(1 + y/2) = $40 = $265.32 .
0.04

3. At the end of the third year, the Treasury Note can be regarded as a coupon bond with the same
coupon rate as its yield, so it is still a par bond. Hence, the new price is still $1000 and the capital
gain is 0.

4.
1.036 − 1
 
′ 5
F V (C) = $40 + $40(1 + 0.06/2) + · · · + $40(1 + 0.06/2) = $40 = $258.74 ,
0.03
13
′
X $40 $1030
P = t
+ = $1112.96 .
(1 + 0.06/2) (1 + y/2)14
t=1

As the market yield decreases, the accrued coupon interest will decrease, but you will get a positive
capital gain of $112.96.
Takeaway: There are three components affecting the return on bond investment:
1. Coupon payments,
2. Income from reinvestment of coupons,
3. Capital gains/losses when the bond matures or is sold.

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The second one reflects the reinvestment risk, and the third reflects interest rate risk. In this Exercise, the
drop in yield leads to a smaller reinvestment income, but the capital gain dominates the overall return. To see
this, we can calculate the realized yield by

F V (C)′ + P ′
P = ⇒ y ′ = 10.82% .
(1 + y ′ /2)6

Note that the realized yield (10.82%) is higher than the original YTM (8%). What is the realized yield if your
holding period is 7 years?

Exercise 5.

1. Consider a 20-year 10% coupon bond with a par value of $1000. Suppose that the required yield on
this bond is 11%. The cash flows for this bond are as follows: 40 semiannual coupon payments of
$50; $1000 to be received 20 years from now. What is the price of this bond?

2. There is a 12% coupon bond on the market that sells for par value. What is the yield to maturity
(YTM) of this bond? Explain your answer.

3. Which security has a higher effective annual interest rate?

A A zero-coupon bond selling at $97,645 with par value $100,000 maturing in 3 months.
B A coupon bond selling at par and paying a 10% coupon semiannually.

Solution.

1.   
1 1 1000
50 1− + = 919.77
0.055 (1.055)40 (1.055)40

2. 12%

3.
  12
100, 000 − 97, 645 3
1+ − 1 = 10.00%
97, 645
12
(1 + 5%) 6 − 1 = 10.25%

Exercise 6. Suppose that Tony’s company needs to raise $45 million and he wants to issue 30-year bonds
for this purpose. Assume that the required return on his bond issue will be 6% and he is evaluating two
issue alternatives: A semiannual coupon bond with a 6% coupon rate and a zero coupon bond.

a) How many of the coupon bonds does he need to issue to raise the $45 million? How many of the
zeroes does he need to issue?

b) In 30 years, what will his company’s repayment be if he issues the coupon bonds? What if he issues
the zeros?
Solution.

a) The coupon bonds have a 6% coupon which matches the 6% required return, so they will sell at par.
The number of bonds that must be sold is the amount needed divided by the bond price.
Number of coupon bonds to sell = 45, 000, 000/1, 000 = 45, 000
Price of zero coupon bonds = 1, 000/1.0360 = 169.73
Number of zero coupon bonds to sell = 45, 000, 000/169.73 = 265, 122

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Solution.

b) The repayment of the coupon bond will be the par value plus the last coupon payment times the
number of bonds issued.
Coupon bonds repayment = 45, 000(1, 030) = 46, 350, 000
The repayment of the zeros will be the par value times the number of bonds issued. 265, 122(1, 000) =
265, 122, 140

LRemark Use Excel to calculate or verify the Yield/PV/FV. Consider a 3-year bond with a 8% semiannual
coupon, selling at $97.42 (per $100 face) to yield 9%.

1. The bond price P is unknown:

Function: PV(rate,nper,pmt,[fv],[type]).
Input: =-PV(0.09/2,6,4,100).
Output: $97.42.

2. The yield y is unknown:

Function: RATE(nper,pmt,pv,[fv],[type],[guess]).
Input: =2*RATE(6,4,-97.42,100).
Output: 9%
(You can also use “Goal Seek” introduced in class).

3. Total value of coupons at maturity:

Function: FV(rate,nper,pmt,[pv],[type]).
Input: =-FV(0.09/2,6,4).
Output: $26.87.

4. The coupon payment is unknown:

Function: PMT(rate,nper,pv,[fv],[type]).
Input: =PMT(0.09/2,6,-97.42,100).
Output: $4.00.
(So the coupon rate is 2 × 4/100 = 8%).

Similarly, you can also use PMT(rate,nper,pv,[fv],[type]) to calculate the payment in each period of
a mortgage, and use IRR(values,[guess]) to calculate the return of a series of irregular cash flows.

Exercise 7. A 30-year maturity, 8% coupon bond paying coupons semiannually is callable in five years at
a call price of $1,100. The bond currently sells at a yield to maturity of 7% (3.5% per half-year).

a) What is the yield to call?

b) What is the yield to call if the call price is only $1,050?

c) What is the yield to call if the call price is $1,100 but the bond can be called in two years instead of
five years?

Solution. a. 3.3679% per half-year b. 2.9763% per half-year c. 3.0312% per half-year.

5 Duration
Definition 5 Duration. Suppose that the face value of a coupon bond was $100. Given that the initial
yield is y0 .

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• (Dollar Duration) We say that the derivative P ′ (y) = dP dy is the Dollar Duration ($Dur). We may
approximate the profit resulting from a decrease in yield of ∆y0 by

P (y0 − ∆y0 ) − P (y0 ) ≈ (−∆y0 )P ′ (y0 ).

For a bond, the dollar duration is

n
X t · CFt
P ′ (y) = −
(1 + y)t+1
t=1

• (DV01) We define the change in bond price for one basis point decrease in yield as

P ′ (y0 )
DV01 = −
10000
Note that the profit generated by a decrease of δ b.p. in yield follows
position size
Approximated profit = × δ × DV01
100

• (Modified duration) We say that the proportional change −P ′ (y0 )/P (y0 ) is the Modified Duration
(MD).

LRemark More about duration.

• Duration is a commonly used measure of bond price sensitivity. Higher duration means higher price
sensitivity to interest rate changes (more volatile).

• Dollar duration can be interpreted as the slope of a price curve P (y).

• Dollar Duration is a negative value (in $-term).

• One basis point (1 b.p.) equals 0.01%.

• Modified duration measures the percentage increase in bond value per one basis point of decrease in
yield, and it is a positive unitless value.

• Relationship among Dollar Duration ($Dur), DV01 and MD:

−$Dur MD × P
DV01 = =
10000 10000

Exercise 8 Approximate profit using duration. A bond that pays annual coupons has a par value of $1,000,
an 8% coupon rate, 3 years left to maturity, and is currently priced at a YTM of 6.0%.

1. Calculate the dollar duration and modified duration for the bond.

2. If the YTM changes from its current 6.0% to 8.0%, what is the approximated profit?

3. What is the approximation error?

4. If the YTM changes from 6.0% to 10.0%, what is the approximation error?

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Solution.

1. We can first calculate the bond price,

$80 $80 $1080

P = + 2
+ = $1053.46
(1 + 6%) (1 + 6%) (1 + 6%)3

Then the dollar duration and modified duration are given by

 
1 × $80 2 × $80 3 × $1080
$Dur = − + + = −$2771.92 ,
(1 + 6%)2 (1 + 6%)3 (1 + 6%)4

M D = −$Dur/P = 2.63

2. We can calculate the price change by dollar duration or modified duration:

∆P = 2.0% × (−$2771.92) = −$55.44 ,

or equivalently,
∆P/P = −2.0% × 2.63 ⇒ ∆P = −$55.44
So the approximated loss is $55.44.

3. Note that the new yield is equal to the coupon rate, so the new price of the bond is its par value,
$1000. Therefore, the exact change in price is $1000 − $1053.46 = −$53.46, which is quite close to
our approximation in 2. The approximation error is $55.44 − $53.46 = $1.98.

4. First, calculate the new price and the actual price change:

$80 $80 $1080

P′ = + + = $950.26
(1 + 10%) (1 + 10%)2 (1 + 10%)3

Thus, the actual change in price is $950.26 − $1053.46 = −$103.20. If we approximate this change
by dollar duration:
∆P = 4% × (−$2771.92) = −$110.88
Thus, the approximation difference is $110.88 − $103.20 = $7.68, which is larger than the error in
the previous question.

Takeaway: Using duration to estimate the change in price will only be accurate for small changes in
yield!

LRemark @ Macaulay Duration. Macaulay Duration (D) is the weighted average of the times to each
coupon or principal payments made by the bond. The formula for a bond that pays annual coupon is
T
X P V (CFt ) CFt
D= t × w(t), w(t) = = ,
Total PV P · (1 + y)t
t=1

where y is the yield. From the formula, notice that its relationship with dollar duration and modified
duration is D = −$Dur(1+y)
P = M D(1 + y).

Recall that in Exercise 4, if the market yield goes up, then the reinvestment income goes up, but there
is a capital loss; on the contrary, if the yield goes down, the reinvestment income goes down, but there
is a capital gain. At what investment horizon does the two effects offset each other (the portfolio return
will not be affected by the interest rate change)? The answer is (Macaulay) Duration. Duration can be

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interpreted as a break-even point. If the investment horizon in Exercise 4 is 7 years, which is the duration
of the bond, then you might find that the realized yield is quite close to the original YTM, which means
that the impact of the yield change is very small.

• Longer-term bond has higher duration than shorter-term bond.

• Duration is a time-varying property.

• Duration is the weighted average of the timings of future cash flows. Each cash flow has its own timing.
Each timing (cash flow) has different weights depending on the amount of the payment and the time
remaining until the payment. The weight is the present value of the cash flow.

LRemark Immunisation. To manage the risk of loss, portfolio managers may immunise the portfolio by
taking long and short positions in certain bonds with certain durations so that the portfolio as a whole does
not change in value even when interest rates change. e.g. net worth immunisation: matching the duration
of assets with the duration of liabilities, target date immunisation: holding period matches duration.

Risks associated with bond investment: interest rate risk, reinvestment risk, yield curve risk, liquidity risk, credit
risk (default risk, credit spread risk, downgrade risk), call risk, prepayment risk, exchange rate risk, inflation
risk, event risk, sovereign risk, etc.

6 @ Bond Arbitrage

Exercise 9. Suppose that the yield-to-maturity (YTM) on 2-year coupon bonds with coupon rates of 10%
(coupons paid annually) is 7%, the YTM on 1-year zero-coupon bonds is 6% and the YTM on 2-year
zero-coupon bonds is 8%. Derive an arbitrage opportunity available.

Solution.
The 2-year maturity coupon bond has a coupon rate of 10% with annual coupon payments and a yield to
maturity of 7%. The face value is $1,000.
The price of the 2-year maturity coupon bond is:

1, 000 × 10% 1, 000 × 10% + 1, 000 100 1, 100

P = + 2
= + = $1, 054.24
1 + 7% (1 + 7%) 7% (1 + 7%)2

A 1-year zero-coupon bond (strip) with face value of $100 and a yield to maturity of 6% should sell at
100
1+6% = $94.34.

A 2-year zero-coupon bond (strip) with a face value of $1,100 and a yield to maturity of 8% should sell at
1,100
(1+8%)2
= $943.07.

The total price of the 1-year zero-coupon bond (strip) and the 2-year zero-coupon bond (strip) is $1,037.41

Therefore, the 10% coupon bond is relatively overpriced and the two strips of zero-coupon bonds are
relatively underpriced. Arbitrage opportunity is available.
The arbitrage strategy is to take long (buy) positions in the zero-coupon bond with maturity of 1 year
and face value of $100 and the zero-coupon bond with maturity of 2 years and face value of $1,100, and
then simultaneously take short (sell) position in the coupon bond with maturity of 2 years, face value of
$1,000 and coupon rate of 10% with annual coupon payments. The cash flow table demonstrates how this
arbitrage strategy generates riskless profit with zero net investment.

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Solution.

at time 0 after 1 year after 2 years

short the 2-year coupon bond +1,054.24 −100 −1,100
buy the 1-year zero coupon bond with face value of $100 −94.34 +100 0
buy the 2-year zero coupon bond with face value of $1,100 −934.07 0 +1,100
net cash flow +16.83 0 0
cumulative net cash flow +16.83 +16.83 +16.83

In the second half of the course, you will be introduced to the basic structures of financial derivatives (forward
/ futures, European call and put options, swaps, barrier options, knock-out options, knock-in options, CBBC
contracts, accumulators, exotic options, etc.) as well as how we can use them to perform hedging. These will
be followed by discussions on the no-arbitrage principle, leading to the pricing formulas for forward / futures,
and call and put options, including the put-call parity, together with simple pricing models for derivatives such
as binomial trees. Lastly, you will learn about the calculations involving value-at-risk as well as how you can
perform simulations to compute VaR.

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