International Management Institute New Delhi

Academic Year 2024-25

Fixed Income Securities | Term IV
Faculty: Prateek Bedi
PRACTICE QUESTIONS

1. Mr. Himesh invests Rs.10,000 for five years in a zero-coupon bond and five years later, he gets
Rs. 16,105.10. On the other hand, his friend Mr. Dhananjay also invests Rs. 10,000 to buy a 5-year
coupon bearing bond priced at par but he gets Rs. 1,000 every year along with redemption of the
principal at the end of 5th year. Both claim that they earn 10% yield to maturity on their investment.
Do you agree with their claims? Give reasons for your answer.

Answer: Yes, their claims are true. If we calculate the yield to maturity on the zero-coupon bond
held by Mr. Himesh we get:

Y = (16105.10/10,000)1/5 – 1 = 10%

Now, coupon rate on the coupon-bearing bond held by Mr. Dhananjay is 10% (i.e. 1000/10,000).
Since this bond is priced at par (i.e. Rs. 10,000), the YTM of this bond will be equal to its coupon
rate. Hence, the YTM of this bond will also be equal to 10%.

2. Abhilash is considering a one-year Rs. 1,000 bond which is offered to him at Rs. 990 with a coupon
rate of 8%. If the current market interest rate for similar bonds is 9.5%, should he buy the bond?

Answer: Current Yield of the bond = 80/990  8.08% which is less than the market yield of 9.5%.
The bond should not be purchased because the bond provides a lower yield than what the market
is offering on similar bonds.

3. Given the following bonds and prices of bonds, what are the spot rates and forward rates assuming
that the Expectations Theory of term structure of interest rates holds?

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 Bonds Prices Amount of cash flows realised at the end of the year
1 2 3 4
A Rs. 900 Rs. 1000
B Rs. 820 Rs. 1000
C Rs. 725 Rs. 1000
D Rs. 675 Rs. 1000

Answer: Spot rate for 1 year = S1 is that discount rate which satisfies the following equation:
900 = 1000/(1+S1)
Solving it for S1 gives S1 = 11.11%
Spot rate for 2 years = S2 is that discount rate which satisfies the following equation:
820 = 1000/(1+S2)2
Solving it for S2 gives S2 = 10.43%
Spot rate for 3 years = S3 is that discount rate which satisfies the following equation:
725 = 1000/(1+S3)3
Solving it for S3 gives S3 = 11.32%
Spot rate for 4 years = S4 is that discount rate which satisfies the following equation:
675 = 1000/(1+S4)4
Solving it for S4 gives S4 = 10.33%
1 year forward rate after one year = F11 is that interest rate which satisfies the following equation:
(1+S1)(1+F11) = (1+S2)2
 (1.1111)(1+F11) = (1.1043)2
 F11 = 9.76%
1 year forward rate after two years = F21 is that interest rate which satisfies the following equation:
(1+S1)(1+F11)(1+F21) = (1+S3)3
 (1.1111)(1.0976)(1+F21) = (1.1132)3
 F21 = 11.31%
2 years forward rate after one year = F12 is that interest rate which satisfies the following equation:
(1+S1)(1+F12)2 = (1+S3)3
 (1.1111)(1+F12)2 = (1.1132)3
 F12 = 11.42%
1 year forward rate after three years = F31 is that interest rate which satisfies the following equation:
(1+S1)(1+F11)(1+F21)(1+F31) = (1+S4)4
 (1.1111)(1.0976)(1.1131)(1+F31) = (1.1033)4
 F31 = 7.39%

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 2 years forward rate after two years = F22 is that interest rate which satisfies the following equation:
(1+S1)(1+F11)(1+F22)2 = (1+S4)4
 (1.1111)(1.0976)(1+F22)2 = (1.1033)4
 F22 = 10.22%
3 years forward rate after one year = F13 is that interest rate which satisfies the following equation:
(1+S1)(1+F13)3 = (1+S4)4
 (1.1111)(1+F13)3 = (1.1033)4
F13 = 10.06%

4. Deepanshi is planning to buy a bond that has a maturity of 6 years with a coupon of 10% paid half
yearly. If the market yield is 12% p.a., then determine the maximum price she can pay to buy it.

Answer: Since this is a half-yearly bond, the half-yearly coupon rate is 10%/2 = 5%, the half-yearly
YTM is 12%/2 = 6% and number of half-yearly periods is 6*2 = 12. The maximum price one would
like to pay would be –

C 1  1
PRICE = 1− n
+ FV 
Y  (1 + Y)  (1 + Y) n

Price = (5/0.06)*(1 – (1/(1.06)12)) + (100/(1.06)12) = Rs. 91.61

5. A zero-coupon bond is presently trading in the bond market at Rs. 736.75. If its face value is Rs.
1,000 and maturity 5 years, you are required to determine its yield-to-maturity.

Answer: If we calculate the yield to maturity on the zero-coupon bond we get:

Y = (1000/736.75)1/5 – 1 = 6.30%

Hence, Yield to Maturity = 6.30%

6. A step-up bond offers the following coupon rates: first year 5%, second year 6%, third year 7%,
fourth year 8% and fifth and last year 9%. If this bond is earning a YTM of 8.50% and the par value
Rs. 1,000, then you are required to determine its price.

Answer: To calculate the price of this bond, we need to first calculate the coupon payment for each
year by multiplying the coupon rate for each year with the face value of the bond. Subsequently,
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 we need to discount the cash flows at the given YTM of 8.50% and add the present values of all
cash flows.

Time Coupon Rate Coupon Payment Present Value of Coupon Payment at 8.50%
1 5% 50 46.08
2 6% 60 50.97
3 7% 70 54.80
4 8% 80 57.73
5 9% 1090 724.90

Answer: Price of the Bond Rs. 934.48

7. A bond gives a coupon of 8% for the first two years, for the next two years 10% and then, 9% till its
maturity. This bond trades in the market at Rs. 797.35. It has a maturity of 8 years, and the par
value of the bond is Rs. 1,000. The company will redeem the bond at 5% premium. You are
requested to determine the YTM on this bond. Consider a reference rate of 13%.

Answer: To calculate the YTM of the bond, we can use the interpolation formula for which we need
to compute the price of the bond at two discount rates, one higher rate and one lower rate. Below
is the price calculation of the bond at a discount rate of 13%.

TIME COUPON RATE CASH FLOWS DISCOUNT RATE PV OF CASH FLOWS

1 8% Rs.80 13% Rs.70.80
2 8% Rs.80 13% Rs.62.65
3 10% Rs.100 13% Rs.69.31
4 10% Rs.100 13% Rs.61.33
5 9% Rs.90 13% Rs.48.85
6 9% Rs.90 13% Rs.43.23
7 9% Rs.90 13% Rs.38.26
8 9% Rs.1,090 13% Rs.410.01
Price of Bond @13% Rs.804.43
NPV of Bond @13% Rs.7.08 (804.43-797.35)
Since the NPV at the discount rate of 13% is positive, we need to increase the discount rate and
find the NPV again so that it turns out negative. Below is the price calculation at 14%.

TIME COUPON RATE CASH FLOWS DISCOUNT RATE PV OF CASH FLOWS

1 8% Rs.80 14% Rs.70.18
2 8% Rs.80 14% Rs.61.56

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 3 10% Rs.100 14% Rs.67.50
4 10% Rs.100 14% Rs.59.21
5 9% Rs.90 14% Rs.46.74
6 9% Rs.90 14% Rs.41.00
7 9% Rs.90 14% Rs.35.97
8 9% Rs.1,090 14% Rs.382.11
Price of Bond @14% Rs.764.26
NPV of Bond @14% Rs.33.09 (764.26-797.35)

Using the IRR interpolation formula as mentioned above, we can now solve the YTM of the bond.

YTM = 13% +
7.08
14% − 13%
7.08 - (-33.09)

YTM of the bond = 13.18% (approximately)

8. A coupon bearing bond with a maturity of 10 years presently trading in the bond market at Rs.
1,235.50 is giving a yield of 11.35%. Its par value is Rs. 1,000, You are required to determine the
coupon rate of the bond.

Answer: We know that the formula for the price of the bond is as follows.

C 1  1
PRICE = 1− n
+ FV 
Y  (1 + Y)  (1 + Y) n

Putting the values of the price of the bond, YTM and maturity period of the bond, in this equation,
we can solve for the coupon rate.

C  1  1
1235.50 = 1− 10 
+ 1000 
11.35%  (1 + 11.35%)  (1 + 11.35%)10

Coupon, C = INR 154.08

Coupon Rate = 154.08/1000 = 0.15408 or 15.41%

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9. An insurance company needs to value a riskless 5-year bond, with an 8% annual coupon paid half-
yearly and a face value of Rs. 1,000. Assume that the bond is not actively traded and that there are
no recent transactions reported for this particular security. Consider the term structure of interest
rates given in the graph below to value this bond as on March 31, 2024.

Answer: To find out the price of the riskless bond, we can discount the cash flows to be received at
the respective spot rate corresponding to timing of the cash flows. The spot rates are as follows.

Maturity (Yrs) Spot Rate

0.5 3.48%
1.0 3.87%
1.5 4.22%
2.0 4.52%
2.5 4.79%
3.0 5.04%
3.5 5.26%
4.0 5.46%
4.5 5.64%
5.0 5.80%
5.5 5.94%
6.0 6.07%
6.5 6.19%
7.0 6.29%
7.5 6.38%
8.0 6.46%
8.5 6.54%
9.0 6.60%
9.5 6.66%
10.0 6.71%

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 To price the bond, we need to calculate the present value of the future cash flows of the bond as
shown below. We will have to adjust the coupon rate and YTM (spot rates) by dividing them by 2
since we are considering 10 half-yearly periods i.e. 5*2.

PERIODS - HALF YEARLY CASH FLOWS PV OF CASH FLOWS

1 Rs.40 Rs.39.32
2 Rs.40 Rs.38.50
3 Rs.40 Rs.37.57
4 Rs.40 Rs.36.58
5 Rs.40 Rs.35.53
6 Rs.40 Rs.34.45
7 Rs.40 Rs.33.35
8 Rs.40 Rs.32.25
9 Rs.40 Rs.31.14
10 Rs.1,040 Rs.781.41
Price of the Bond Rs.1,100.10

10. Yukti bought a government bond with a coupon rate of 5%; it will mature in 2023. The bond offers
semi-annual payments — one on December 1 and another on June 1. Yukti bought the bond on
January 1, 2021, for a quoted clean price of Rs.1,800. Calculate the accrued interest and dirty
price of the bond.

Answer: The accrued interest is a culmination of interest since the last payment date. Since Yukti
purchased the bond on January 1, 2022, 31 days have elapsed (December 1 to January 1). Based
on the given values, accrued interest is as follows:

Accrued interest = 1800 x 0.05/2 x 31/182

Accrued Interest = 1800 x 0.025 x 0.169
Accrued Interest = Rs.7.60
Dirty Price = Clean Price + Accrued Interest
Dirty Price = 1800 + 7.60
Dirty Price = Rs.1807.60
Therefore, on January 1, 2022, the bond’s dirty price was Rs.1807.60.

11. An analyst is valuing a 7% bond issued by TVS Motors Ltd. The bond was issued on April 1, 2024.
The bond matures on December 31, 2031, and has a face value of INR 1000. The bond pays semi-
annual coupons on June 30 and December 31 every year. The valuation of the bond is being

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 conducted on August 25, 2024. If the current risk-free rate is 5% and the risk premium on the
concerned bond is 5.5%, what is the flat price of this bond?

Answer:

12. Falguni is trying to calculate par rate of a three-year bond. If the spot rates are as follows, help her
find out the par rate of the three-year bond.
1 year Spot Rate = 4%
2 Year Spot Rate = 5%
3 Year Spot Rate = 6%
Answer: The par rate C is the coupon rate that equates the bond's price to its face value (let us
assume it to be 100).
The price of a bond selling at par value is given by:

Let's plug in the spot rates and solve for C.

Hence, par rate for the 3-year bond is approximately 5.91% (i.e. Coupon/Face Value = 5.91/100).

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13. Lakshay wants to calculate the 3-year spot rate from the data given below.
1-Year Par Rate: 2.5%
2-Year Par Rate: 3%
3-Year Par Rate: 3.5%
Help him find out the 3-year spot rate in a step-by-step manner.
Answer: We know that for a 1-year bond, the par rate equals the spot rate because there’s only
one payment period.
Therefore, 1-year par rate = 1-year spot rate = 2.5%
For a 2-year bond, the price of the bond at par is:

2-Year Spot Rate = S2 = 3.01%

For a 3-year bond, the price of the bond at par is:

Solving for S3, we get S3 = 3.52%

14. Rohan holds a step-down bond which offers the following coupon rates: first year 6.5%, second
year 6%, third year 5.5%, fourth year 4.5% and fifth and last year 4%. If this bond is earning a YTM
of 9.50% and the par value Rs. 1,000, then you are required to determine its price.

Answer: To calculate the price of this bond, we need to first calculate the coupon payment for each
year by multiplying the coupon rate for each year with the face value of the bond. Subsequently,
we need to discount the cash flows at the given YTM of 9.50% and add the present values of all
cash flows.
Time Coupon Rate Coupon Payment Present Value of Coupon Payment at 9.50%
1 6.50% 65 59.36
2 6.00% 60 50.04
3 5.50% 55 41.89
4 4.50% 45 31.30
5 4.00% 1040 660.64
Price of the Bond Rs. 843.23

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15. Ronika holds a 9% bond that makes coupon payments on June 15 and December 15 and is
trading with a YTM of 8%. The bond is purchased and will settle on August 26 when there will be
eight coupons remaining until maturity. Calculate the full price and flat price of the bond using
actual days convention.

Answer: We need to calculate the value of the bond on the last coupon date. The coupons are
semiannual, so we use 8% / 2 = 4% as the semi-annual discount rate and 9%/2 = 4.5% as coupon
rate. Further, n = 8 as given in the question. We assume the face value of the bond as Rs. 1000.
The formula for the price of the bond is as follows.

C 1  1
PRICE = 1− n
+ FV 
Y  (1 + Y)  (1 + Y) n

Putting the values of the price of the bond, YTM and maturity period of the bond, in this equation,
we can solve for the coupon rate.

45  1  1
PRICE = 1− 8
+ 1000 
4%  (1 + 4%)  (1 + 4%)8

Price of the bond as on the last coupon data = Rs. 1033.66

Days between the last coupon date (June 15) and settlement date (August 26) = 72

Days in the coupon period (i.e. between June 15 and December 15) = 183

Dirty Price (Full Price) of the bond = 1033.66*(1.04)72/183 = Rs. 1049.73

Accrued Interest = 45 * (72/183) = Rs. 17.70

Clean Price (Flat Price) of the bond = Dirty Price – Accrued Interest = 1049.73-17.70 = INR 1032.03

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