YTM, HPR & TERM STRUCTURE DUE IN WEEK 3

The following que!ion "efe" !o !he #on$ e"ie !h%! i $e!e"&ine$ #' !he $%' of
'ou" !u!o"i%l % ugge!e$ #' !he l%! (olu&n of !he !%#le)
Thu" & *"i+
Cou,on "%!e+ -).-/
M%!u"i!'+ M%" .012
Yiel$ 3/ ,)%)4+ 5)32-
Co""e,on$ing 6iqui$%!ion $%!e+ 11727.008
Co""e,on$ing 'iel$ %! whi(h #on$ i ol$+ 5)8-0
i4 H%$ 'ou #ough! % #on$ on !he .9!h :ul' .008 %n$ ol$ !he in;e!&en! on !he
liqui$%!ion $%!e %! !he ugge!e$ 'iel$, (o&,u!e !he hol$ing ,e"io$ "e!u"n of
'ou" in;e!&en!)
First, we must work out the settlement price:
( )
( )
21
21
1 1 0.031975
$100
' $2.625
0.031975
1 0.031975
91.3405002
p

+
+
+

number of days between settlement date and next coupon payment date
number of days between pre!ous and next coupon payment dates
number of days between 2"#07#0" and 15#09#0"
number of days between 15
f

#03#0" and 15#09#0"

49
1"4

( )
( )
0
49
1"4
'
1
91.3405002 2.625
$93.1"1
1 0.031975
f
p CPP
P
r
+

+
+

+
Now, to compute HPR , we first need the terminal value of the investment:
First, calculate proceeds of sale:
( )
( )
21
21
1 1 0.034125
$100
$2.625
0.034125
1 0.034125
91.3405002
t
P

+
+
+

ii4 Wh' $i$ 'ou e%"n % "e!u"n !h%! i $iffe"en! f"o& !he 'iel$<
Yi, 3.00-4 Seion 9, D= > !o E)
D= >+
Coupon Rate
(% p.a.)
Time to aturit!
(!ear)
"T
(% p.a.)
#.$ % &.'(
%(.$ ' #.#(
&.( ) #.*(
+.( * #.((
+.( $ +.&$
i4 , would e-pect the same holdin. period return from investin. in the two/!ear 0ond for one
!ear compared to investin. in the one/!ear 0ond for one !ear. Computin. the holdin. period
return for the two strate.ies .ives:
1trate.! one: investin. in the two/!ear 0ond for one !ear
Cost of investin. in the two/!ear 0ond 2 price of the two !ear 0ond:
( )
2 year bond 2
10.5 100 10.5
pr!ce $105.014
1 0.0770
1 0.0770
+
+
+
+
3ppl!in. the present value concepts to o0tain:
( ) ( ) ( )
10.5 100 10.5
$105.014
1 0.0"20 1 0.0"20 1 1 f
+
+
+ + +
solvin. .ives:
( ) 1 7.15$ f
For the e-pectations theor!, we e-pect that ( ) ( ) % 1 1 7.15$ r f 1
]
so
( )
100 10.5
%xpected sell!n& pr!ce
1 % 1
110.5
1.0715
$103.126
r
+

+ 1
]

Now, usin. the formula for 45R

0
1
t
t t
HPR
P CI P
m
_
+ +

,
.ives
( ) $105.014 1 10.5 103.126 HPR + +
3nd rearran.in. and solvin. for HPR .ives:
( ) $105.014 1 10.5 103.126
113.626
1 0.0"200"... ".20$
105.014
HPR
HPR
+ +

1trate.! two: investin. in the one/!ear 0ond for one !ear
1 year bond
100 7.5
pr!ce $99.353
1 0.0"20
+

+
1
100 7.5 107.5
t
P P +
Therefore, calculation for HPR .ives:
107.5
1 0.0"20005... ".20$
99.353
HPR
The calculations verif! the e-pectation, .ivin. a holdin. period return of &.'(% for the two
strate.ies.
ii4 6i7uidit! premium of $( 0asis points 2 (.$%, investin. in the ' !ear 0ond for one !ear.
Calculations:
( )
2 year bond 2
10.5 100 10.5
pr!ce $105.014
1 0.0770
1 0.0770
+
+
+
+
iii4 3ccordin. to the li7uidit! premium theor!, investors are risk averse. This means that
the! re7uire compensation for investin. in 0onds with maturities lar.er than their intended
holdin. period. 4ence, 0orrowers must offer a li7uidit! premium to offset the risk e-posure
to the uncertain sellin. price.
i;4 The ac7uisition cost of the '/!ear 8ero/coupon 0ond com0ined with a %/!ear 8ero/coupon
0ond is e7uivalent to the cost of ac7uirin. the '/!ear %(.$% coupon 0ond since the cash flows
of the latter is the same as the former. 9 (see dia.ram)
4ence, we have:
( ) ( )
0 2 2
10.5 110.5 10.5 110.5
$105.014
1.077 1.077 1.0"2
1 2
P
y
+ +
+
1olvin. .ives us:
( ) 2 0.0767440... 7.674$ y
;4 1imilarl! to 7uestion iv, so we now have:
( ) ( ) ( ) ( )
0 2 3 2 3
" " 10" " " 10"
$101.563
1.074 1.074 1.074 1.0"2
1 2 1 3
P
y y
+ + + +
+ +
:here: ( ) 2 7.674$ y
1olvin. .ives us:
( ) 3 0.0736294... 7.363$ y
D= C+
Coupon strippin. refers to splittin. the coupon pa!ments and face value of a 0ond into
individual cash flows 9 which can then 0e repacka.ed and sold separatel! as individual 8ero
coupon 0onds.
Financial institutions which own an inventor! of 0onds, as well as erchant 0ankers, could
do this to earn profit. The Commonwealth ;overnment does not issue 8ero coupon 0onds,
despite the demand for 8ero coupon 0onds due to its risk free and ta-/deferral advanta.es (if
held to maturit!). 4ence there is niche market to support the coupon strippin. activit!.
D= D+
3ccordin. to the e-pectations theor!, investors are risk neutral. 4ence the! rank investments
on the 0asis of e-pected return. For a .iven holdin. period, since 0onds with different times
to maturit! are e-pected to provide the same return, investors are indifferent 0etween 0onds
with different times to maturit!.
3ccordin. to the li7uidit! premium theor!, investors are risk averse. 4ence the! rank
investments on the 0asis of e-pected return and risk. For a .iven holdin. period, althou.h the
lon. term 0onds are e-pected to provide more return than the short term 0ond, the lon. term
0onds also e-pose investors to more price risk as interest rates are less predicta0le. Thus lon.
term 0onds are preferred if and onl! if the investor perceives that the additional return
e-pected from the lon. term 0ond more than offsets the e-posure to price risk.
D= E+