PROBLEM SET 2

1) The following bonds are trading in the market:

Bond Time-to-maturity Face value Coupon rate Price

A 1 year $100 0% $95.24
B 2 years $100 10% $107.42
C 3 years $100 20% $140.51
D 4 years $100 0% $85.48

Infer the term structure of interest rates.

2) In addition to the bonds in the last question, you also observe some other
bond (bond E) trading in the market at $136. Bond E has a time-to-
maturity of two years, a face value of $100 and pays a coupon rate of %25.
Show that there is an arbitrage oppurtunity and how to exploit it.

3) Suppose instead that the following bonds are trading in the market:

Bond Time-to-maturity Face value Coupon rate Price

X 2 years $100 10% $105.60
Y 2 years $100 20% $123.86

Infer the term structure of interest rates.

4) Consider a two-year bond with a face value of $100 and a coupon rate of
10%. The current term structure of interest rates is flat at 5%. What kind
of risk are you exposed to if you hold the bond and your investment horizon
is...

a. ... one year?

b. ... three years?

5) Assume that the current term structure of interest is known. Show that the
arbitrage-free forward rate between year s and year t is

1
(1 + yt )t
  ts
s ft = 1
(1 + ys )s

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6) Suppose that the expectations hypothesis holds and that the current term
structure of interest rates is as follows:

y1 = 5%
y2 = 6%
y3 = 7%

a. What is the expected value of the two-year spot rate realizing at year
one, E(1 y3 )?
b. What is the expected price of a two-year zero-coupon bond with a face
value of $100 trading at year one?

7) You observe the following forward rates in the market:

0 f1 = 7%
1 f2 = 9%
2 f3 = 10%

What is the price of a 10% coupon bond with a face value of $100 and a
time-to-maturity of three years?

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Selectedendofchapterquestions(Optional):
BKM15:1,2,4,7,11,12,15,18,19

Note:
Essentialstocoverquestions:
Q1:calculatethetermstructureofinterestratesuptoyear2;
Q2,Q3,Q7

Toobtainthefullcredit,youwouldneedtoattemptallessentialtocoverquestions.
Toobtainthehalfcredit,youwouldneedtoattemptatleast2essentialtocoverquestions.