CHAPTER 4: Practice questions (Page 82)

7. The following table shows the prices of a sample of U.S Treasury strips in August
2006. Each strip makes a single payment of 1000 at maturity.

Maturity Price(%)
August 2007 95,53
August 2008 91,07
August 2009 86,2
August 2010 81,08

a) Calculate the annually compounded, spot interest rate for each year.
1000
= 955.3 ⇒ r1 = 4.68%
1 + r1
1000
= 910.7 ⇒ r2 = 4.79%
(1 + r2 )2
1000
= 862 ⇒ r3 = 5.08%
(1 + r3 )3
1000
= 862 ⇒ r4 = 5.38%
(1 + r4 )4
b) Is the term structure upward- or downward-sloping or flat?

The term structure is upward-sloping.

c) Would you expect the yield on a coupon bond maturing in August 2010 to be
higher or lower than the yield on the 2010 strip?

The yield is a weighted average of the different spot rates which are increasing over time,
i.e. the term structure is upward-sloping. Therefore we expect the yield on the coupon
bond to be lower than the yield on the strip.

d) Calculate the annually compounded, one year forward rate of interest for
August 2008. Now do the same for August 2009.

(1 + r2 ) 2
(1 + r2 ) 2 = (1 + r1 ) × (1 + f 2008 ) ⇒ f 2008 = − 1 ≈ 4.90%
(1 + r1 )

1
 (1 + r3 ) 3
(1 + r3 ) = (1 + r2 ) × (1 + f 2009 ) ⇒ f 2009
3 2
= − 1 ≈ 5.65%
(1 + r2 ) 2

15. Suppose that 5-year government bonds are selling on a yield of 4 percent. Value a
5-year bond with a 6% coupon. Start by assuming that the bond is issued by a
continental European government and makes annual coupon payments. Then rework
your answer assuming that the bond is issued by the U.S. Treasury, so that the bond
pays semiannual coupons and the yield is quoted as twice the semiannually
compounded rate.

Continental European government bond:

Period = 5 years
Yield = 4%
(Annual) coupon payments = 1,000*6% = 60
Now, we use the PV(bond) formula to calculate the present value of the coupons and then
sum the present value of the initial investment:

PV(bond) = PV(coupons) +PV(Final_Payment)

PV(bond) = (Coupon * 5year_AF) + (Final_payment * discount_factor)
⎡ 1 1 ⎤ 1,000
PV(bond) = 60 × ⎢ − 5⎥
+ = 1,089.04
⎣ 0.04 0.04 × (1.04) ⎦ (1.04)
5

US Treasury bonds:
Period = 5 years Æ 10 semesters
Yield = 4% Æ 2% semiannual
Coupon payments = semiannual = 1,000*3% = 30

Following the same procedure as before:

⎡ 1 1 ⎤ 1,000
PV(bond) = 30 × ⎢ − 10 ⎥
+ = 1,089.83
⎣ 0.02 0.02 × (1.02) ⎦ (1.02)
10

17. A 6-year government bond makes annual coupon payments of 5% and offers a yield
of 3% annually compounded. Suppose that one year later the bond still yields 3%. What

2
return has the bondholder earned over the 12-month period? Now suppose instead that
the bond yields 2% at the end of one year. What return would the bondholder earn in this
case?

Purchase price for a 6-year government bond with 5 percent annual coupon:
⎡ 1 1 ⎤ 1,000
PV0 = 50 × ⎢ − 6⎥
+ = 1,108.34
⎣ 0.03 0.03 × (1.03) ⎦ (1.03)
6

Price one year later (yield = 3%):

⎡ 1 1 ⎤ 1,000
PV1 = 50 × ⎢ − 5 ⎥
+ = 1,091.59
⎣ 0.03 0.03 × (1.03) ⎦ (1.03)
5

Rate of return = [$50 + ($1,091.59 – $1,108.34)]/$1,108.34 = 3.00%

Now, if the the bond yields 2% at the on of one yaer:

⎡ 1 1 ⎤ 1,000
PV1 = 50 × ⎢ − 5⎥
+ = 1,141.40
⎣ 0.02 0.02 × (1.02) ⎦ (1.02)
5

Rate of return = [$50 + ($1,141.40 – $1,108.34)]/$1,108.34 = 7.49%

35. (Tutorial) See BMA for the questions

a. We make use of the one-year Treasury bill information in order to determine the
one-year spot rate as follows:
93,46(1 + r1 ) = 100
100
r1 = −1
93,46
r1 = 7,00%
The following position provides a cash payoff only in year two:
a long position in twenty-five two-year bonds and a short position in one
one-year Treasury bill. Cash flows for this position are:
[(–25 × $94.92) + (1 × $93.46)] = –$2,279.54 today
[(25 × $4) – (1 × $100)] = $0 in year 1
(25 × $104) = $2,600 in year 2
We determine the two-year spot rate from this position as follows:
$2,600
$2,279.54 =
(1 + r2 ) 2

3
 r2 = 0.0680 = 6.80%
The forward rate f2 is computed as follows:
f2 = [(1.0680)2/1.0700] – 1 = 0.0660 = 6.60%
The following position provides a cash payoff only in year three:
a long position in the three-year bond and a short position equal to (8/104)
times a package consisting of a one-year Treasury bill and a two-year
bond. Cash flows for this position are:
[(–1 × $103.64) + (8/104) × ($93.46 + $94.92)] = –$89.15 today
[(1 × $8) – (8/104) × ($100 + $4)] = $0 in year 1
[(1 × $8) – (8/104) × $104] = $0 in year 2
1 × $108 = $108 in year 3
We determine the three-year spot rate from this position as follows:
$108
$89.15 =
(1 + r3 ) 3
r3 = 0.0660 = 6.60%
The forward rate f3 is computed as follows:
f3 = [(1.0660)3/(1.0680)2] – 1 = 0.0620 = 6.20%

b. We make use of the spot and forward rates to calculate the price of the 4 percent
coupon bond:

40 40 1040
P= + + = $931.01
(1.07) (1.07) (1.066) (1.07) (1.066) (1.062)

The actual price of the bond ($950) is significantly greater than the price deduced
using the spot and forward rates embedded in the prices of the other bonds
($931.01). Hence, a profit opportunity exists. In order to take advantage of this
opportunity, one should sell the 4 percent coupon bond short and purchase the 8
percent coupon bond.