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Liam Rice

1. Chapter 3: (Quantitative Problems): #11, $12, #14


2. Chapter 4: ( Quantitative Problems ) #2, #5

11. Calculate the duration of a $1,000 6% coupon bond with three years to maturity. Assume
that all market interest rates are 7%

Coupon payment = per value of bond *coupon payment


Coupon payment = $1,000 * 60
Coupon payment = $60.00

Years Cash Present value Present value Weights Weighted


Payments factor at 7% of cash Maturities
interest rate payments
1 $60 0.9346 $60 * 0.9346 $56.0748 / 1 * 0.0576 =
= $56.0748 $973.7568 = 0.0576
0.0576
2 $60 0.8734 60 * .08734 = 52.4063 / 2 * 0.0538 =
$52.4063 973.7658 = 0.1076
0.0538
3 $60 0.8163 60 * 0.8163 = 48.9779 / 3 * 0.0503 =
$48.9779 973.7658 = 0.1509
0.0503
3 $1,000 .08163 1,000 * 816.2979 / 3 * 0.8383 =
0.1863 = 973.7658 = 2.5149
$816.2979 0.8383
Totals $973.7658 2.8310

Duration is therefore 2.83 years

12. Consider the bond in the previous question. Calculate the expected price change if the
interest rates drop to 6.75% using the duration approximation. Calculate the actual price change
using discounted cash flow.
Initial interest rate = 7%
New Interest rate = 6.75%
Duration of the bond = 2.83 years
Initial price = $973.4

Price change in dollar = - (duration) * Change in interest rate / (1 + initial interest rate) * initial
price of bond

Price Change in Dollar = -(2.83) * (0.0675 – 0.070) / (1 + 0.07) * $973.4


Price change in dollar = -*2.83) * -0.00233 * $973.4
Price change in dollar 0.00659 * $973.4
Price change in dollar = $6.4185

If the interest rate decreases to 6.75% the bond price will therefore be increased by
$6.4185.

14. A bank has two 3-year commercial loans with a present value of $70 million. The first $30
million loan that requires a single payment of $37.8 million in three years with no other
payments till then. The second loan is for $40 million. It requires an annual interest payment of
$3.6 million. The principal of $40 million is due in three years.
A. What is the duration of the bank’s commercial loan portfolio?
Year Coupon PV @ 8% Present Weights Weighted
Payment Values Maturities
1 3.6 0.926 3.33 8.12 0.08
2 3.6 0.857 3.09 7.52 0.15
3 43.6 0.794 34.62 84.35 2.35
Total 41.03 100.00 2.76

Duration is 2.76

Weight of $30 assets (wi) = $30 / $70 = 0.428


Weight of $40 asset (wi) = $40 / $70 = 0.57

portfolio duration = 3 * 0.428 + 2.76 * 0.57


Portfolio duration = 1.28 1.57
Portfolio duration = 2.86
B. What will happen to the value of the its portfolio if the general level interest rates
increase from 8% to 8.5%?

Price change in dollar = -(duration) * change in interest rate / (1 + initial interest rate) * initial
price of bond
Price change in dollar + -2.86 * 0.005 / 1 + 0.08 * $70 million
Price change in dollar = -$1.078 million
Change in price of the portfolio is $1.078 million

2. Consider a $1,000-par junk bond paying a 12% annual coupon with two years to
maturity. The issuing company has a 20% chance of defaulting this year, in which case
the bond would not pay anything. If the company survives the first year, paying the
annual coupon payment, it then has a 25% chance of defaulting in the second year. If the
company defaults in the second year, neither the final coupon payment nor par value of
the bond will be paid.
a. What price must investors pay for this bond to expect a 10% yield to maturity?

Expected Cash flows (T1) = .2 * 0 + .8 (1,000 * 12%)


Expected cash flows (T1) = .2 * 0 + .8 * $120
Expected cash flows (T1) = $96.00

Expected Cash flows of (T2) = .25 * 0 + .75 *$1,120


Expected cash flows of (T2) = *840

P = price
C = cash flows or coupon payment
R – investors required annual yield
Price of the bond (P) – C1 / (1 +r) ^1 + C2 / (1 + r) ^2 + … + Cn / (1 + r ) ^n
P = $96 / (1 +.1) ^1 + $840 / (1 +.1) ^2
P = $87.27 + $694.21
P = $781.48
The expected price an investor pays for the bond is $781.48

b. At that price, what is the expected holding period return and standard deviation of
returns? Assume that periodic cash flows are reinvested at 10%.

Total amount of cash flow for year on if the company defaults = 0


Total amount of cash flow if the company survives the first year = $120 ( 12 *
10/100) = $132

Total amount of cash flow if the company survives the second year = coupon
payment + first year cash flow + second year coupon payment

= $1,000 + $132 + $120


= $1,252

first year:
Holding period return = [ (cash inflow – purchase price) / purchase price * 100]
HPR = (0 - $781.48) / 781.48 * 100
HPR = (-781.48) / 781.48 * 100
HPR = -100%

Second year: (if company survives in the second year)


HPR = (132 – 781.48) / 781.48 * 100
HPR = (-649.48) / 781.48 * 100
HPR -83.11%

Second year: (if the company survives in the first year and defaults during the
second year.)

HPR = (1,252 – 781.48) / 781.48 * 100


HPR = 470.52 / 781.48 * 100
HPR = 60.21%

Probability Cash flow HPR Probability * HPR –


HPR expected
HPR ^2
.2 $0 -100% -20% 19.8%
.8 * .25 = .2 132 83.11 -16.62 13.65
.8 * .75 = .6 1,252 60.21 36.12 22.11%
Totals -.5% 55.56%

The standard deviation of return = (the square root of) PR1 (R1 – Re) ^2 +Pr2 (R2
– Re)^2 + … + Prn (Rn – Re)^2

 = standard deviation
Pr = Probability of occurance of price
R = Return
Re = expected return

Therefore, based on the chart above:

 = (the square root of) 55.56


 = 7.45

So, the expected holding period return is -.5% and the  is 7.45

5. The demand curve and the supply curve for one-year discount bonds were estimated
using the following equations:
Bd: Price = -2 / 5 quantity + 940
Bs: price = quantity + 500
Following a dramatic increase in the value of the stock market, many retirees started
moving money out of the stock market and into bonds. This resulted in a parallel shift in
the demand for bonds, such that the price of bonds at all quantities increased $50.
Assuming no change in the supply equation for bonds, what is the new equilibrium price
and quantity? What is the new market interest rate?

P = -2 / 5Q +990
-( P = Q +500) / 0 = -7 / 5 Q + 490
Q = 350

Price = quantity + 500


Price = 350 + 500
Price = $850

i=F–P/P

i = interest rate
F = face value of discount bond
P = initial purchase price of discount bond
i = $1,000 – 850 / 850
i = 150 / 850
i = 17.65%

So, assuming there is no change in the supply equation for bonds, the new equilibrium
price and quantity would be $850 and $350 respectively. Since the purchase price is $850 and
face value was $1,000 the new market interest rate would be 17.65%