ANALYTICAL PROBLEM SET 5 LECTURES TUTORIALS DR ROBERT KOSOWSKI FAROUK JIVRAJ (FAROUK.JIVRAJ01@IMPERIAL.AC.UK), SAAD BADAOUI (SAAD.BADAOUI07@IMPERIAL.AC.

UK)

PURPOSE AND DESCRIPTION: This APS is designed to cover the readings for lecture 5 of the IPM Course (see course outline). To facilitate the submission process and give you flexibility regarding when and where you work on the assignments, you will be able to submit your answers to the APS on the course webpage in the form of a Quiz. Note: Answers to the Section B questions will not be included within the overall mark for each of the APSs. SECTION A

(Questions related to Bond Predictability Appendix, IPM 4) Q1. (1 Point) In the expression 1 +

, 1+

refers to

(a) the simple log return (b) the gross simple return (c) the simple net return (d) the log return Q2. (1 Point) If a 2 year zero-coupon bond with a face value of $1, trades at a current market price of $0.95, then the log price is equal to (a) 0 (b) 1 (c) -1 (d) -0.05129 Q3. (1 Point) The log yield to maturity of the 2-year bond in the previous example is close to (a) 10%

(b) 5% (c) 2.5% (d) 1% Q4. (1 Point) If the price of a 3 year zero-coupon bond is 0.9 and the price of a 2-year zero coupon bond is 0.95, then the implied log forward rate between year 2 and 3 is (a) 5% (b) 1% (c) 0.05% (d) 0.1% Cochrane (2005, Chapter 20, pages 426-432) related questions: Q5. (1 Point) Table 20.9 in Cochrane (2005, p. 428) can be used to test the following prediction of the Expectation hypothesis a) The expectation hypothesis predicts a coefficient of zero when regressing the change in one-year yields on long-term bonds on the forward-spot spread. b) The expectation hypothesis predicts a coefficient of zero when regressing one-year excess return on long-term bonds on the forward-spot spread. c) The expectation hypothesis predicts a coefficient of zero when regressing the change in one-year yields on the excess return on long-term bonds. d) The expectation hypothesis predicts a coefficient of 1 when regressing one-year excess return on long-term bonds on the forward-spot spread. Q6. (1 Point) A comparison of actual forecasts of future spot rates using regression estimates with the forecasts from the expectation hypothesis in Figure 20.7 in Cochrane (2005, p. 429) shows the following: a) Excess returns on bonds follow a random walk. b) Short-term yields are forecastable. c) Short-term rates adjust very quickly. d) Bond prices do not follow a random walk. Q7. (3 Points) This question is designed to help you practice Matlab and apply it to the expectations hypothesis test described in QCS 5 which is on blackboard:

Following the instructions of QCS5 and replicate the results using Matlab and answer the following question: What is the effect of a 100 percent increase of the forward spot spread on the change in the short-term bond yield? a) less than -100 percent b) between -100 and -1 percent c) between 0 and 50 percent d) between 50 and 100 percent Q8. (1 Point) Find the duration of a 6% coupon bond making annual coupon payments if it has 3 years until maturity and has a yield to maturity of 6%. The duration is closest to: (a) 2.81 (b) 2.83 (c) 2.85 (d) 2.87 Q9. (1 Point) Refer to the previous question: what is the duration if the yield to maturity is 10%? The duration is closest to: (a) 2.82 (b) 2.84 (c) 2.86 (d) 2.88 Q10. (1 Point) An insurance company must make payments to a customer of $10 million in 1 year and $4 million in 5 years. The yield curve is flat at 10%. If it wants to fully fund and immunize its obligation to this customer using a single issue of a zero-coupon bond, what maturity bond must it purchase? The required maturity is closest to (a) 1 year (b) 2 years (c) 3 years (d) 4 years

Q11. (1 Point) Refer to the previous question, what must be the face value and the market value of that zero-coupon bond? The face value is closest to: (a) $11 million (b) $12 million (c) $14 million (d) $16 million Q12. (1 Point) Currently, the term structure is as follows: 1-year bonds yield 7%, 2-year bonds yield 8%, 3-year bonds and longer-maturity bonds all yield 9%. An investor is choosing between 1-, 2-, and 3-year maturity bonds all paying annual coupons of 8%, once a year. Which bond should you buy if you strongly believe that at year-end the yield curve will be flat at 9%? (a) 1-year maturity bond (b) 2-year maturity bond (c) 3-year maturity bond

Use the following information when answering questions 13-15. You will be paying $10,000 a year in tuition expenses at the end of the next 2 years. Bonds currently yield 8%. Q13. (1 Point) What is the present value and duration of your obligation? The duration is closest to (a) 1 year (b) 1.5 years (c) 2 years (d) 4 years Q14. (1 Point) What maturity zero-coupon bond would immunize your obligation? What should be the face-value of the bonds? The face value should be closest to: (a) $15,000 (b) $17,000 (c) $19,000 (d) $20,000 Q15. (1 Point) Suppose you buy a zero-coupon bond with value and duration equal to your obligation. Now suppose that rates immediately increase to 9%. What happens to your net position,

that is, to the difference between the value of the bond and that of your tuition obligation? What if rates fall to 7%? The net position changes in absolute value by (a) $0.19 (b) $1.19 (c) $2.19 (d) $3.19

Use the following when answering questions 16-17. A 30-year maturity bond making annual coupon payments with a coupon rate of 12% has a duration of 11.54 years and convexity of 192.4. The bond currently sells at a yield to maturity of 8%. Q16. (1 Point) Use a financial calculator or spreadsheet to find the price of the bond if its yield to maturity falls to 7% or rises to 9%. What prices for the bond at these new yields would be predicted by the duration rule? What is the percentage error for the duration rule compared to the actual change? The percentage error is closest to (a) 7% (b) 5% (c) 3% (d) 1 % Q17. (1 Point) What prices for the bond at these new yields would be predicted by the duration-withconvexity rule? What is the percentage error for the duration-with-convexity rule compared to the actual change? The percentage error is closest to (a) 0.7% (b) 0.5% (c) 0.3% (d) 0.1 % SECTION B: Q18. (3 Points) What is the definition of Macaulay duration D, modified duration D^{} and convexity for bonds? Q19. (3 Points)

Assume that on January 7, 2009, a 5-year zero-coupon US Treasury bond (with face value 100) with a yield to maturity of 3% has duration of 5, a modified duration of 4.854 and a convexity of 28.278. Its price is 86.261. You know that as the yield to maturity changes to 4% (2%) its price falls (rises) to 82.193 (90.573). The duration-convexity formula is given by

Supposed the yield to maturity changes by y=1% from 3% to 4%. What is the actual percentage capital loss on the bond? What percentage capital loss would be predicted by the duration-with-convexity formula? Q20 (3 Points) Now assume that another coupon-paying US Treasury bond with the same yield to maturity, longer maturity, the same modified duration as the zero coupon bond but higher convexity exited in the market. What would be the relative magnitude of the percentage gain on the coupon bond compared to the zero coupon bond if (a) yields to maturity increased from 3% to 4% and (b) yields to maturity decreased from 3% to 2%? Based on the comparative investment performance explain the attraction of convexity.