Analysis of Fixed-Income Investment

Tutorial 2: Yield & The Spot Rate Curve

Q 1.
What is a spot rate?

Q 2.
Explain why it is inappropriate to use one yield to discount all the cash flows of a financial asset.

Q 3.
We consider the following zero-coupon curve (for simplicity assuming annual compounding):
Maturity (years)
1
2
3
4
5

Zero-Coupon Rate (%)

4.00
4.50
4.75
4.90
5.00

(a) What is the price of a 5-year bond with a $100 face value, which delivers a 5% annual
coupon rate?
(b) What is the yield to maturity of this bond?
(c) We suppose that the zero-coupon curve increases instantaneously and uniformly by 0.5%.
What is the new price and the new yield to maturity of the bond? What is the impact of this
rate increase for the bondholder?
(d) We suppose now that the zero-coupon curve remains stable over time. You hold the bond
until maturity. What is the annual return rate of your investment? Why is this rate different
from the yield to maturity?
Q 4.
We consider three bonds with the following features
Bond
Bond 1
Bond 2
Bond 3

Maturity (years)
1
2
3

Annual Coupon
10
8
8

Price
106.56
106.20
106.45

All of the interest rates in this question are assumed to be compounded annually for simplicity.
(a) Find the 1-year, 2-year and 3-year zero-coupon rates from the table above.
(b) We consider another bond with the following features
1

Bond
Maturity
Annual Coupon
Bond 4
3 years
9
Use the zero-coupon curve to price this bond.

Price
109.01

(c) Find an arbitrage strategy.

Q 5.
Given the following zero coupon bonds
Bond
Bond 1
Bond 2
Bond 3

Maturity
6 months
1 year
1.5 years

Price
97.5
99.2
98.3

Construct the par yield curve.

Q 6.
A portfolio manager is considering buying two bonds. Bond A matures in three years and has a
coupon rate of 10% payable semiannually. Bond B, of the same credit quality, matures in 10
years and has a coupon rate of 12% payable semiannually. Both bonds are priced at par.
(a) Suppose that the portfolio manager plans to hold the bond that is purchased for three
years. Which would be the best bond for the portfolio manager to purchase?
(b) Suppose that the portfolio manager plans to hold the bond that is purchased for six years
instead of three years. In this case, which would be the best bond for the portfolio
manager to purchase?
(c) Suppose that the portfolio manager is managing the assets of a life insurance company
that has issued a five-year guaranteed investment contract (GIC). The interest rate that
the life insurance company has agreed to pay is 9% on a semiannual basis. Which of the
two bonds should the portfolio manager purchase to ensure that the GIC payments will be
satisfied and that a profit will be generated by the life insurance company?

Q 7.
We consider two bonds with the following features
Bond
Bond 1
Bond 2

Maturity (years)
10
10

Coupon Rate (%) Price

10
1,352.2
5
964.3

YTM (%)
5.359
5.473

YTM stands for yield to maturity. These two bonds have a $1,000 face value, and an annual
coupon frequency.
2

(a) An investor buys these two bonds and holds them until maturity. Compute the annual
return rate over the period, supposing that the yield curve becomes instantaneously flat at
a 5.4% level and remains stable at this level during 10 years.
(b) What is the rate level such that these two bonds provide the same annual return rate? In
this case, what is the annual return rate of the two bonds?