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Professor Homework 5 Fina 4326

1. Greek 10-year treasuries at one time rose from 10% yield to 40% yield in a very
short time. The modified duration was 6% at the time the yield was 10%. If I use
the modified duration to calculate the % loss, I get a loss of 180% which is not
possible. Explain why this loss calculation is incorrect. What is not taken into
account?
We are not taking into account convexity. As the interest rate rises the
sensitivity to interest rates declines.
2. Compare Note A to note B under the following circumstances? Original 5 year
rate on a 5-year T-note is 2.0% and original yield on a 10 year T-note is 3.0%.
The modified duration of Note A is 3.8 and the modified duration of the 10-year
rate is 6.0%. If the two year yield rises to 3.0%, and the 10-year yield rises to
3.2%, which Note falls by a greater price percentage-wise? Note, this is not a
parallel shift in the yield curve.
Without calculating, we cannot determine which T-note falls more percentagewise. The longer duration T-note is more sensitive to interest rate the than
shorter duration T-note. However, we increase the short term rate by more than
we increase the long term rate. For 5-year note, we multiply 3.8 by 1.0% =
3.8%. We lose 3.8%. On the 10 year t-note we lose 6 multiplied by .2%= 1.2%.
We lose 1.2%. Thus the 5-year T-note falls more percentage-wise then does the
10-year T-note.
3. From the question above (question 3), assume you shorted 100 million worth of
a 5 year treasuries and went long 100 million worth of a 10 year treasuries. If
the same non-parallel shift occurs as in question 3, what is your profit or loss?
We would lose 1.2% on the bought 10-years; which is 1.2million. Since we are
short the 5-year T-notes, we will gain on a creased price (higher rate). We gain
3.8%, which is 3.8 million. Thus our net gain is 2.6million.
4. I buy a 10-year BBB bond at a yield over 10-year maturities of 350 basis points
and short a 10-year Treasury. If the spread increases to 400 basis points, do I
make or lose money? What if the spread falls to 300 basis points?
I am long the BBB bonds and thus I would like the BBB yield to decline. I am
short the treasury notes and thus would like the treasury rates to increase. If
interest rates remain the same, we make the differential yield between the BBB

and Treasuries of 350 basis points. However, if spread goes up (assuming we


have matched the duration), the price of the BBB corporate falls relative to the
Treasury Notes. This is the opposite of what we would like to happen as we are
long the BBB notes and short the treasury notes. So as the interest rate spread
increases we start losing the 350 basis point differential and with a large
enough increase in this spread I will actually have a negative return. On the
other hand a decrease in the interest rate spread is exactly what we would like,
and that would add to the 350 spread differential. REMEMBER---You would like
the asset that you buy to rise in price relative to the asset that you short (price
differential increases). If duration is matched that is the same as the interest
rate differential declining.

5. I buy a 10-year callable bond that is not callable for the first 5 years and then
callable at par thereafter. If interest rate volatility rises and all else remains the
same, what happens to the value of my callable bond. What if I am comparing
two callable bonds that are identical (10 year bonds). However Bond A is not
callable for the first 3 years and Bond B is not callable for the first 5 years.
Which bond would you pay more for?
When volatility increases, with all else being held constant the value of the
option increases. We are short the embedded option, and thus our Bond
becomes worth less. When we compare two callable bonds, the value of the
bond with shorter non-callable period will be worth less, and thus we would pay
more for a callable Bond that is non-callable for the first 5 years. Think of it this
way---interest rates might decline significantly, and then rise again between
years 3 and 5. The issuer would be able to call successfully if they can call the
bond between years 3 and 5; but may not find it worthwhile to call after 5
years.
6. It is difficult for the Brazilian government to issue bonds of long maturity,
because of investors inflation fears, as well as fear of the Brazilian real
depreciating. Thus long term Brazilian bonds are often issued in USD. What risk
does the Brazilian Government have, which might cause them to default?
The Brazilian government will have a difficult time making interest and/or
principal payments if BRL depreciates. If USDBRL rose from 3.47 (BRL per USD)
to 34.70, we have witnessed a collapse for sure. The Brazilian government (if it
does not have the USD reserves necessary) will need to obtain USD with its
much depreciated BRL in order to meet its obligations. Most likely in a case
like this, they would choose to default.

7. What happens to the price of a mortgage-backed IO strip as interest rates rise


and why?
As interest rates rise the pre-payment of principal slows down. Thus there is
more principle from which to calculate the interest. This outweighs any
reduction in present value from interest rate increases, except when prepayments can not slow down anymore (very high interest rates).
8. We buy T-notes with 6 years to maturity. The yield curve is currently upward
sloping and the yield on the 6 years to maturity T-note is 2%. What are the
strips maturities that this T-note can be broken up into? Which has a higher
yield, the 6 month strip or the 2 year strip? And why? How does the yield on the
6 month strip compare to the yield on the 6 year Treasury note? Which is
higher? How does the 6 year zero compare to the 6 year Treasury note in terms
of yield?
The six month strip has a lower rate than the 2-year strip when the term
structure is upward sloping. The 2 year also has a higher yield than the 2 year
note, as the 2- year note has effectively a lower duration than 2. The 6-month
STRIP has a lower yield than the 6-year Treasury note. However, the 6-year
STRIP has a higher yield than the 6-year Treasury note.
9. A special purpose vehicle matures in 5 years, and the 5 year zero rate is 2.00%
(p.a.). If the vehicle raises 100million USD, and buys zeroes, such that the
zeroes mature with 100 million of value. Initially how much money is remaining
to buy options?

The present value of 100 million is 100million divided by (1+r) the 5th power =
90.57 million. This leaves us 9.43 million to buy options.
10.

If we buy 10 year BBB


notes and short 10 year treasury notes, what are we betting on, an increase in
interest rate spreads or a decline in interest rate spreads? If rates do not
change, do we profit or lose?
We would like the price of the BBB notes to rise relative to the price of the
Treasury notes. This implies that we would like the rate of the BBB notes to fall
relative to the rate on Treasury notes, and thus we want the spread to narrow.
We still receive the coupon on the BBB and must pay the coupon on the
Treasury. Thus if rates do not change, we still make a profit.

11.

According to the pure


expectation theory is it possible to have an upward sloping yield curve if the
market believes interest rates are falling? According to Liquidity Preference
Theory. , can the term structure be upward sloping even though the market
believes interest rates are falling?
According to the Pure expectations theory forward rates are equal to
expected future spot rates. This means that that unless the market expects
rates to rise, the yield curve cannot be upward sloping. Liquidity preference
theory states that if the market believes that rates are not changing, then the
yield curve is upward sloping because interest rate risk increases with maturity
and investors must be compensated by higher rates. Additionally if the effect of
these premiums is greater than the effect of the market believing that rates are
declining in the future, then the yield curve can still be upward sloping.

12.

Calculate the bond-equivalent yield of the following: 1. a mortgagebacked security with a yield in monthly terms of 6.0%/12 = .50%, 2. a semiannual treasury note with a semi-annual yield of 2.5%, 3. an annual pay bond
with an annual yield of 4.4%.
So we convert all returns to semi-annual, using the proper way (compounding)
and then using the convention multiply x 2.
We need to turn a monthly yield into a semi-annual yield by taking to the power
of 6.
[(1+ .005).6 1] x 2 = 6.08%
Semi-annual Treasury Yield = 2.5% x 2 = 5.0%
Annual pay bond [(1 + .044).5 1] x 2 = 4.35%

13.

We have the following information: 1 year spot rate is 2.2% (p.a.), 2 year
spot rate is 2.8% (p.a.), 3 year spot rate is 3.4% (p.a.). What is the forward rate
starting 1 year from now, with maturity 2-years in the future? What is the
forward rate starting 2 years from now, and maturing 1 year later (3 years
from now)?
1 year forward, 1 year from today.
[1 + .028]2 / [1 + .022] - 1 = 3.40%
(1 + .034)3 / (1 + .028)2 1 = 1.105507 / 1.05678 = 4.61%

14.

What tends to happen to credit spreads over treasuries during a crisis


(for example a credit crunch)? Explain your answer.
There is a flight to quality and prices get bid up more on Treasuries than on
bonds bearing credit risk. Price spreads narrow and interest rate spreads
widen.

15.

Explain downgrade risk. What will happen to the spread over treasuries if
there is a downgrade?
A downgrade is a reassessment of the credit worthiness of a bond. When a
bond is downgraded, the fair value of interest is now higher, resulting in a
decline in bond prices relative to the price of Treasuries. The price spread
narrows and the yield spread widens.

16.

I buy a 10 year BBB bond from Corporation A at 350 basis points above
Treasuries. I can buy a 10 year CDS on corporation A BBB bonds. I pay 300
basis points per annum. It appears that I can make 50 basis points per annum
in arbitrage. What other risk factors might explain the 50 extra basis points in
terms of compensation for additional risk?
There are 2 main issues here:
The lack of liquidity (in case you need to sell early) in the BBB
bond might explain the need for an extra 50 basis point spread, to
compensate for the additional risk. I doubt it though.
It may be that the CDS buyer insists on paying a lower payment,
due to the additional risk of default by the seller of the CDS. In
this case the buyer of the CDS is not fully compensated for the
default on the underlying bonds.