SA.380.

760 Corporate Finance

Week 6 Tutorial Problems

1. Yield To Maturity (YTM) Review

Consider the following:

 A 2 year zero-coupon bond with $1,000 face value currently trading at $950.
 A 5 year zero-coupon bond with $1,000 face value currently trading at $850.
 A 10 year zero-coupon bond with $1,000 face value currently trading at $650.
 A 30 year zero-coupon bond with $1,000 face value currently trading at $200.

a) Solve for the periodic and annualized YTM for each of these bonds.
b) Graph the term structure of risk-free U.S. interest rates.

Maturity = 2 years
Periods per year = 2
Periods = 4 periods
Face Value = $1,000
Market Price = $950
YTM = 1.29% periodic
YTM = 2.58% APR

Maturity = 5 years
Periods per year = 2
Periods = 10 periods
Face Value = $1,000
Market Price = $850
YTM = 1.64% periodic
YTM = 3.28% APR

Maturity = 10 years
Periods per year = 2
Periods = 20 periods
Face Value = $1,000
Market Price = $650
YTM = 2.18% periodic
YTM = 4.35% APR

Maturity = 30 years
Periods per year = 2
Periods = 60 periods
Face Value = $1,000
Market Price = $200
YTM = 2.72% periodic
YTM = 5.44% APR
SA.380.760 Corporate Finance

APR

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%
2 5 10 30

2. Expectation Theory of the Term Structure

The interest rate for a single cash flow in one year, r1 = 1.5% (APR). The interest rate for a
single cash flow in two years, r2 =1.75% (APR). The interest rate for a single cash flow in three
years, r3 = 2.1% (APR) and the interest rate for a single cash flow in five years, r5 = 2.7% (APR).

a) Which direction is the term structure sloping? How do you know?

b) Using the expectation theory of the term structure, what are the one year forward rates for
years 2 and 3 (1F2 and 2F3)?
c) If 3F4 is 3.4%, what would have to be the spot rate today for a single cash flow in 4 years, r4?
d) What is the current forecast for the 2-year forward rate, 3F5?

1 year CF APR R1 1.50%

2 year CF APR R2 1.75%
3 year CF APR R3 2.10%
5 year CF APR R5 2.70%

(1+R2)2=(1+R1)*(1+ 1F2) 1F2= 2.00%

3
(1+R3) =(1+R1)(1+ 1F2)(1+ 2F3) 2F3= 2.80% 2.80%

3F4= 3.40% R4= 2.42% 2.42%

4
(1+R4) =(1+R1)(1+ 1F2)(1+ 2F3)(1+ 3F4)

(1+R5)5=((1+R3)^3)*((1+ 3F5)^(5-3))
5 year forward rate APR 5 years from now = 3 F5 = 3.61%
SA.380.760 Corporate Finance

3. Compare the duration of the following debt instruments

a) A $1,000 face value 5-year zero-coupon debt at 3% (APR) compounded annually?

b) A $1,000 face value 5-year coupon bond with an annual coupon rate of 3% (APR) and a
market interest rate of 3% (APR).
c) A $1,000 monthly mortgage with an interest rate of 5% (APR) to be paid off in 5 years.
d) If interest rates move, rank the above securities in terms of the volatility of their market
prices.

Zero-coupon Bond Coupon rate 0% Market rate of interest 3.00%

Par value of bond $1,000
Coupon payments $0.0 Market price of bond $862.61
Number of periods 5

Period 1 2 3 4 5
Bond CF 0.0 0.0 0.0 0.0 1,000.0
PV(CFt) 0.0 0.0 0.0 0.0 862.6
t*PV(CFt) 0.0 0.0 0.0 0.0 4,313.0
(t*PV(CF))/V0 0.0 0.0 0.0 0.0 5.0
Sum= 5.00
Bond duration in years 5.00

PV(Cft) / Vo 0.0% 0.0% 0.0% 0.0% 100.0%

Sum= 100.0%

Government Bond Coupon rate 3.00% Market rate of interest 3.00%

Par value of bond $1,000
Coupon payments $30.0 Market price of bond $1,000.00
Number of periods 5

Period 1 2 3 4 5
Bond CF $30.0 $30.0 $30.0 $30.0 $1,030.0
PV(CFt) $ 29.13 $ 28.28 $ 27.45 $ 26.65 $ 888.49
t*PV(CFt) $ 29.13 $ 56.56 $ 82.36 $ 106.62 $ 4,442.44
(t*PV(CF))/V0 0.0291 0.0566 0.0824 0.1066 4.4424
Sum= 4.72
Bond duration in years 4.72

PV(Cft) / Vo 2.9% 2.8% 2.7% 2.7% 88.8%

Mortgage $1,000 Interest APR 5.00% PMT $18.87

Periods 60 Period Interest 0.42%
Mortgage Duration: 29.2542 months
Mortgage Duration: 2.44 years