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    Tut - Week 3.v2

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    peter kong
    This document contains a problem set with questions regarding bond pricing and inferring the term structure of interest rates from observed bond prices. It provides the calculations and work shown to solve each question, inferring interest rates at different maturity dates and identifying any arbitrage opportunities that may exist. Key details include inferring the term structure is upward sloping from bond prices, how to construct a replicating portfolio to exploit arbitrage, and calculating forward and expected future interest rates given the current term structure.

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    Tut - Week 3.v2

    Uploaded by

    peter kong
    412 views16 pages
    This document contains a problem set with questions regarding bond pricing and inferring the term structure of interest rates from observed bond prices. It provides the calculations and work shown to solve each question, inferring interest rates at different maturity dates and identifying any arbitrage opportunities that may exist. Key details include inferring the term structure is upward sloping from bond prices, how to construct a replicating portfolio to exploit arbitrage, and calculating forward and expected future interest rates given the current term structure.

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    This document contains a problem set with questions regarding bond pricing and inferring the term structure of interest rates from observed bond prices. It provides the calculations and work shown to solve each question, inferring interest rates at different maturity dates and identifying any arbitrage opportunities that may exist. Key details include inferring the term structure is upward sloping from bond prices, how to construct a replicating portfolio to exploit arbitrage, and calculating forward and expected future interest rates given the current term structure.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    412 views16 pages

    Tut - Week 3.v2

    Uploaded by

    peter kong
    This document contains a problem set with questions regarding bond pricing and inferring the term structure of interest rates from observed bond prices. It provides the calculations and work shown to solve each question, inferring interest rates at different maturity dates and identifying any arbitrage opportunities that may exist. Key details include inferring the term structure is upward sloping from bond prices, how to construct a replicating portfolio to exploit arbitrage, and calculating forward and expected future interest rates given the current term structure.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 16

    FINS2624 Portfolio

    Management
    Tutorial 2 Week 3

    Problem Set 2
    *Q1. The following bonds are trading in the market.
    Infer the term structure of interest rates.

    A.

    FV
    PA
    1 y1

    c1
    c2 FV
    PB

    1 y1 1 y2 2

    100
    95.24
    1 y1

    10
    110
    107.42

    1 0.05 1 y2 2

    y1 5.00%

    y2 6.00%

    Problem Set 2
    Continued A.

    PC

    c1
    c2
    c3 FV

    1 y1 1 y2 2 1 y3 3

    20
    20
    120
    140.51

    2
    1 0.05 1 0.06 1 y3 3
    y3 5.00%

    FV
    PD
    1 y 4 4
    100
    85.48
    4
    1 y 4
    y4 4.00%

    Problem Set 2
    Continued A.
    Term Structure of Interest Rates
    0.07
    0.06
    0.05
    0.04
    Interest Rate

    0.03
    0.02
    0.01
    0
    0

    3
    Year

    Problem Set 2
    *Q2. In addition to the bonds in Question 1, you also
    observe some other bond (bond E) trading in the
    market at $136. Bond E has a time to maturity of two
    years, a face value of $100 and pays a coupon rate of
    25%. Show that there is an arbitrage opportunity and
    how to exploit it.
    A.

    PEImplied

    c1
    c FV
    2
    1 y1 1 y2 2

    PEImplied

    25
    125

    135.06
    2
    1 0.05 1 0.06

    Arbitrage opportunity available by selling Bond E and buying a


    replicating portfolio.

    Problem Set 2
    Continued A.

    125 0 wA 110 wB
    wB 1.1364
    25 100 wA 10 1.1364
    wA 0.1364

    Replicating portfolio consists of buying 0.1364 of Bond A and


    buying 1.1364 of Bond B for a risk free profit today of $0.94.

    Problem Set 2
    *Q3. Suppose instead that the following bonds are
    trading in the market. Infer the term structure of
    interest rates.

    A.

    10
    110
    105.60

    1 y1 1 y2 2
    20
    120
    123.86

    1 y1 1 y2 2

    Problem Set 2
    Continued A.

    123.86

    20
    120

    1 y1 1 y2 2

    1 y 2 2
    105.60

    20
    120
    123.86

    1 0.0498 1 y2 2

    120
    123.86

    y2 7.00%

    20
    1 y1

    10

    1 y1

    110

    120

    123.86

    y1 4.98%

    20
    1 y1

    Problem Set 2
    Q4. Consider a two year bond with a face value of $100 and a
    coupon rate of 10%. The current term structure of interest
    rates is flat at 5%. What kind of risk are you exposed to if
    you hold the bond and your investment horizon is: a. 1 year,
    b. 3 years?
    A.

    t 1
    CF1 c1 P1
    CF1 10

    110
    11 y 2

    Since 1y2 is unknown, we do not know at what price we can sell the
    bond at t = 1, thus exposing the investor to liquidity risk.

    Problem Set 2
    Continued A.

    t 3
    CF3 1011 y3 110 1 2 y3
    2

    Since the 2 year spot rate valued at time 1 and the 1 year
    spot rate valued at time 2 are unknown the investor faces
    reinvestment risk in that they do not know what rate their
    cash flows will be reinvested at.

    Problem Set 2
    Q5. Assume that the current term structure of interest
    is known. Show that the arbitrage free forward rate
    1
    between year s and year t is:
    t t s
    1 yt

    1
    s ft
    s
    1 y s
    A.
    Invest at the
    forward rate
    Invest
    borrowed
    money
    Borrow

    t=0

    t=s

    t=t

    -1

    +(1 + sft)t s

    -1/(1 +
    ys)s

    +1

    -(1 + yt)t/(1 +
    ys)s

    +1/(1 +
    ys)s

    Problem Set 2
    Continued A.

    y
    t
    1 s f t t s
    1 y s s

    1 yt t
    1 s f t
    s
    1 y s
    1 yt
    ft
    s

    y
    s

    1
    t s

    1
    t s

    Problem Set 2
    *Q6a. Suppose that the expectations hypothesis holds
    and that the current term structure of interest rates
    is as follows: y1 = 5%, y2 = 6%, y3 = 7%. What is the
    expected value of the two year spot rate realizing at
    year one, E(1r3)?
    A.

    E 1 y3 1 f 3

    1 y3
    1 f3
    1
    1 y1
    3

    1
    31

    1 0.07
    1 f3
    1
    1 0.05
    3

    1
    31

    1 8.01%

    Problem Set 2
    Q6b. What is the expected price of a two year zero
    coupon bond with a face value of $100 trading at
    year one?
    A.

    P1

    100
    11y3 2

    E P1 E

    100

    2
    11y3

    Problem Set 2
    Continued A.

    100
    E P1
    85.73
    2
    1 E 1 y3

    Problem Set 2
    *Q7. The following forward rates are observed in the
    market: 0f1 = 7%, 1f2 = 9%, 2f3 = 10%. What is the
    price of 10% coupon bond with a face value of $100
    and a time to maturity of three years?
    A.

    10
    10
    110
    P0

    1
    2
    1 y1 1 y2 1 y3 3
    y1 0 f1 7%
    1
    2

    y2 0 f 2 1 y1 11 f 2 1 8.00%

    1
    3

    y3 0 f 3 1 y2 1 2 f 3 1 8.66%
    P0

    10
    10
    110

    103.66
    1
    2
    3
    1.07 1.08 1.0866

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