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EC3314 Spring PSet 4 Solutions

This document contains solutions to problems from a financial economics textbook. It discusses the concepts of bond duration and how duration is affected by changes in yield. It provides calculations to determine the duration and price changes of different bonds given changes in yield. It also discusses using a portfolio of bonds and perpetuities to match a target duration, and how the weights would change over time as the bonds mature.

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720 views6 pages

EC3314 Spring PSet 4 Solutions

This document contains solutions to problems from a financial economics textbook. It discusses the concepts of bond duration and how duration is affected by changes in yield. It provides calculations to determine the duration and price changes of different bonds given changes in yield. It also discusses using a portfolio of bonds and perpetuities to match a target duration, and how the weights would change over time as the bonds mature.

Uploaded by

christina0107
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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EC3314 Financial Economics Spring 2015

Vinay P NUNDLALL
Problem Set 4 Solutions
Question 1
BKM 9th Ed, Chapter 16, Problems 3
BKM 7th Ed, Chapter 16, Problems 1
BKM 8th Ed, Chapter 16, Problems 3
A 9 year bond has a yield of 10% and a duration of 7.194 years. If the
market yield changes by 50 basis points, what is the percentage
change in the bonds price?
50 basis points is equivalent to 0.5% or 0.005.
proportionate price change and duration is:

The relationship between

P
1 y
7.194
D

0.005 0.0327
P
1 y
1.1
That is, if the yield increases by 0.5 %, the price of the bond will fall by 3.27%.
Question 2
BKM 7th Ed, Chapter 16, Problems 2
BKM 8th Ed, Chapter 16, Problems 4
Find the duration of a 6% coupon bond making annual coupon
payments if it has 3 years until maturity and a yield to maturity of 6%.
What is the duration if the YTM is 10% instead?
T

D wt t
t 1

CFt


(1 y t ) t

wt

60
60
1,060

1
2
3
1
2
3
(1 0.06)
(1 0.06)
(1 0.06)
2.83

1,000

Par
YTM

1,000
0.06

Coupon
Rate

CFt
Pmt
Cash
Year Period
Flow
1
1
60
2
2
60
3
3
1060
Bond
Price =
0.06

CFt
(1 yt )t

t1

1.0000

2.8334


1,060

60
60
1
2
3
1
2
3
(1 0.1)
(1 0.1)
(1 0.1)
2.82

900.53

D wt t

1000

Duration
0.0566
0.1068
2.6700

Weight
0.0566
0.0534
0.8900

When YTM = 10%,

CFt

(1 y t ) t

wt

PV of CF
56.6038
53.3998
889.9964

Duration = 2.83 (years)

CFt


t
(1

y
)

wt

Par
YTM

1,000
0.1

Coupon
Rate

CFt

0.06
Year
1
2
3

CFt
(1 yt )t

Pmt
Perio
d
1
2
3

Cash
Flow
60
60
1060
Bond
Price =

Duration is 2.82 (years)

CFt


t
(1

y
)

wt

D wt t

t1

PV of CF
54.5455
49.5868
796.3937

Weight
0.0605
0.0551
0.8844

Duration
0.0605
0.1101
2.6531

900.5260

1.0000

2.8237

Question 3
There are two bonds available: Bond A that pays a semi-annual coupon
at a rate of 4% per annum and matures in 4 years;
Bond B that pays a semi-annual coupon at a rate of 7% per annum and
matures in 4 years.
The yield curve is flat at 6% per annum.
a) Calculate the duration of each bond.
How does coupon rate affect duration?

Bond A has a duration of 3.72 years and Bond B has a duration of 3.57
years.
As coupon rate increases, ceteris paribus, duration decreases.
b) If the interest rates change to 6.25%, what are the prices of the
bonds?
What are the prices if interest rates change to 7.50% instead?
When rates increase to 6.25%, the change in rate = +0.25% =
+0.0025
Bond A:
P
1 y
3.72
D

0.0025 0.0088
P
1 y
1.06

P = 929.80 x (1 0.0088) = 921.63


Bond B:
P
1 y
3.57
D

0.0025 0.0084
P
1 y
1.06
P = 1,035.10 x (1 0.0084) =1,026.38
When rates increase to 7.5%, the change in rate = +1.5% = +0.015
Bond A:
P
1 y
3.72
D

0.015 0.0526
P
1 y
1.06
P = 929.80 x (1 0.0526) = 880.85
Bond B:
P
1 y
3.57
D

0.015 0.0505
P
1 y
1.06
P = 1,035.10 x (1 0.0505) =982.81
Question 4
BKM 9th Ed, Chapter 16, Problems 14
BKM 7th Ed, Chapter 16, Problems 14
BKM 8th Ed, Chapter 16, Problems 12
1 ytm 1 0.05
ytm 0.05 21

The duration of the perpetuity, in years, is


The duration of the zero-coupon bond is the same as its real maturity, 5 years.
We have to match the maturity of the portfolio and that of the portfolio of
bonds. Let the weight of wealth invested in the zero-coupon bond be w. Then
weight in the perpetuity is (1 w). Therefore:
(w x 5) +[(1 w) x 21] = 10
w = 11/16 or 0.6875
(1 w) = 5/16 or 0.3125
In order to match the duration of our initial portfolio, we invest 11/16 of our
wealth in the zero and 5/16 in the perp.
5

After one year, target duration is 9 years.


change?

How do these fractions

After one year the zero has a maturity of only 4 years. The perp. however still
has a maturity of 21 years. The initial portfolio has a duration of 9 years so
using the same notation as earlier:
(w x 4) +[(1 w) x 21] = 9
w = 12/17 or 0.7059
(1 w) = 5/17 or 0.2941
In order to match the duration of our initial portfolio, we increase investment
to 12/17 of our wealth in the zero and decrease investment to 5/17 in the
perp.

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