Investment and Portfolio Management - Tutorial 1

Oren Schneorson
[email protected]
 Admin

I Our main objective is to solve the problem sets

I Please attempt solving them yourselves before the tutorial

I Solutions uploaded to the Hub on Fridays

I If time allows, we will also solve questions from quiz/mock exam

I Office hours:
• Time: Mon 9am - 10am, weeks 19/10/2020 - 07/12/2020
• Location: Zoom

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 Problem set 1
I Pricing coupon bonds and zero-coupon bonds

I Effective interest rate

I Compounding

I Yield to maturity (YTM)

I Discount rate

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 Question 1

Which security has a higher effective annual interest rate?

a) A three-month T-bill selling at $97,645 with face value of $100,000 OR a coupon
bond selling at face value and paying a 10% coupon semi-annually

b) A six-month T-bill selling at $98,058 with face value of $100,000 OR a coupon bond
selling at face value and paying a 4.2% coupon (2.1% every six months)

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 1a) 3m T-bill OR coupon bond

I The total return of this 3 months investment is 100000

97645
− 1 = 0.024 (or 2.4%)
I To annualize: compound by 4 (3 months T-bill ⇒ 4 × 3 months = 12 months
 4
100000
(effective annual interest rate) i = − 1 ≈ 10.00%
97645

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 1a) 3m T-bill OR coupon bond

I YTM: the lowest positive number that makes the price on the LHS equal the stream
of cash on the right hand side
T
X cash-flow at t
Price =
t=1
(1 + YTM)t

I Notice that thus defined, YTM depends on the frequency of cash-flows (say every
1/m years), so we should write YTM(m) as a function of m. To get effective
interest rate one has to annualize it using the formula

IRR = (1 + YTM(m))m

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 Note about compounding

I Never compound an interest rate that is not given in a gross form. For example, a
2.4% interest rate compounded 4 times
• percent: (2.4)4 = 33.1776 (WRONG)
• net: (0.024)4 = 0.000000331776 (WRONG)
• gross: (1.024)4 ≈ 1.1 (CORRECT)
I Think of compounding as re-investing in the same instrument over and over again.
• t = 0, $97,645 and invest it in an instrument that pays 2.4% at the end of 3 months.
• t = 3m, $97, 645 × (1 + 0.024) = $97, 645 + $2343 ≈ $100, 000...


($102, 400 × 1.024) × 1.024 = ($100, 000 × 1.024) × 1.024 × 1.024 =
 
($97, 645 × 1.024) × 1.024) × 1.024 × 1.024 = $97, 645 × 1.0244

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 1a) 3m T-bill OR coupon bond
I A coupon bond selling at par: YTM = coupon rate
coupon coupon coupon+par
par = + 2
+ ··· +
1| + {z
YTM} (1 + YTM) (1 + YTM)n
=x

n

2 n−1
 1−x
par × x = coupon × 1 + x + x + · · · + x × + par
1−x
coupon
= x − 1 = 1 + YTM − 1 = YTM
par
I Bond paying every 6 months ⇒ YTM is given at semi-annual frequency
 2
10%
(effective annual interest rate) i = 1 + − 1 = 10.25%
2

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 1b) 6m T-bill OR coupon bond
I T-bill:
 2
10000
i= − 1 = 4.00%
98058
I Coupon bond:

 2
4.2%
i = 1+ − 1 = 4.24%
2
I Face value (par): the amount paid at maturity
I Coupon: % from par, paid every x months/years (the frequency)

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 Question 2

You are given the following prices of U.S. Treasury Strips (discount or zero-coupon
bonds):

Maturity Price
1 year 96.2
2 years 91.6
3 years 86.1

Assuming face values of 100, compute the spot rates for years 1, 2 and 3.

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 Question 2
I Price of a zero-coupon bond equals to the discounted face value.
I The discount rate is the spot rate.

100
96.2 = ⇒ s1 = 3.95%
1 + s1
100
91.6 = ⇒ s2 = 4.48%
(1 + s2 )2
100
86.1 = ⇒ s3 = 5.12%
(1 + s3 )3
I Spot means the contract starts now (‘on the spot’)
I We will see that we can also discount cash-flow using spot rates

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 Question 3
Assume that spot interest rates are as follows:

Maturity Spot rate

1 year 3.0
2 years 3.5
3 years 4.0
4 years 4.5

Compute the prices and yields to maturity of the following bonds, assuming annual
coupon payments and face values of 100:
a) A zero-coupon bond with 3 years to maturity.
b) A bond with coupon rate 5% and 2 years to maturity.
c) A bond with coupon rate 6% and 4 years to maturity.

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 Question 3

I We are assuming implicitly that the bond is risk free.

I If it is risk free, the following must hold in order for there to not be arbitrage
opportunities:
T
X cash-flow at t
Price =
t=1
(1 + st )t

I where st is the spot rate in period t.

I Arbitrage: able to earn positive profit with certainty without investing any of your
own money (100% debt 0% equity portfolio).

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 Question 3
I Price of a bond equals to the sum of discounted future cash flows.
I The discount rates are the spot rates.
I YTM is a type of average of the relevant spot rates.
100 100
a) P= (1+s3 )3
= (1+4.00%) 3 = 88.90

b) P = coupon
1+s1
+ coupon+par
(1+s2 )2
5
= 1+3.00% 105
+ (1+3.5%) 2 = 102.87

coupon
P= 1+YTM
+ coupon+par
(1+YTM)2
⇒ 102.87 = 1+YTM 5 105
+ (1+YTM) 2 ⇒ YTM = 3.49%
c) P = coupon
1+s1
coupon
+ (1+s 2)
coupon coupon+par
2 + + (1+s )3 + + (1+s )4
3 4
6 6 6 106
= 1+3.0% + (1+3.5%) 2 + + (1+4.0%)3
+ + (1+4.5%)4
= 105.65
P4 6 100
105.65 = t=1 (1+YTM) t + (1+YTM)4 ⇒ YTM = 4.43%

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 Question 4

Treasury bonds paying an 8% coupon rate with semiannual payments currently sell at
face value. What coupon rate would they have to pay in order to sell at face value if
they paid their coupons annually?

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 Question 4
I The effective annual interest rates of this bond needs to be the same whether it is
paying annual coupons or semiannual coupons.
I Since the bond trades at par, we know it’s return is 4% per six-months.

 2
8%
i= 1+ − 1 = 8.16%
2
I i needs to be the yield of the bond with annual coupon payments. Since this bond
needs to be sold at face value, its coupon rates should equal its yields. Thus,

coupon rate = 8.16%

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 Question 5

You are a bond trader and see on your screen the following information on three bonds
with annual coupon payments and par value (face value) of $100:

Bond Coupon rate Maturity YTM

A 0.0% 1 5.0%
B 5.0% 2 5.5%
C 6.0% 3 6.0%

a) What are the prices of the above bonds?

b) Construct the current term structure of spot interest rates (the 1, 2, and 3-year spot
rates).

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 Question 5
a)
100 5 105
PA = = 95.24, PB = + = 99.08, PC = par = 100
1 + 5% 1 + 5.5% (1 + 5.5%)2

b) Because the 1 year zero-coupon bond yield = 1 year spot rate ⇒ s1 = 5.0%. s2 =?
coupon coupon+par 5 105
PB = + ⇒ 99.08 = + ⇒ s2 = 5.51%
1 + s1 (1 + s2 )2 1 + 5.0% (1 + s2 )2
I The 3 year spot rate can be soled by:
6 6 106
100 = + +
|{z} 1 + 5.0% (1 + 5.51%)2 (1 + s3 )3 ⇒ s3 = 6.04%
PC

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 Question 6

Consider the following prices of zero-coupon bonds with face value of $1,000:

Maturity Price
1 year 968.52
2 years 929.02
3 years 915.15
4 years 905.95

a) Compute the spot rates implied by these prices.

b) Use the information in the above bond prices to find the price of a coupon bond
with maturity 4 years from now, annual coupon rate 7%, and face value $1000.

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 Question 6

a) Spot rate is the zero coupon interest rate.

 1
1000 1000 2
s1 = − 1 = 3.25%, s2 = − 1 = 3.75%
968.52 929.02
 1  1
1000 3 1000 4
s3 = − 1 = 3.00%, s4 = − 1 = 2.50%
915.15 905.95

b)
70 70 70 1070
P= 1+3.25%
+ (1+3.75%)2
+ (1+3.00%)3
+ (1+2.50%)4
= 1166.26

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 Question 7*

The yield to maturity (denoted y ) on a two period bond is defined by the equation:
C C +F
P= +
1+y (1 + y )2
Where P is the bond price now, C is coupon and F is face value. We assume coupons
are paid once each year and y is the annual yield to maturity. This means that:

P(1 + y )2 = C (1 + y ) + (C + F ) (1)

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 Question 7*

The spot rates s1 and s2 are the yields on pure discount bonds that pay off in 1 and 2
years. Show the relation between spot rates and yields to maturity when the spot rate
are such that
I s 2 > s1

I s 2 = s1

I s 2 < s1
What does this imply about the one year forward rate f1,1 relative to the yield to
maturity in each case?

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 Question 7*

P(1 + y )2 = C (1 + y ) + (C + F ) (1)

I LHS: terminal value of P invested now for two periods at the constant annual rate y .
I RHS: what you get at the terminal date if you take the cash flows at the end and
also the value of re-invested cash flows from the coupon paid at the end of the first
year.

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 Question 7*

Bond price = its present value, i.e. the discount sum of cash-flows given by
C C +F
P= +
1 + s1 (1 + s2 )2
Equate this equation with equation 1 to get:
C C +F C C +F
+ 2
= + (2)
1+y (1 + y ) 1 + s1 (1 + s2 )2

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 Question 7*

When s2 > s1 we must have that s2 > y > s1 . Observe that

C C
>
1 + s1 1 + s2
C +F C +F
2
>
(1 + s1 ) (1 + s2 )2
If y ≥ s2 then equation 2 is contradicted because LHS < RHS due to
C C +F C C +F C C +F
+ ≤ + < +
1+y (1 + y )2 1 + s2 (1 + s2 )2 1 + s1 (1 + s2 )2

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 Question 7*

If y ≤ s1 then equation 2 is contradicted because LHS > RHS due to

C C +F C C +F C C +F
+ 2
≥ + 2
> +
1+y (1 + y ) 1 + s1 (1 + s1 ) 1 + s1 (1 + s2 )2
Thus y must lie strictly between s1 and s2 .

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 Question 7*

The 1 year forward rate 1 year ahead (f1,1 ) is such that:

(1 + s1 )(1 + f1,1 ) = (1 + s2 )2

so that
(1 + s2 )2
1 + f1,1 =
1 + s1
If s2 > s1 , then
(1 + s2 )2 (1 + s2 )(1 + s1 )
1 + f1,1 = > = 1 + s2 > 1 + y
1 + s1 1 + s1

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