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CFA Exercise With Solution - Chap 15

The document contains 4 problems related to analyzing yields on Treasury securities and determining forward rates of interest. Problem 1 asks to calculate a forward rate and explain when it would be an unbiased estimate of future spot rates. Problem 2 provides spot rates and asks for an implied forward rate. Problem 3 compares two bonds and recommends which to purchase based on yield curves. Problem 4 discusses strategies for managing a bond portfolio based on expectations and liquidity preference theories of the yield curve.

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Fagbola Oluwatobi Omolaja
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282 views5 pages

CFA Exercise With Solution - Chap 15

The document contains 4 problems related to analyzing yields on Treasury securities and determining forward rates of interest. Problem 1 asks to calculate a forward rate and explain when it would be an unbiased estimate of future spot rates. Problem 2 provides spot rates and asks for an implied forward rate. Problem 3 compares two bonds and recommends which to purchase based on yield curves. Problem 4 discusses strategies for managing a bond portfolio based on expectations and liquidity preference theories of the yield curve.

Uploaded by

Fagbola Oluwatobi Omolaja
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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CFA Chapter 15 PROBLEMS

1. The following table shows yields to maturity of zero-coupon Treasury securities.

Term to Maturity (years) Yield to Maturity (%)

1 3.5%

2 4.5

3 5

4 5.5

5 6

10 6.6

a. Calculate the forward 1-year rate of interest for year 3.

b. Describe the conditions under which the calculated forward rate would be an
unbiased estimate of the 1-year spot rate of interest for that year.

c. Assume that a few months earlier, the forward 1-year rate of interest for that year
had been significantly higher than it is now. What factors could account for the
decline in the forward rate?

2. The 6-month Treasury bill spot rate is 4%, and the 1-year Treasury bill spot rate is
5%. What is the implied 6-month forward rate for 6 months from now?
3. The tables below show, respectively, the characteristics of two annual-pay bonds
from the same issuer with the same priority in the event of default, and spot
interest rates. Neither bond’s price is consistent with the spot rates. Using the
information in these tables, recommend either bond A or bond B for purchase.

Bond Characteristics

Bond A Bond B

Coupons Annual Annual

Maturity 3 years 3 years

Coupon rate 10% 6%

Yield to maturity 10.65% 10.75%

Price 98.40 88.34

Spot Interest Rates

Term (years) Spot rates (zero-coupon)

1 5%

2 8

3 11

4. Sandra Kapple is a fixed-income portfolio manager who works with large


institutional clients. Kapple is meeting with Maria VanHusen, consultant to the Star
Hospital Pension Plan, to discuss management of the fund’s approximately $100 million
Treasury bond portfolio. The current U.S. Treasury yield curve is given in the following
table. VanHusen states, “Given the large differential between 2- and 10-year yields, the
portfolio would be expected to experience a higher return over a 10-year horizon by
buying 10-year Treasuries, rather than buying 2-year Treasuries and reinvesting the
proceeds into 2-year T-bonds at each maturity date.”

Maturity Yield Maturity Yield

1 year 2.00% 6 years 4.15%

2 2.90 7 4.30%

3 3.50 8 4.45

4 3.80 9 4.60

5 4.00 10 4.70
a. Indicate whether VanHusen’s conclusion is correct, based on the pure expectations
hypothesis.

b. VanHusen discusses with Kapple alternative theories of the term structure of interest
rates and gives her the following information about the U.S. Treasury market:

Maturity 2 3 4 5 6 7 8 9 10
(years)

Liquidity 0.55 0.55 0.65 0.75 0.90 1.10 1.20 1.50 1.60
premium(%
)

Use this additional information and the liquidity preference theory to determine what
the slope of the yield curve implies about the direction of future expected short-term
interest rates.
CFA Chapter 15 Solution

1. a. (1+y4 )4 = (1+ y3 )3 (1 + f 4 )
(1.055)4 = (1.05)3 (1 + f 4 )
1.2388 = 1.1576 (1 + f 4 )  f 4 = 0.0701 = 7.01%

b. The conditions would be those that underlie the expectations theory of the
term structure: risk neutral market participants who are willing to substitute
among maturities solely on the basis of yield differentials. This behavior
would rule out liquidity or term premia relating to risk.

c. Under the expectations hypothesis, lower implied forward rates would


indicate lower expected future spot rates for the corresponding period. Since
the lower expected future rates embodied in the term structure are nominal
rates, either lower expected future real rates or lower expected future
inflation rates would be consistent with the specified change in the observed
(implied) forward rate.

2. The given rates are annual rates, but each period is a half-year. Therefore, the per
period spot rates are 2.5% on one-year bonds and 2% on six-month bonds. The
semiannual forward rate is obtained by solving for f in the following equation:
1.0252
1 f   1.030
1.02
This means that the forward rate is 0.030 = 3.0% semiannually, or 6.0% annually.

3. The present value of each bond’s payments can be derived by discounting each
cash flow by the appropriate rate from the spot interest rate (i.e., the pure yield)
curve:
$ 10 $ 10 $ 110
PV = + + =$ 98 .53
Bond A: 1 . 05 1 .08 2 1 .11 3
$6 $ 6 $ 106
PV = + + =$ 88 .36
Bond B: 1 . 05 1 .08 2 1 .11 3
Bond A sells for $0.13 (i.e., 0.13% of par value) less than the present value of its
stripped payments. Bond B sells for $0.02 less than the present value of its
stripped payments. Bond A is more attractively priced.

4. a. Based on the pure expectations theory, VanHusen’s conclusion is incorrect.


According to this theory, the expected return over any time horizon would be
the same, regardless of the maturity strategy employed.

b. According to the liquidity preference theory, the shape of the yield curve
implies that short-term interest rates are expected to rise in the future. This
theory asserts that forward rates reflect expectations about future interest rates
plus a liquidity premium that increases with maturity. Given the shape of the
yield curve and the liquidity premium data provided, the yield curve would
still be positively sloped (at least through maturity of eight years) after
subtracting the respective liquidity premiums:
2.90% – 0.55% = 2.35%
3.50% – 0.55% = 2.95%
3.80% – 0.65% = 3.15%
4.00% – 0.75% = 3.25%
4.15% – 0.90% = 3.25%
4.30% – 1.10% = 3.20%
4.45% – 1.20% = 3.25%
4.60% – 1.50% = 3.10%
4.70% – 1.60% = 3.10%

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