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QF2104 Tutorial - Assignment 4

This document provides self-practice and discussion problems for a quantitative finance tutorial. The self-practice problems involve calculating bond prices, yields, durations, and convexities given various cash flow structures and rates. The discussion problems ask students to derive duration formulas, calculate durations of specific cash flows, and analyze bond duration graphs and an investor's utility maximization problem.

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igndunno
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85 views3 pages

QF2104 Tutorial - Assignment 4

This document provides self-practice and discussion problems for a quantitative finance tutorial. The self-practice problems involve calculating bond prices, yields, durations, and convexities given various cash flow structures and rates. The discussion problems ask students to derive duration formulas, calculate durations of specific cash flows, and analyze bond duration graphs and an investor's utility maximization problem.

Uploaded by

igndunno
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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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QF2104 Fundamentals of Quantitative Finance

Tutorial 4

Submission by 3 March 23:59pm

Self-Practice Problems (Not to be submitted or discussed in class)

1 A 30-year bond that pays coupons annually c% has an effective annual yield of 5% and a
Macaulay duration of 14.33. Find c to the nearest integer. [10]

2 A 2-year bond of face value 100 that pays coupons semi-annually at a nominal rate of 4%
coupon has a yield to maturity of 4.8% convertible semi-annually. Calculate the price and
Macaulay’s duration of the bond. Hence, find an approximation for the bond price when the
yield falls to 4.5%. [ P = 98.492, D = 1.941 years; DM = 1.896; 𝑃(4.5%) ≈ 99.05 ]

3 The price, 𝑃(𝜆) of a five-year bond is given by the formula

7𝜆4 + 35𝜆3 + 70𝜆2 + 70𝜆 + 235


𝑃(𝜆) =
2(1 + 𝜆)5
where λ is the effective annual yield. The gradient of the price-yield curve for this bond at
𝜆 = 10% is – 316.1316. Find, to 3 significant figures, the duration of the bond at 𝜆 =
10%. [4.61]

4 A portfolio containing two bonds, A and B, of market values $600,000 and $400,000
respectively has a duration of 6.7 years. The duration of bond A is known to be 8.5 years.
Determine the duration of bond B. [ 4 years]

5 A 10-year coupon bond that pays coupons semi-annually at 7% per annum is priced $103.635
to yield 6.5%. The Macaulay’s duration is 7.4083. It can be shown that the convexity at this
yield is 65.239. Estimate the bond price when the yield changes to (i) 6% (ii) 6.7%.
[𝑃(6%) ≈ 107.44 ; 𝑃(6.7%) ≈ 102.16]

6 A 12-year bond that pays coupons semi-annually at 6% per annual is priced at $108. 9425 to
yield 5%. The Macaulay duration is 8.8784. it can be shown that the convexity at this yield is
95.4356. estimate the bond price when the yield changes to 4.8%.
1
7 A gambler with an initial wealth of $100 and utility function 𝑈(𝑤) = 1− is offered a
w
lottery from which he has a probability 𝑝 of losing $50 and a probability (1 − 𝑝) of gaining
$200.
(i) If 𝑝 = 0.8, will he play the lottery?
(ii) Find the range of values of 𝑝 for which he will play the lottery.
[ (i) No, expected utility is 0.983 if he plays and 0.99 if he doesn’t; (ii) 0 ≤ 𝑝 < 0.4]

Discussion Problems (to be submitted and discussed in class)

Question 1

A n-year bond and a 2n-year bond, both paying coupons annually, have the same annual yield to
maturity, λ. It is also given that the coupon rate is equal to the yield rate. If the Macaulay duration of
1
the n-year bond is k times the Macaulay duration of the 2n-year bond for some 𝑘 𝜖 (2 , 1). Express λ in

terms of 𝑘 and 𝑛.

Question 2 (Duration of Perpetual Annuity)

The present value, 𝑃 of a perpetual annuity that pays $𝐴 at 𝑡 = 1, 2, 3, … is given by

𝐴
𝑃 =
𝜆

Derive the Macaulay’s duration, D of this perpetual annuity in two ways.

𝑑𝑃/𝑑𝜆
(i) Use the equation = −𝐷𝑀 to find 𝐷𝑀 , and hence find 𝐷.
𝑃

∑∞
𝑖=1 𝑖𝐴(1+𝜆)
−𝑖
(ii) Find D directly from the definition 𝐷 = ∑∞ −𝑖 .
𝑖=1 𝐴 (1+𝜆)

𝑦
[Hint: you may want to use the result: ∑∞ 𝑖
𝑖=1 𝑖𝑦 = (1−𝑦)2 for part (ii).]
Question 3

Let N > 100 be a positive integer. In terms of the integer N, find the duration of the following cash
flow (1, 0, 2, 0, 3, 0, 4..., N), given that the yield is zero for the first 2N years. Give your answer in
simplified exact term.

𝑁(𝑁+1) 𝑁(𝑁+1)(2𝑁+1)
[Hint: you may use the formula ∑𝑁
𝑘=1 𝑘 = 2
and ∑𝑁 2
𝑘=1 𝑘 = 6
]

Question 4

For fixed coupon rate and yield to maturity, sketch the graph of duration against time to maturity for a
(i) zero-coupon bond, (ii) bond that is priced at par (i.e. P = F) Indicate clearly the limiting value (if
any) of the duration as the time to maturity approaches infinity. Justify your answers.

Question 5

Let 𝑈(𝑤) = 𝑙𝑛 𝑤 be the utility function of an investor whose initial wealth is $2𝑎 (𝑎 > 1) . The investor
is offered an investment that pays $2𝑎 and $(−𝑎) with probabilities 1/3 and 2/3 respectively.

(i) Prove analytically that the investor will not invest.


(ii) Illustrate this result graphically.

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