Test 1 Answers

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Test 1

Q1. Is the following an arbitrage opportunity? A security that costs zero and might pay (with
a very small probability) a dollar in the future, but pays zero otherwise.

a) True
b) False

Feedback: This is an arbitrage opportunity because I get for free the chance of getting a
dollar in the future.

Q2. Is LIBOR generally higher, lower or the same as the repo rate?

a) higher
b) lower
c) the same
d) could be either depending on market conditions

Feedback: LIBOR should be higher than the repo rate since it is not collateralized with
another security, as it occurs with the repo rate.

Q3. What is the return on capital for a trader who entered into a one-month repo where Pt =
98.5$, PT = 99.01$, Repo= 5% and haircut= 0.8$?

a) 0%
b) 5%
c) 12.9%
d) 15.5%

Feedback: The capital committed by the trader is 0.8$. Thus, in the repo transaction she can
borrow (98.5$-0.8$) and she buys the bond for 98.5$, which she sells later for 99.01$. Also,
at maturity she has to pay interests (5%) from the repo transaction on the amount borrowed,
i.e. (98.5$-0.8$). Thus, the return on capital for the trader is:

[99.01$-98.5$-0.05x(1/12)x(98.5$-0.8$)]/0.8$=0.129=12.9%.

Q4. What is the price on a 4.5-year floating rate bond that pays a semiannual coupon (no
spread)?

a) Not enough information


b) 100

Feedback: The price of the coupon bond is 100.

Q5. What is the price on a 5.75-year floating rate bond that pays a semiannual coupon (no
spread)? We know the following:
a. There is a coupon bond paying 3% quarterly P(0, 0.25) = 100.0448.
b. Last quarter the semiannually compounded rate was 3%.
[Note: the next coupon payment is in 3 months.]

a) 100
b) 100.0448
c) 100.75
d) 100.7895

Feedback: In 3 months the floating rate bond will pay a coupon 3/2=1.5, thus its price, just
before the coupon payment will be 101.5. We need to discount it to the present value. The
discount factor is: Z(0,0.25)=100.0448/(100+3/4)=0.993. Thus, the price of the floating rate
bond is: 101.5x0.993=100.7895.

Q6. From the following data obtain the discount curve:


a. A zero coupon bond Pz(0, 0.5) = 99.20.
b. A coupon bond paying 3% quarterly P(0, 0.25) = 100.5485.
c. A coupon bond paying 6% quarterly P(0, 0.75) = 103.1655.
d. A coupon bond paying 5% semiannually P(0, 1) = 103.0325.

The discount factors are the following (round up to three decimal places):

t Z(0, t)
0.25 [a]
0.50 [b]
0.75 [c]
1.00 [d]

a) 0.998
b) 0.992
c) 0.987
d) 0.981

Feedback: Start from the smallest maturity. In this case: 100.5485=[100 + 3/4] x Z(0,0.25),
which gives: Z(0,0.25)=0.998.

The zero coupon bonds give the discounts directly, so Z(0,0.5)=99.2/100=0.992.

Use these discount factors to find Z(0,0.75) and Z(0,1).

Q7. You have two coupon bonds with same maturity, one pays 5% semiannually and the
other 5% quarterly. Which one has a higher yield to maturity?

a) they have exactly the same yield to maturity


b) seminannual bond
c) quarterly bond
d) could be either
Feedback: The quarterly bond has a higher yield to maturity because it compounds more
frequently than the first one, increasing the expected return.

Q8. You are given the following data on different rates with the same maturity (1.5 years),
but quoted on a different basis and different compounding frequencies:

a. Continuously compounded rate: 2% annualized rate


b. Continuously compounded return on maturity: 3%
c. Annually compounded rate: 2.1% annualized rate
d. Semi-annually compounded rate: 2.01% annualized rate

You want to find an arbitrage opportunity among these rate. Is there any one that seems to be
mispriced?

Feedback: Compute respective discount factors taking into account the convention on which
the interest rate is given:
1. Z(t, t + 1.5) = exp(−0.02 × 1.5) = 0.97045
2. Z(t, t + 1.5) = exp(−0.03) = 0.97045
3. Z(t, t + 1.5) =1/(1 + 0.021)^(1.5) = 0.96931
4. Z(t, t + 1.5) =1/(1 + 0.0201/2)^(2×1.5) = 0.97045
Bond 3 is mispriced.

Q9. The average shape of the yield curve is:

a) upward sloping
b) flat
c) downward sloping
d) hump shaped
e) inverted hump shaped (U-shaped)

Feedback: Although the term structure of interest rates can take different shapes in different
times, on average (most typically) it is upward sloping.

Q10. Generally, if inflation increases, (nominal) discount factors:

a) go up
b) go down
c) not enough information to say
d) discount factors are unrelated to inflation

Feedback: Higher inflation makes less appealing money in the future, so discount factors
will go down.

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