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Problems and Solutions

1 CHAPTER 1—Problems
1.1 Problems on Bonds
Exercise 1.1 On 12/04/01, consider a fixed-coupon bond whose features are the following:
• face value: $1,000
• coupon rate: 8%
• coupon frequency: semiannual
• maturity: 05/06/04

What are the future cash flows delivered by this bond?

Solution 1.1 1. The coupon cash flow is equal to $40

8% × $1,000
Coupon = = $40
2
It is delivered on the following future dates: 05/06/02, 11/06/02, 05/06/03,
11/06/03 and 05/06/04.
The redemption value is equal to the face value $1,000 and is delivered
on maturity date 05/06/04.

Exercise 1.3 An investor has a cash of $10,000,000 at disposal. He wants to invest in a bond with
$1,000 nominal value and whose dirty price is equal to 107.457%.
1. What is the number of bonds he will buy?
2. Same question if the nominal value and the dirty price of the bond are respec-
tively $100 and 98.453%.

Solution 1.3 1. The number of bonds he will buy is given by the following formula
Cash
Number of bonds bought =
Nominal Value of the bond × dirty price
Here, the number of bonds is equal to 9,306
10,000,000
n= = 9,306.048
1,000 × 107.457%
2. n is equal to 101,562
10,000,000
n= = 101,571.31
100 × 98.453%

Exercise 1.4 On 10/25/99, consider a fixed-coupon bond whose features are the following:
• face value: Eur 100

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Problems and Solutions

• coupon rate: 10%

• coupon frequency: annual
• maturity: 04/15/08

Compute the accrued interest taking into account the four different day-count
bases: Actual/Actual, Actual/365, Actual/360 and 30/360.

Solution 1.4 The last coupon has been delivered on 04/15/99. There are 193 days between
04/15/99 and 10/25/99, and 366 days between the last coupon date (04/15/99) and
the next coupon date (04/15/00).
• The accrued interest with the Actual/Actual day-count basis is equal to Eur
5.273
193
× 10% × Eur 100 = Eur 5.273
366
• The accrued interest with the Actual/365 day-count basis is equal to Eur 5.288
193
× 10% × Eur 100 = Eur 5.288
365
• The accrued interest with the Actual/360 day-count basis is equal to Eur 5.361
193
× 10% × Eur 100 = Eur 5.361
360
There are 15 days between 04/15/99 and 04/30/99, 5 months between
May and September, and 25 days between 09/30/99 and 10/25/99, so that there
are 190 days between 04/15/99 and 10/25/99 on the 30/360 day-count basis
15 + (5 × 30) + 25 = 190

• Finally, the accrued interest with the 30/360 day-count basis is equal to Eur
5.278
190
× 10% × Eur 100 = Eur 5.278
360
Exercise 1.8 An investor wants to buy a bullet bond of the automotive sector. He has two
choices: either invest in a US corporate bond denominated in euros or in a French
corporate bond with same maturity and coupon. Are the two bonds comparable?

Solution 1.8 The answer is no. First, the coupon and yield frequency of the US corporate bond is
semiannual, while it is annual for the French corporate bond. To compare the yields
on the two instruments, you have to convert either the semiannual yield of the US
bond into an equivalently annual yield or the annual yield of the French bond into
an equivalently semiannual yield. Second, the two bonds do not necessarily have
the same rating, that is, the same credit risk. Third, they do not necessarily have
the same liquidity.

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Problems and Solutions

Exercise 1.15 What is the price P of the certificate of deposit issued by bank X on 06/06/00,
with maturity 08/25/00, face value $10,000,000, an interest rate at issuance of 5%
falling at maturity and a yield of 4.5% as of 07/31/00?

Solution 1.15 Recall that the price P of such a product is given by


1 + c × nBc
P =F ×

1 + ym × nBm
where F is the face value, c the interest rate at issuance, nc is the number of
days between issue and maturity, B is the year-basis (360 or 365), ym is the
yield on a money-market basis and nm is the number of days between settlement
and maturity.
Then, the price P of the certificate of deposit issued by bank X is equal to
 
80
1 + 5% × 360
P = $10,000,000 ×   = $10,079,612.3
25
1 + 4.5% × 360
Indeed, there are 80 calendar days between 06/06/00 and 08/25/00, and 25 calendar
days between 07/31/00 and 08/25/00.

2 CHAPTER 2—Problems
Exercise 2.1 Suppose the 1-year continuously compounded interest rate is 12%. What is the
effective annual interest rate?

Solution 2.1 The effective annual interest rate is

R = e0.12 − 1 = 0.1275
= 12.75%.

Exercise 2.2 If you deposit $2,500 in a bank account that earns 8% annually on a continuously
compounded basis, what will be the account balance in 7.14 years?

Solution 2.2 The account balance in 7.14 years will be

$2,500.e8%×7.14 = $4,425.98

Exercise 2.3 If an investment has a cumulative 63.45% rate of return over 3.78 years, what is
the annual continuously compounded rate of return?

Solution 2.3 The annual continuously compounded rate of return R is such that
c
1.6345 = e3.78R
We find R c = ln(1.6345)/3.78 = 13%.

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Problems and Solutions

Exercise 2.7 1. What is the price of a 5-year bond with a nominal value of $100, a yield to
maturity of 7% (with annual compounding frequency), a 10% coupon rate and
an annual coupon frequency?
2. Same question for a yield to maturity of 8%, 9% and 10%. Conclude.

Solution 2.7 1. The price P of a bond is given by the formula

n
 N ×c N
P = +
(1 + y)i (1 + y)n
i=1
which simplifies into
 
N ×c 1 N
P = 1− n
+
y (1 + y) (1 + y)n
where N , c, y and n are respectively the nominal value, the coupon rate, the
yield to maturity and the number of years to maturity of the bond.
Here, we obtain for P
 
10 1 100
P = 1− +
7% (1 + 7%)5 (1 + 7%)5
P is then equal to 112.301% of the nominal value or $112.301. Note that we
can also use the Excel function “Price” to obtain P .
2. Prices of the bond for different yields to maturity (YTM) are given in the fol-
lowing table
YTM (%) Price ($)
8 107.985
9 103.890
10 100

Bond prices decrease as rates increase.

Exercise 2.14 We consider the following zero-coupon curve:

Maturity (years) Zero-Coupon Rate (%)
1 4.00
2 4.50
3 4.75
4 4.90
5 5.00
1. What is the price of a 5-year bond with a $100 face value, which delivers a 5%
annual coupon rate?
2. What is the yield to maturity of this bond?
3. We suppose that the zero-coupon curve increases instantaneously and uniformly
by 0.5%. What is the new price and the new yield to maturity of the bond? What
is the impact of this rate increase for the bondholder? Absolute Loss
Relative capital loss

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Problems and Solutions

4. We suppose now that the zero-coupon curve remains stable over time. You hold
the bond until maturity. What is the annual return rate of your investment? Why
is this rate different from the yield to maturity?

Solution 2.14
5 5 5 5 105
1. P = + 2
+ + 4
+
1 + 4% (1 + 4.5%) (1 + 4.75%) 3 (1 + 4.9%) (1 + 5%) 5
= $100.136

4
 5 105
2. 100.136 = + => R = 4.9686%
(1 + R)i (1 + R)5
i=1

3.
5 5 5 5 105
P = + 2
+ 3
+ 4
+
1 + 4.5% (1 + 5%) (1 + 5.25%) (1 + 5.4%) (1 + 5.5%)5
= $97.999

4
 5 105
97.999 = + => R = 5.4682%
(1 + R)i (1 + R)5
i=1

Rate increase => Absolute capital loss

Absolute Loss = 97.999 − 100.136 = −$2.137

−2.137
Relative capital loss = = −2.134%
100.136

4. Before maturity, the bondholder receives intermediate coupons that he reinvests

in the market:

• after one year, he receives $5 that he reinvests for 4 years at the 4-year zero-
coupon rate to obtain on the maturity date of the bond
5 × (1 + 4.9%)4 = $6.0544
• after two years, he receives $5 that he reinvests for 3 years at the 3-year zero-
coupon rate to obtain on the maturity date of the bond
5 × (1 + 4.75%)3 = $5.7469

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Problems and Solutions

• after three years, he receives $5 that he reinvests for 2 years at the

2-year zero-coupon rate to obtain on the maturity date of the bond
5 × (1 + 4.5%)2 = $5.4601
• after four years, he receives $5 that he reinvests for 1 year at the 1-year zero-
coupon rate to obtain on the maturity date of the bond
5 × (1 + 4%) = $5.2
• after five years, he receives the final cash flow equal to $105.

• The bondholder finally obtains 6.0544 + 5.7469 + 5.4601 + 5.2 + 105 = $127.4614

127.4614 1/5

=> Annual return rate = − 1 = 4.944%
100.136

• This return rate is different from the YTM of this bond (4.9686%)
because the curve is not flat at a 4.9686% level.

• With a flat curve at a 4.9686% level, the bondholder finally obtains

6.0703 + 5.7829 + 5.5092 + 5.2484 + 105 = $127.6108
 1/5
=> Annual return rate = 127.6108 − 1 = 4.9686%
100.136

Exercise 2.20 We consider two bonds with the following features

Bond Maturity (years) Coupon Rate (%) Price YTM (%)

Bond 1 10 10 1,352.2 5.359
Bond 2 10 5 964.3 5.473

YTM stands for yield to maturity. These two bonds have a $1,000 face value, and
an annual coupon frequency.
1. An investor buys these two bonds and holds them until maturity. Compute
the annual return rate over the period, supposing that the yield curve becomes
instantaneously flat at a 5.4% level and remains stable at this level during
10 years.
2. What is the rate level such that these two bonds provide the same annual return
rate? In this case, what is the annual return rate of the two bonds?

Solution 2.20 1. We consider that the investor reinvests its intermediate cash flows at a unique
5.4% rate.

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Problems and Solutions

For Bond 1, the investor obtains the following sum at the maturity of the
bond
9

100 × (1 + 5.4%)i + 1,100 = 2,281.52
i=1
which corresponds exactly to a 5.3703% annual return rate.
2,281.52 1/10

− 1 = 5.3703%
1,352.2
For Bond 2, the investor obtains the following sum at the maturity of the
bond
9

50 × (1 + 5.4%)i + 1,050 = 1,640.76
i=1
which corresponds exactly to a 5.4589% annual return rate.
1,640.76 1/10

− 1 = 5.4589%
964.3
2. We have to find the value R, such that
9 i 9 i
100 × i=1 (1 + R) + 1,100 50 × i=1 (1 + R) + 1,050
=
1,352.2 964.3
Using the Excel solver, we finally obtain 6.4447% for R.
The annual return rate of the two bonds is equal to 5.6641%
9 1/10
100 × i
i=1 (1 + 6.4447) + 1,100
− 1 = 5.6641%
1,352.2

Exercise 2.24 Assume that the following bond yields, compounded semiannually:
6-month Treasury Strip: 5.00%;
1-year Treasury Strip: 5.25%;
18-month Treasury Strip: 5.75%.
1. What is the 6-month forward rate in six months?
2. What is the 1-year forward rate in six months?
3. What is the price of a semiannual 10% coupon Treasury bond that matures in
exactly 18 months?

Solution 2.24 1.
 2 
R2 (0, 1) R2 (0, 0.5) F2 (0, 0.5, 0.5)
1+ = 1+ 1+
2 2 2

F2 (0, 0.5, 0.5)
1.026252 = 1.025 1 +
2

⇒ F2 (0, 0.5, 0.5) = 5.5003%

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Problems and Solutions

2.
  3  2
R2 (0, 1.5) R2 (0, 0.5) F2 (0, 0.5, 1)
1+ = 1+ 1+
2 2 2
 2
F2 (0,0.5,1)
1.028753 = 1.025 1 +
2

⇒ F2 (0, 0.5, 1) = 6.1260%
3. The cash flows are coupons of 5% in six months and a year, and coupon plus
principal payment of 105% in 18 months. We can discount using the spot rates
that we are given:
5 5 105
P = 
0.05
+ 2 +  3 = 106.0661
1+ 2 0.0525 0.0575
1+ 2 1+ 2

3 CHAPTER 3—Problems
Exercise 3.1 We consider three zero-coupon bonds (strips) with the following features:

Bond Maturity (years) Price

Bond 1 1 96.43
Bond 2 2 92.47
Bond 3 3 87.97

Each strip delivers $100 at maturity.

1. Extract the zero-coupon yield curve from the bond prices.
2. We anticipate a rate increase in one year so the prices of strips with residual
maturity 1 year, 2 years and 3 years are respectively 95.89, 90.97 and 84.23.
What is the zero-coupon yield curve anticipated in one year?

Solution 3.1 1. The 1-year zero-coupon rate denoted by R(0, 1) is equal to 3.702%
100
R(0, 1) = − 1 = 3.702%
96.43
The 2-year zero-coupon rate denoted by R(0, 2) is equal to 3.992%
100 1/2

R(0, 2) = − 1 = 3.992%
92.47
The 3-year zero-coupon rate denoted by R(0, 3) is equal to 4.365%
100 1/3

R(0, 2) = − 1 = 4.365%
87.97
2. The 1-year, 2-year and 3-year zero-coupon rates become respectively 4.286%,
4.846% and 5.887%.

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Problems and Solutions

Exercise 3.3 We consider the following decreasing zero-coupon yield curve:

Maturity (years) R(0, t) (%) Maturity (years) R(0, t) (%)
1 7.000 6 6.250
2 6.800 7 6.200
3 6.620 8 6.160
4 6.460 9 6.125
5 6.330 10 6.100
where R(0, t) is the zero-coupon rate at date 0 with maturity t.
1. Compute the par yield curve.
2. Compute the forward yield curve in one year.
3. Draw the three curves on the same graph. What can you say about their relative
position?

Solution 3.3 1. Recall that the par yield c(n) for maturity n is given by the formula
1
1− (1+R(0,n))n
c(n) = n 1
i=1 (1+R(0,i))i

Using this equation, we obtain the following par yields:

Maturity (years) c(n) (%) Maturity (years) c(n) (%)
1 7.000 6 6.293
2 6.807 7 6.246
3 6.636 8 6.209
4 6.487 9 6.177
5 6.367 10 6.154
2. Recall that F (0, x, y − x), the forward rate as seen from date t = 0, starting at
date t = x, and with residual maturity y − x is defined as
  1
(1 + R(0, y))y y−x
F (0, x, y − x) ≡ −1
(1 + R(0, x))x
Using the previous equation, we obtain the forward yield curve in one
year
Maturity (years) F (0, 1, n) (%) Maturity (years) F (0, 1, n) (%)
1 6.600 6 6.067
2 6.431 7 6.041
3 6.281 8 6.016
4 6.163 9 6.000
5 6.101 — —
3. The graph of the three curves shows that the forward yield curve is below the
zero-coupon yield curve, which is below the par yield curve. This is always the
case when the par yield curve is decreasing.

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Problems and Solutions

7.25

Par yield curve

7.00
Zero-coupon yield curve
Forward yield curve
6.75
Yield (%)

6.50

6.25

6.00

5.75
1 2 3 4 5 6 7 8 9 10
Maturity

Exercise 3.13 Explain the basic difference that exists between the preferred habitat theory and
the segmentation theory.

Solution 3.13 In the segmentation theory, investors are supposed to be 100% risk-averse. So
risk premia are infinite. It is as if their investment habitat were strictly con-
strained, exclusive.
In the preferred habitat theory, investors are not supposed to be 100% risk
averse. So, there exists a certain level of risk premia from which they are ready
to change their habitual investment maturity. Their investment habitat is, in this
case, not exclusive.

4 CHAPTER 4—Problems
Exercise 4.1 At date t = 0, we consider five bonds with the following features:

Annual
Coupon Maturity Price
Bond 1 6 1 year P01 = 103
Bond 2 5 2 years P02 = 102
Bond 3 4 3 years P03 = 100
Bond 4 6 4 years P04 = 104
Bond 5 5 5 years P05 = 99

Derive the zero-coupon curve until the 5-year maturity.

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Problems and Solutions

Solution 4.1 Using the no-arbitrage relationship, we obtain the following equations for the five
bond prices:


 103 = 106B(0, 1)
 102 = 5B(0, 1) + 105B(0, 2)


100 = 4B(0, 1) + 4B(0, 2) + 104B(0, 3)



 104 = 6B(0, 1) + 6B(0, 2) + 6B(0, 3) + 106B(0, 4)

99 = 5B(0, 1) + 5B(0, 2) + 5B(0, 3) + 5B(0, 4) + 105B(0, 5)
which can be expressed in a matrix form as
     
103 106 B(0, 1)
 102   5 105   B(0, 2) 
     
 100  =  4 4 104  ×  B(0, 3) 
     
 104   6 6 6 106   B(0, 4) 
99 5 5 5 5 105 B(0, 5)
We get the following discount factors:
   
B(0, 1) 0.97170
 B(0, 2)   0.92516 
   
 B(0, 3)  =  0.88858 
   
 B(0, 4)   0.82347 
B(0, 5) 0.77100
and we find the zero-coupon rates
 
R(0, 1) = 2.912%
 R(0, 2) = 3.966% 
 
 R(0, 3) = 4.016% 
 
 R(0, 4) = 4.976% 
R(0, 5) = 5.339%

Exercise 4.4 1. The 10-year and 12-year zero-coupon rates are respectively equal to 4% and
4.5%. Compute the 111/4 and 113/4 -year zero-coupon rates using linear inter-
polation.
2. Same question when you know the 10-year and 15-year zero-coupon rates that
are respectively equal to 8.6% and 9%.

Solution 4.4 Assume that we know R(0, x) and R(0, z) respectively as the x-year and the
z-year zero-coupon rates. We need to get R(0, y), the y-year zero-coupon rate with
y ∈ [x; z]. Using linear interpolation, R(0, y) is given by the following formula:
(z − y)R(0, x) + (y − x)R(0, z)
R(0, y) =
z−x
1. The 111/4 and 113/4 -year zero-coupon rates are obtained as follows:
0.75 × 4% + 1.25 × 4.5%
R(0, 111/4 ) = = 4.3125%
2

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Problems and Solutions

0.25 × 4% + 1.75 × 4.5%

R(0, 113/4 ) = = 4.4375%
2
2. The 111/4 and 113/4 -year zero-coupon rates are obtained as follows:
3.75 × 8.6% + 1.25 × 9%
R(0, 111/4 ) = = 8.70%
5
3.25 × 8.6% + 1.75 × 9%
R(0, 113/4 ) = = 8.74%
5
Exercise 4.7 From the prices of zero-coupon bonds quoted in the market, we obtain the follow-
ing zero-coupon curve:
Maturity (years) Zero-coupon Rate R(0, t) (%) Discount Factor B(0, t)
1 5.000 0.95238
2 5.500 0.89845
3 5.900 0.84200
4 6.200 0.78614
5 ? ?
6 6.550 0.68341
7 6.650 0.63720
8 ? ?
9 6.830 0.55177
10 6.900 0.51312
where R(0, t) is the zero-coupon rate at date 0 for maturity t, and B(0, t) is the
discount factor at date 0 for maturity t.
We need to know the value for the 5-year and the 8-year zero-coupon rates.
We have to estimate them and test four different methods.
1. We use a linear interpolation with the zero-coupon rates. Find R(0, 5), R(0, 8)
and the corresponding values for B(0, 5) and B(0, 8).
2. We use a linear interpolation with the discount factors. Find B(0, 5), B(0, 8)
and the corresponding values for R(0, 5) and R(0, 8).
−
3. We postulate the following form for the zero-coupon rate function R(0, t):
−
R(0, t) = a + bt + ct 2 + dt 3
Estimate the coefficients a, b, c and d, which best approximate the given zero-
coupon rates using the following optimization program:
 −
Min (B(0, i) − B(0, i))2
a,b,c,d
i
where B(0, i) are the zero-coupon rates given by the market.
− −
Find the value for R(0, 5) = R(0, 5), R(0, 8) = R(0, 8), and the corre-
sponding values for B(0, 5) and B(0, 8).

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Problems and Solutions

−
4. We postulate the following form for the discount function B(0, t):
−
B(0, t) = a + bt + ct 2 + dt 3
Estimate the coefficients a, b, c and d, which best approximate the given
discount factors using the following optimization program:
 −
Min (B(0, i) − B(0, i))2
a,b,c,d
i
where B(0, i) are the discount factors given by the market.
− −
Obtain the value for B(0, 5) = B(0, 5), B(0, 8) = B(0, 8), and the corre-
sponding values for R(0, 5) and R(0, 8).
5. Conclude.

Solution 4.7 1. Consider that we know R(0, x) and R(0, z) respectively as the x-year and the
z-year zero-coupon rates and that we need R(0, y), the y-year zero-coupon rate
with y ∈ [x; z]. Using linear interpolation, R(0, y) is given by the following
formula:
(z − y)R(0, x) + (y − x)R(0, z)
R(0, y) =
z−x
From this equation, we find the value for R(0, 5) and R(0, 8)
(6 − 5)R(0, 4) + (5 − 4)R(0, 6)
R(0, 5) =
6−4
R(0, 4) + R(0, 6)
= = 6.375%
2
(9 − 8)R(0, 7) + (8 − 7)R(0, 9)
R(0, 8) =
9−7
R(0, 7) + R(0, 9)
= = 6.740%
2
Using the following standard equation in which lies the zero-coupon rate R(0, t)
and the discount factor B(0, t)
1
B(0, t) =
(1 + R(0, t))t
we obtain 0.73418 for B(0, 5) and 0.59345 for B(0, 8).
2. Using the same formula as in question 1 but adapting to discount factors
(z − y)B(0, x) + (y − x)B(0, z)
B(0, y) =
z−x
we obtain 0.73478 for B(0, 5) and 0.59449 for B(0, 8).
Using the following standard equation
 1/t
1
R(0, t) = −1
B(0, t)
we obtain 6.358% for R(0, 5) and 6.717% for R(0, 8).

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Problems and Solutions

3. Using the Excel function “Linest”, we obtain the following values for the param-
eters:

Parameters Value
a 0.04351367
b 0.00720757
c −0.000776521
d 3.11234E-05

which provide us with the following values for the zero-coupon rates and asso-
ciated discount factors:

− −
Maturity R(0, t) R(0, t) B(0, t) B(0, t)
(%) (%)
1 5.000 4.998 0.95238 0.95240
2 5.500 5.507 0.89845 0.89833
3 5.900 5.899 0.84200 0.84203
4 6.200 6.191 0.78614 0.78641
5 ? 6.403 ? 0.73322
6 6.550 6.553 0.68341 0.68330
7 6.650 6.659 0.63720 0.63681
8 ? 6.741 ? 0.59339
9 6.830 6.817 0.55177 0.55237
10 6.900 6.906 0.51312 0.51283

4. We first note that there is a constraint in the minimization because we must

have
B(0, 0) = 1
So, the value for a is necessarily equal to 1.
Using the Excel function “Linest”, we obtain the following values for the
parameters:

Parameters Value
a 1
b −0.04945479
c −0.001445358
d 0.000153698

which provide us with the following values for the discount factors and associ-
ated zero-coupon rates:

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Problems and Solutions

− −
Maturity B(0, t) B(0, t) R(0, t) (%) R(0, t) (%)
1 0.95238 0.94925 5.000 5.346
2 0.89845 0.89654 5.500 5.613
3 0.84200 0.84278 5.900 5.867
4 0.78614 0.78889 6.200 6.107
5 ? 0.73580 ? 6.328
6 0.68341 0.68444 6.550 6.523
7 0.63720 0.63571 6.650 6.686
8 ? 0.59055 ? 6.805
9 0.55177 0.54988 6.830 6.871
10 0.51312 0.51461 6.900 6.869

5. The table below summarizes the results obtained using the four different meth-
ods of interpolation and minimization

— Rates Interpol. DF Interpol. Rates Min. DF Min.

R(0, 5) 6.375% 6.358% 6.403% 6.328%
R(0, 8) 6.740% 6.717% 6.741% 6.805%
B(0, 5) 0.73418 0.73478 0.73322 0.73580
B(0, 8) 0.59345 0.59449 0.59339 0.59055

“Rates Interpol.” stands for interpolation on rates (question 1). “DF Interpol.”
stands for interpolation on discount factors (question 2). “Rates Min” stands for
minimization with rates (question 3). “DF Min.” stands for minimization with
discount factors (question 4).
The table shows that results are quite similar according to the two methods
based on rates. Differences appear when we compare the four methods. In par-
ticular, we can obtain a spread of 7.5 bps for the estimation of R(0, 5) between
“Rates Min.” and “DF Min.”, and a spread of 8.8 bps for the estimation of R(0, 8)
between the two methods based on discount factors. We conclude that the zero-
coupon rate and discount factor estimations are sensitive to the method that is used:
interpolation or minimization.

Exercise 4.15 Consider the Nelson and Siegel Extended model

      
1 − exp − τθ1 1 − exp − τθ1 
θ
R c (0, θ ) = β0 + β1  θ
 + β2 
θ
− exp − 
τ τ
τ1
1 1
   
1 − exp − τθ2 
θ 
+ β3  θ
− exp −
τ2
τ2

with the following base-case parameter values: β0 = 8%, β1 = −3%, β2 = 1%,

β3 = −1%, 1/τ1 = 0.3 and 1/τ2 = 3.

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Problems and Solutions

We give successively five different values to the parameter β3 : β3 =

−3%, β3 = −2%, β3 = −1%, β3 = 0% and β3 = 1%. The other parameters are
fixed. Draw the five different yield curves to estimate the effect of the curvature
factor β3 .

Solution 4.15 The following graph shows clearly the effect of the curvature factor β3 for the five
different scenarios:

0.08

0.075

0.07
Zero-coupon rate

0.065

0.06

0.055 b3 = −3%
b3 = −2%
0.05 base case
b3 = 0%
b3 = 1%
0.045

0.04
0 5 10 15 20 25 30
Maturity

5 CHAPTER 5—Problems
Exercise 5.1 Calculate the percentage price change for 4 bonds with different annual coupon
rates (5% and 10%) and different maturities (3 years and 10 years), starting with
a common 7.5% YTM (with annual compounding frequency), and assuming suc-
cessively a new yield of 5%, 7%, 7.49%, 7.51%, 8% and 10%.

Solution 5.1 Results are given in the following table:

New Change 5%/3yr 10%/3yr 5%/10yr 10%/10yr
Yield (%) (bps)
5.00 −250 6.95 6.68 20.71 18.31
7.00 −50 1.34 1.29 3.76 3.34
7.49 −1 0.03 0.03 0.07 0.07
7.51 +1 −0.03 −0.03 −0.07 −0.07
8.00 +50 −1.32 −1.26 −3.59 −3.19
10.00 +250 −6.35 −6.10 −16.37 −14.65

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Problems and Solutions

Exercise 5.7 Compute the dirty price, the duration, the modified duration, the $duration and the
BPV (basis point value) of the following bonds with $100 face value assuming
that coupon frequency and compounding frequency are (1) annual; (2) semiannual
and (3) quarterly.
Bond Maturity (years) Coupon Rate (%) YTM (%)
Bond 1 1 5 5
Bond 2 1 10 6
Bond 3 5 5 5
Bond 4 5 10 6
Bond 5 5 5 7
Bond 6 5 10 8
Bond 7 20 5 5
Bond 8 20 10 6
Bond 9 20 5 7
Bond 10 20 10 8

Solution 5.7 We use the following Excel functions “Price”, “Duration” and “MDuration” to
obtain respectively the dirty price, the duration and the modified duration of each
bond. The $duration is simply given by the following formula:
$duration = −price × modified duration
The BPV is simply
−$duration
BPV =
10,000
1. When coupon frequency and compounding frequency are assumed to be annual,
we obtain the following results:

Price Duration Modified $Duration BPV

Duration
Bond 1 100 1 0.95 −95.24 0.00952
Bond 2 103.77 1 0.94 −97.90 0.00979
Bond 3 100 4.55 4.33 −432.95 0.04329
Bond 4 116.85 4.24 4 −467.07 0.04671
Bond 5 91.8 4.52 4.23 −388.06 0.03881
Bond 6 107.99 4.2 3.89 −420.32 0.04203
Bond 7 100 13.09 12.46 −1,246.22 0.12462
Bond 8 145.88 11.04 10.42 −1,519.45 0.15194
Bond 9 78.81 12.15 11.35 −894.72 0.08947
Bond 10 119.64 10.18 9.43 −1,127.94 0.11279

2. When coupon frequency and compounding frequency are assumed to be semi-

annual, we obtain the following results:

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Problems and Solutions

— Price Duration Modified Duration $Duration BPV

Bond 1 100 0.99 0.96 −96.37 0.009637
Bond 2 103.83 0.98 0.95 −98.45 0.009845
Bond 3 100 4.49 4.38 −437.60 0.04376
Bond 4 117.06 4.14 4.02 −470.04 0.047004
Bond 5 91.68 4.46 4.31 −394.87 0.039487
Bond 6 108.11 4.1 3.94 −425.73 0.042573
Bond 7 100 12.87 12.55 −1,255.14 0.125514
Bond 8 146.23 10.77 10.46 −1,529.39 0.152939
Bond 9 78.64 11.87 11.47 −902.13 0.090213
Bond 10 119.79 9.87 9.49 −1,136.91 0.113691
3. When coupon frequency and compounding frequency are assumed to be quar-
terly, we obtain the following results:
— Price Duration Modified Duration $Duration BPV
Bond 1 100 0.98 0.97 −96.95 0.009695
Bond 2 103.85 0.96 0.95 −98.72 0.009872
Bond 3 100 4.45 4.40 −439.98 0.043998
Bond 4 117.17 4.08 4.02 −471.53 0.047153
Bond 5 91.62 4.42 4.35 −398.40 0.03984
Bond 6 108.18 4.04 3.96 −428.51 0.042851
Bond 7 100 12.75 12.60 −1,259.67 0.125967
Bond 8 146.41 10.64 10.48 −1,534.44 0.153444
Bond 9 78.56 11.73 11.53 −905.89 0.090589
Bond 10 119.87 9.71 9.52 −1,141.47 0.114147

Exercise 5.11 Zero-coupon Bonds

1. What is the price of a zero-coupon bond with $100 face value that matures in
seven years and has a yield of 7%? We assume that the compounding frequency
is semiannual.
2. What is the bond’s modified duration?
3. Use the modified duration to find the approximate change in price if the bond
yield rises by 15 basis points.

Solution 5.11 1. The price P is given by

$100
P = 2×7 = $61.77818
1 + 7%
2

2. The modified duration MD is given by

1 
MD =  × ti PV(CFi ) = 6.763
7%
P 1+ 2 i

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Problems and Solutions

3. The approximate change in price is −$0.627

P ≃ −MD × y × P = −6.763 × 0.0015 × $61.77818 = −$0.627

Exercise 5.19 An investor holds 100,000 units of a bond whose features are summarized in the
following table. He wishes to be hedged against a rise in interest rates.

Maturity Coupon Rate YTM Duration Price

18 Years 9.5% 8% 9.5055 $114,181

Characteristics of the hedging instrument, which is here a bond are as follows:

Maturity Coupon Rate YTM Duration Price
20 Years 10% 8% 9.8703 $119.792

Coupon frequency and compounding frequency are assumed to be semian-

nual. YTM stands for yield to maturity. The YTM curve is flat at an 8% level.
1. What is the quantity φ of the hedging instrument that the investor has to sell?
2. We suppose that the YTM curve increases instantaneously by 0.1%.
(a) What happens if the bond portfolio has not been hedged?
(b) And if it has been hedged?
3. Same question as the previous one when the YTM curve increases instanta-
neously by 2%.
4. Conclude.

Solution 5.19 1. The quantity φ of the hedging instrument is obtained as follows:

11,418,100 × 9.5055
φ=− = −91,793
119.792 × 9.8703
The investor has to sell 91,793 units of the hedging instrument.
2. Prices of bonds with maturity 18 years and 20 years become respectively
$113.145 and $118.664.
(a) If the bond portfolio has not been hedged, the investor loses money. The
loss incurred is given by the following formula (exactly −$103,657 if we
take all the decimals into account):
Loss = $100,000 × (113.145 − 114.181) = −$103,600
(b) If the bond portfolio has been hedged, the investor is quasi-neutral to an
increase (and a decrease) of the YTM curve. The P&L of the position is
given by the following formula:
P&L = −$103,600 + $91,793 × (119.792 − 118.664) = −$57
3. Prices of bonds with maturity 18 years and 20 years become respectively
$95.863 and $100.

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Problems and Solutions

(a) If the bond portfolio has not been hedged, the loss incurred is given by the
following formula:
Loss = $100,000 × (95.863 − 114.181) = −$1,831,800
(b) If the bond portfolio has been hedged, the P&L of the position is given by
the following formula:
P&L = −$1,831,800 + $91,793 × (119.792 − 100) = −$15,032
4. For a small move of the YTM curve, the quality of the hedge is good. For a
large move of the YTM curve, we see that the hedge is not perfect because of
the convexity term that is no more negligible (see Chapter 6).

6 CHAPTER 6—Problems
Exercise 6.1 We consider a 20-year zero-coupon bond with a 6% YTM and $100 face value.
Compounding frequency is assumed to be annual.
1. Compute its price, modified duration, $duration, convexity and $convexity?
2. On the same graph, draw the price change of the bond when YTM goes from
1% to 11%
(a) by using the exact pricing formula;
(b) by using the one-order Taylor estimation;
(c) by using the second-order Taylor estimation.

Solution 6.1 1. The price P of the zero-coupon bond is simply

$100
P = = $31.18
(1 + 6%)20
Its modified duration is equal to 20/(1 + 6%) = 18.87
Its $duration, denoted by $Dur, is equal to
$ Dur = −18.87 × 31.18 = −588.31

Its convexity, denoted by RC, is equal to

100
RC = 20 × 21 × = 373.80
(1 + 6%)22
Its $convexity, denoted by $Conv, is equal to
$Conv = 373.80 × 31.18 = 11,655.20
2. Using the one-order Taylor expansion, the new price of the bond is given by
the following formula:
New Price = 31.18 + $ Dur ×(New YTM − 6%)

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Problems and Solutions

Using the two-order Taylor expansion, the new price of the bond is given by
the following formula:
New Price = 31.18 + $ Dur ×(New YTM − 6%)
$Conv
+ × (New YTM − 6%)2
2
We finally obtain the following graph.
The straight line is the one-order Taylor estimation. Using the two-order
Taylor estimation, we underestimate the actual price for YTM inferior to 6%,
and we overestimate it for YTM superior to 6%.

90

80

70
Actual price
60 One-order taylor estimation
Two-order taylor estimation
50

40

30

20

10

0
1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11%

Exercise 6.6 Assume a 2-year Euro-note, with a $100,000 face value, a coupon rate of 10% and
a convexity of 4.53. If today’s YTM is 11.5% and term structure is flat. Coupon
frequency and compounding frequency are assumed to be annual.
1. What is the Macaulay duration of this bond?
2. What does convexity measure? Why does convexity differ among bonds? What
happens to convexity when interest rates rise? Why?
3. What is the exact price change in dollars if interest rates increase by 10 basis
points (a uniform shift)?
4. Use the duration model to calculate the approximate price change in dollars if
interest rates increase by 10 basis points.
5. Incorporate convexity to calculate the approximate price change in dollars if
interest rates increase by 10 basis points.

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Problems and Solutions

Solution 6.6 1. Duration

10,000 10,000 100,000
1× 1.115 + 2 × 1.1152 + 2 × 1.1152
D= 10,000 10,000 100,000
1.115 + 1.1152 + 1.1152
10,000 10,000 100,000
1× 1.115 +2× 1.1152
+2× 1.1152
= = 1.908
97,448.17
2. Convexity measures the change in modified duration or the change in the slope
of the price-yield curve. Holding maturity constant, the higher the coupon, the
smaller the duration. Hence, for low duration levels the change in slope (con-
vexity) is small. Alternatively, holding coupon constant, the higher the maturity,
the higher the duration, and hence, the higher the convexity. When interest rates
rise, duration (sensitivity of prices to changes in interest rates) becomes smaller.
Hence, we move toward the flatter region of the price-yield curve. Therefore,
convexity will decrease parallel to duration.
3. Price for a 11.6% YTM is
10,000 10,000 100,000
P (11.6%) = + + = $97,281.64
1.116 1.1162 1.1162
Price has decreased by $166.53 from P (11.5%) = $97,448.17 to $97,281.64
4. We use
D
P ≃ −MD × y × P (11.5%) = − × y × P
1+y
1.908
=− × 97,448.17 × 0.001 = −$166.754
1.115
5. We use
1
P ≃ −MD × y × P + × RC × (y)2 × P
2
1.908 1
=− × 97,448.17 × 0.001 +
1.115 2
×4.53 × (0.001)2 × 97,448.17 = −$166.531
Hedging error is smaller when we account for convexity.

Exercise 6.8 Modified Duration/Convexity Bond Portfolio Hedge

At date t, the portfolio P to be hedged is a portfolio of Treasury bonds with
various possible maturities. Its characteristics are as follows:
Price YTM MD Convexity
$28,296,919 7.511% 5.906 67.578
We consider Treasury bonds as hedging assets, with the following features:
Bond Price ($) Coupon Rate (%) Maturity date
Bond 1 108.039 7 3 years
Bond 2 118.786 8 7 years
Bond 3 97.962 5 12 years

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Problems and Solutions

Coupon frequency and compounding frequency are assumed to be annual. At date

t, we force the hedging portfolio to have the opposite value of the portfolio to be
hedged.
1. What is the number of hedging instruments necessary to implement a modified
duration/convexity hedge?
2. Compute the YTM, modified duration and convexity of the three hedging assets.
3. Which quantities φ1 , φ2 and φ3 of each of the hedging asset 1, 2, 3 do we have
to consider to hedge the portfolio P ?

Solution 6.8 1. We need three hedging instruments.

2. We obtain the following results:
Bond YTM (%) MD Convexity
Bond 1 6.831 2.629 9.622
Bond 2 7.286 5.267 36.329
Bond 3 7.610 8.307 90.212
3. We then are looking for the quantities φ1 , φ2 and φ3 of each hedging instrument
1, 2, 3 as solutions to the following linear system:
   −1    
φ1 100.445 103.808 79.929 −28,296,919 −279,536
 φ2  =  −264.057 −546.791 −663.947   167,143,615  =  290,043 
φ3 966.460 3,771.257 7,210.58 −1,912,260,201 −379,432

7 CHAPTER 7—Problems
Exercise 7.1 Would you say it is easier to track a bond index or a stock index. Why or why
not?

Solution 7.1 As is often the case, the answer is yes and no.
On the one hand, it is harder to perform perfect replication of a bond index
compared to a stock index. This is because bond indices typically include a huge
number of bonds. Other difficulties include that many of the bonds in the indices
are thinly traded and the fact that the composition of the index changes regularly,
as they mature.
On the other hand, statistical replication on bond indices is easier to per-
form than statistical replication of stock indices, in the sense that a significantly
lower tracking error can usually be achieved for a given number of instruments
in the replicating portfolio. This is because bonds with different maturities tend to
exhibit a fair amount of cross-sectional correlation so that a very limited number
of factors account for a very large fraction of changes in bond returns. Typically, 2
or 3 factors (level, slope, curvature) account for more than 80% of these variations.
Stocks typically exhibit much more idiosyncratic risk, so that one typically needs
to use a large number of factors to account for not much more than 50% of the
changes in stock prices.

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Problems and Solutions

8 CHAPTER 8 — Problems
Exercise 8.2 Choosing a Portfolio with the Maximum $ Duration or Modified Duration Possible
Consider at date t, five bonds delivering annual coupon rates with the fol-
lowing features:

Maturity (years) CR (%) YTM (%) Price

5 7 4 113.355
7 6 4.5 108.839
15 8 5 131.139
20 5 5.25 96.949
22 7 5.35 121.042

CR stands for coupon rate and YTM for yield to maturity.

A portfolio manager believes that the YTM curve will very rapidly decrease
by 0.3% in level. Which of these bonds provides the maximum absolute gain?
Which of these bonds provides the maximum relative gain?

Solution 8.2 We compute the modified duration and the $duration of these five bonds. In the
scenario anticipated by the portfolio manager, we then calculate the absolute gain
and the relative gain that the portfolio manager will earn with each of these five
bonds

Maturity MD $Dur Absolute Relative

(years) Gain ($) Gain (%)
5 4.258 −482.7 1.448 1.28
7 5.711 −621.62 1.865 1.71
15 9.52 −1,248.4 3.745 2.86
20 12.322 −1,194.6 3.584 3.70
22 12.095 −1,464 4.392 3.63

MD stands for modified duration and $Dur for $duration.

If he wants to optimize his absolute gain, the portfolio manager will choose
the 22-year maturity bond. On the contrary, if he prefers to optimize his relative
gain, he will invest in the 20-year maturity bond.

Exercise 8.4 Rollover Strategy

An investor has funds to invest over one year. He anticipates a 1% increase in
the curve in six months. The 6-month and 1-year zero-coupon rates are respectively
3% and 3.2%. He has two different opportunities:
• he can buy the 1-year zero-coupon T-bond and hold it until maturity,
• or he can choose a rollover strategy by buying the 6-month T-bill, holding it
until maturity, and buying a new 6-month T-bill in six months, and holding it
until maturity.

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Problems and Solutions

1. Calculate the annualized total return rate of these two strategies assuming that
the investor’s anticipation is correct.
2. Same question when interest rates decrease by 1% after six months.

Solution 8.4 1. The annualized total return rate of the first strategy is, of course, 3.2%
100
100 −
(1 + 3.2%) 100 − 96.899
= = 3.2%
100 96.899
(1 + 3.2%)
By doing a rollover, the investor will invest at date t = 0, $98.533 to obtain
$100 six months later. Note that $98.533 is obtained as follows:
$100
6
= $98.533
(1 + 3%) 12
Six months later, he will thenbuy a quantity α = 100/98.058 of a 6-month
$100
T-bill, whose price is $98.058 6 = $98.058 and which pays $100 at
(1+4%) 12
maturity so that the annualized total return rate of the second strategy is 3.5%
100 × α − 98.533
= 3.5%
98.533
2. The annualized total return rate of the first strategy is still 3.2% as it is only
2.5% for the rollover strategy
100 × β − 98.533
= 2.5%
98.533
where β = 100/99.015.
In this case, the rollover strategy is worse than the simple buy-and-hold
strategy.

Exercise 8.7 Butterfly

We consider three bonds with short, medium and long maturities whose fea-
tures are summarized in the following table:

Maturity Coupon YTM Bond Price ($) $Duration Quantity

(years) Rate (%) (%)
2 6 6 100 −183.34 qs
10 6 6 100 −736.01 −10,000
30 6 6 100 −1,376.48 ql

YTM stands for yield to maturity, bond prices are dirty prices, and we assume
a flat yield-to-maturity curve in the exercise. We structure a butterfly in the fol-
lowing way:
• we sell 10,000 10-year bonds;
• we buy qs 2-year bonds and ql 30-year bonds.

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Problems and Solutions

1. Determine the quantities qs and ql so that the butterfly is cash-and-$duration-

neutral.
2. What is the P&L of the butterfly if the yield-to-maturity curve goes up to a 7%
level? And down to a 5% level?
3. Draw the P&L of the butterfly depending on the value of the yield to maturity.

Solution 8.7 1. The quantities qs and ql , which are determined so that the butterfly is cash-
and-$duration-neutral, satisfy the following system:

(qs × 183.34) + (ql × 1,376.48) = 10,000 × 736.01
(qs × 100) + (ql × 100) = 10,000 × 100
whose solution is
  −1  
qs 183.34 1,376.48 7,360,100 5,368
= × =
ql 100 100 1,000,000 4,632
2. If the yield-to-maturity curve goes up to a 7% level or goes down to a 5% level,
bond prices become
Maturity (years) Price if Y T M = 7% Price if Y T M = 5%
2 98.19 101.86
10 92.98 107.72
30 87.59 115.37
P&Ls are respectively $3,051 and $3,969 when the yield-to-maturity curve goes
up to a 7% level or goes down to a 5% level.
3. We draw below the P&L profile of the butterfly depending on the value of the
yield to maturity

100000

90000

80000

70000
Total return in $

60000

50000

40000

30000

20000

10000

0
0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
Yield to maturity

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Problems and Solutions

The butterfly has a positive convexity. Whatever the value of the yield to matu-
rity, the strategy always generates a gain. This gain is all the more substantial
as the yield to maturity reaches a level further away from 6%.

9 CHAPTER 9—Problems
Exercise 9.2 We have registered for each month the end-of-month value of a bond index, which
is as follows:
Month Index Value Month Index Value
January 98 July 112
February 101 August 110
March 104 September 111
April 107 October 112
May 111 November 110
June 110 December 113

At the beginning of January, the index value is equal to 100.

1. Compute the arithmetic average rate of return denoted by AARR, and calculate
the final index value by using the following formula:
Final Index Value = 100 × (1 + AARR)12
2. Compute the time-weighted rate of return denoted by TWRR, and calculate the
final index value by using the following formula:
Final Index Value = 100 × (1 + TWRR)12
3. Same question with the following index values:
Month Index Value Month Index Value
January 85 July 115
February 110 August 130
March 120 September 145
April 135 October 160
May 115 November 145
June 100 December 160

4. Conclude.

Solution 9.2 1. We first compute the monthly rate of return

Month Monthly Rate Month Monthly Rate
of Return (%) of Return (%)
January −2.00 July 1.82
February 3.06 August −1.79
March 2.97 September 0.91
April 2.88 October 0.90
May 3.74 November −1.79
June −0.90 December 2.73

Downloaded by Anh Khoa Phan Qu?c ([email protected])