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Tutorial-8-Solutions

The document covers various questions related to investment and portfolio management, focusing on bond duration, price changes due to yield fluctuations, and the impact of coupon payments. It includes calculations for present value, duration, and convexity of bonds under different yield scenarios. Additionally, it discusses how changes in interest rates affect bond pricing and duration, providing formulas and examples for better understanding.

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Chu Thuy Dung
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2 views

Tutorial-8-Solutions

The document covers various questions related to investment and portfolio management, focusing on bond duration, price changes due to yield fluctuations, and the impact of coupon payments. It includes calculations for present value, duration, and convexity of bonds under different yield scenarios. Additionally, it discusses how changes in interest rates affect bond pricing and duration, providing formulas and examples for better understanding.

Uploaded by

Chu Thuy Dung
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Investment and Portfolio Management

TOPIC 8 – TUTORIAL 8
Note: Many of these questions can be more easily answered using Excel rather than a
calculator. You are encouraged to attempt Questions 1, 3) and 4(a) using the Excel
spreadsheet. This will be demonstrated in your tutorial and Excel solutions will be provided
after the tutorials.

Question 1

(a) Find the duration of a 6% coupon bond making annual coupon payments if it has three
years until maturity and a yield to maturity of 6%.

(b) What is the duration if the yield to maturity is 8%?


Investment and Portfolio Management

(c) What is the duration if the yield is 6% and coupon payments occur semi-annually?

5.5797 semi-annual periods = 2.7899 years

At a higher coupon frequency, some cash flows occur earlier than they otherwise would, reducing
the duration.

Question 2

A 9-year bond has a yield of 10% and a duration of 7.194 years. If the market yield changes by
50 basis points, what is the percentage change in the bond’s price?

DP/P = –D x [Dy / (1+y)]


Percentage change in Price = - 7.194 * (0.5% / (1 + 10%)) = - 3.27%

Question 3

You will be paying $10,000 a year in tuition expenses at the end of the next two years. Bonds
currently yield 8%.

(a) What is the present value and duration of your obligation?


Investment and Portfolio Management

(b) What maturity zero-coupon bond would immunise your obligation?

A zero-coupon bond maturing in 1.4808 years would immunize the obligation. Since the present
value of the zero-coupon bond must be $17,832.65, the face value (i.e., the future redemption
value) must be
$17,832.65 × 1.081.4808 = $19,985.26

(c) Suppose you buy a zero-coupon bond with value and duration equal to your obligation.
Now suppose that rates immediately increase to 10%. What happens to your net position,
that is, to the difference between the value of the bond, and that of your tuition obligation?
What if rates fall to 7%?

If the interest rate increases to 9%, the zero-coupon bond would decrease in value to
$19,985.26
= $17,590.92
1.091.4808
The present value of the tuition obligation would decrease to $17,591.11
The net position decreases in value by $0.19
If the interest rate decreases to 7%, the zero-coupon bond would increase in value to
$19,985.26
= $18,079.99
1.071.4808
The present value of the tuition obligation would increase to $18,080.18
The net position decreases in value by $0.19
The reason the net position changes at all is that, as the interest rate changes, so does the duration
of the stream of tuition payments.
Investment and Portfolio Management

Question 4

Given a two-year coupon-paying bond (paying annual coupons) with a face value of $100,000,
coupon of 8% per annum and yield of 10% per annum:

(a) Calculate the duration of the bond.

(b) Use the duration measure to estimate the change expected in the bond price if the yield
increases to 10.5% per annum.
Investment and Portfolio Management

(c) Calculate the convexity of the bond.

(d) Decide whether convexity can be used to improve the estimate of the price effect if the
yield changes to 10.5% per annum. Explain your answer.

% Change in YTM = 0.5%

Duration overestimates the decline in price from an increase in yield, and for large changes in yield
this can be significant. Convexity allows for a more accurate estimate of the price change. The
actual price based on convexity is about $107 less than the one based purely on duration.
Investment and Portfolio Management

Extra Exercises:

1. A 6% coupon bond paying interest annually has a modified duration of 10 years, sells for $800,
and is priced at a yield to maturity of 8%. If the YTM increases to 9%, what is the predicted
change in price using the duration concept?

DP/P = –D x [Dy / (1+y)]


Percentage change in YTM = 1%

Modified Duration = D* = D / (1+y)

Percentage change in Price = - D * x % change in YTM = - 10 x (1%) = - 10%

$ change in Price = -10% * $800 = - $80

Due to the inverse relationship between YTM and Prices, YTM increases => Price decreases

2. A 6% coupon bond with semiannual coupons has a convexity (in years) of 120, sells for 80%
of par, and is priced at a yield to maturity of 8%. If the YTM increases to 9.5%, what is the
predicted contribution to the percentage change in price due to convexity?

DP
P
= -D ´
Dy
(1 + y )
[
+ 1/ 2 ´ Convexity ´ Dy 2 ]
Percentage change in YTM = 1.5%

Predicted contribution to the percentage change in Price due to convexity

= (1/2 * Convexity * % change in YTM^2) = (1/2 * 120 * 1.5%^2) = 1.35%

3. A bond with annual coupon payments has a coupon rate of 8%, yield to maturity of 10%, and
Macaulay duration of 9 years. What is the bond’s modified duration?

Modified duration = D/(1+y) = 9 / (1 + 10%) = 8.182 years


Investment and Portfolio Management

4. When interest rates decline, the duration of a 30-year bond selling at a premium:

i. Increases.
ii. Decreases.
iii. Remains the same.
iv. Increases at first, then declines.

YTM decreases => Duration increases

5. Which bond has the longest duration?

i. 8-year maturity, 6% coupon.


ii. 8-year maturity, 11% coupon.
iii. 15-year maturity, 6% coupon.
iv. 15-year maturity, 11% coupon.

Coupon rate decreases => Duration increases

Maturity increases => Duration increases

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