Debt HW3
Debt HW3
[Note: There are some questions about Term Structure Theory (e.g., market segmentation
theory), such as Question <6>. If we haven’t got a chance to discuss this topic before the due
date, then you do not have to complete it before Due Date. ]
<1> Suppose that you invest in a 10-year 8% Treasury Note sold at par and the interest rate drops
to 6% after your purchase. What will be the Total Dollar Return and the Realized Yield if you
hold the bond (a) for 3 years; (b) for 7 years; (c) to maturity. In each case, decompose the Total
Dollar Return into (1) Total Coupon Interest; (2) Interest on Interest; (3) Capital Gain / Loss.
FV=1,258.74
PV=-1,000
N=6
PMT=0
I/Y=3.91%X2 =7.81%
FV=1,683.45
PV=-1,000
N=14
PMT=0
I/Y=3.79%X2 =7.58%
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Capital Gain=0
FV=2,074.81
PV=-1,000
N=20
PMT=0
I/Y=3.72%X2 =7.43%
<2> Suppose that you invested in the 10 year 8% $100-par US Treasury Note sold at par
Par bond implies that YTM = 8%
Suppose that the next day after your purchase the market yield increases to 12% and stays
there
(i)What will be the realized yield if you hold the bond (1) for 10 years; (2) for 3 years; (3)
for 7 years? [Note: This is a simple Excel Spreadsheet practice. Please use Excel Spread
Sheet to do the calculation when answering this question. ]
(ii) Any patterns if we compare the realized spread in these 3 scenarios with the YTM? If
we compare the results with the answers to Question <1> above, any additional
interesting patterns?
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(iii) [Not required question] Can you use Excel “Goal Seek” function or a Python
program to figure out the holding year that would make the Realized Yield equals to the
original YTM (i.e., 8%)?
Maturity is in years, coupons are paid annually, and prices are quoted per $100 face value.
(a) [Bootstrapping Method] Construct the three-year spot yield curve. State the results as
effective annual rates.
(b) Use the curve in part (a) to compute the implied one-year forward rates in the yield curve, 1f1
and 2f1.
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Please calculate the following forward rates:
f -- one year forward rate from year 2 to year 3;
2 1
=(1+0.0279)^3/(1+0.0258)^2-1
=3.21%
=((1+0.0407)^10/(1+0.0279)^3)^(1/7)-1
=4.62%
<5> Imagine that currently in the market the following bonds are available:
0.5 0% $ 97.087
1.5 8% $101.120
1.5 0% $ 89.900
2.0 0% $ 84.663
Maturity is in years, coupons are paid semiannually but quoted annually on a bond equivalent
basis, and prices are quoted per $100 face value.
(a) Construct a 2-year spot yield curve from this information. More precisely, calculate a spot
rate for each six-month period. Report the rate on a bond equivalent basis.
(b) In six months, your company plans to issue a 1.5 year zero coupon bond with a face value of
$500,000 to finance a small acquisition. If the traditional expectations theory of the term
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structure is correct, and if the risk of your company's bonds is similar to that of the above bonds,
what is the expected price of your company's bond at issue (i.e., in six months hence)?
0.5 years from today = [(1 + S2/2)4 / (1 + S0.5/2)]1/3 - 1 = [(1 + 0.085/2)4 / (1 + 0.06/2)]1/3 - 1 =
9.34%
(c) Having heard reports that interest rates could rise sharply in the next six months, you suggest
to the CFO that the company issue the bond immediately, locking in current rates, and invest the
proceeds in a six month bond. In other words, today you would issue a bond maturing in two
years with a face value of $500,000 ("Bond X"). If you follow this strategy, how much money
does the firm initially borrow? How much will be available to finance the acquisition in six
months?
The current price per $100 for a 2 year zero bond is $84.66
Total borrowed number for $500,000 face value = 500,000 x 84.663/100 = $423,315
<6> A common practice of government: “Financially stressed nations, facing high yield spreads
(interest rate payments above relatively risk-free bonds), issue less debt and rely increasingly on
short-term debt—actively refinancing short-term debt, but simply retiring long-term debt as it
comes due”.
Imagine that the yield curve is currently flat. The Treasury announces that they will no longer
issue securities with maturities longer than two years. As a result, long-term government bonds
will be refinanced using only relatively short-term debt. If the "market segmentation theory" of
the yield curve is correct, what will happen to the slope of the yield curve as a result of this policy
change? Explain briefly.
Since the market segmentation theory shows that there is no direct relationship between short
term and long term bonds interest rates, there would not be a change in the yield curve based on
the direct relationship between these bonds. However, we know that the interest rates, just like
most of the things in today’s world are driven by demand and supply. If this policy change takes
place, the supply of the short term bonds would increase, thus, decreasing the yield of those
bonds. On the other hand, the supply of long term bonds would decrease, therefore, increasing the
yields. The yield curve in this case would slope upwards and become more steep.
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