UNIVERSITY OF ILLINOIS AT URBANA-CHAMPAIGN Actuarial Science Program DEPARTMENT OF MATHEMATICS

Math 210 Theory of Interest Prof. Rick Gorvett Fall, 2011

Homework Assignment # 9 (max. points = 10) Due at the beginning of class on Tuesday, December 6, 2011 You are encouraged to work on these problems in groups of no more than 3 or 4. However, each student must hand in her/his own answer sheet. Please show your work enough to show that you understand how to do the problem and circle your final answer. Full credit can only be given if the answer and approach are appropriate. Please give answers to two decimal places e.g., xx.xx% and $xx,xxx.xx . Note: Homework assignments are due at the beginning of the class. If you arrive at the class after it has started, you must hand in your assignment upon entering the classroom. Assignments will not be accepted at the end of the class period.

1) Let X be the Macaulay duration of a 30-year 10% annual coupon bond, and let Y be the modified duration of that same bond. Assume an effective annual interest rate of 10%. Determine the value of the difference, X Y. 2) Find the modified duration of a 10-year zero-coupon bond. Assume an effective annual interest rate of 12%. 3) Determine the modified duration of a share of common stock (where the price of the stock is determined according to the Dividend Discount Model (also known as the Gordon Growth Model)). Make the following assumptions: the first dividend is payable 12 months from now, and dividends will be paid annually after that; the annual growth rate of the dividends is 2%; and the interest rate is 10%. 4) Suppose that a perpetuity will pay you 100 annually, beginning with the first payment 12 months from now. The effective annual interest rate is 20%. Find the convexity of this perpetuity. 5) An insurance company accepts an obligation to pay $ 5,000 one year from now, and $ 10,000 two years from now. The insurance company purchases a combination of the following two bonds (both with $ 1,000 par and redemption values) in order to exactly match its obligation: Bond A: A 1-year 4% annual coupon bond with a yield rate of 6%. Bond B: A 2-year 8% annual coupon bond with a yield rate of 9%.

Determine how many (the numbers need not be integers) units of each bond the insurer must purchase to exactly match its obligations. Then, find the total cost, now, to the insurer of purchasing the needed number of bonds. 6) You are given the following term structure (yield curve) of interest rates: Years 1 2 3 Annual Spot Rate 7% 6% 5%

Find the one-year forward rate two years from now (i.e., the interest rate anticipated between time-points 2 and 3). 7) You are given the following term structure (yield curve) of interest rates: Years 1 2 3 4 Annual Spot Rate 4.0% 5.0% 5.8% 6.4%

Find the 3-year forward rate one year from now (i.e., the expected 3-year spot rate starting one year from now express it as an annual rate). 8) A one-year zero-coupon bond has a price of 93.46. A two-year zero-coupon bond has a price of X. A three-year zero-coupon bond has a price of 77.75. A three-year 10% annualcoupon bond has a price of 103.43. All these bonds have face (and redemption) values of 100. Find the price, X, of the two-year zero-coupon bond. 9) Find the yield-to-maturity on the bond in problem (8) above. 10) You are given the following term structure (yield curve) of interest rates: Years 1 2 3 Annual Spot Rate 4.5% 5.2% 5.8%

Find the expected cost, one year from now, of a 2-year 1,000 par value zero-coupon bond.