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Date of completion 14 November Group number MIF Full time

Instructor Ludovic Phalippou Academic year 2007/2008


Course name Investments Semester, block First, second
Nagornov Alexander (5812437)
Agababov Boris (5843634)

A. The case
1. Assume that you bought $50,000 worth of Sleeping Beauties. Ignore the call feature for now. Sleeping
beauties were issued at par. What is the YTM?
Without calculations it is clear that the YTM =7.55%
2. Compute how much you would have to pay for different level of YTM and plot it. Comment on the shape
of the plotted relationship. See question 3.
3. Do the same as above but for napping beauties: they are like Sleeping beauties but a maturity of 10 years
instead of 100 years.
In the following table and graph you can find answers for questions 2 and 3:
YTM Bond 100 Bond 10
2.50% 285.160 144.438
3.50% 212.113 133.925
4.50% 166.986 124.345
5.50% 137.109 115.608
6.50% 116.127 107.633
7.50% 100.666 100.347
8.50% 88.826 93.685
9.50% 79.476 87.588
10.50% 71.906 82.002
11.50% 65.653 76.880
12.50% 60.400 72.179
13.50% 55.926 67.861
14.50% 52.069 63.890
15.50% 48.710 60.236
16.50% 45.758 56.869
17.50% 43.143 53.765
18.50% 40.811 50.899

We can see from the graph that the Sleeping beauty is more sensitive to YTM, it is reflected in the higher
slope of the curve. And obviously we see a negative relationship of hyperbolic style.
4. Assume the YTM of these two bonds is 8%. Compute their duration. Could you have anticipated which one
would have the highest duration and which one would have the lowest duration?
Using the formulas in Excel we can easily compute the following for 8%YTM:
Duration Sleeping beauty 12.997
Duration Napping beuty 7.145
Obviously it is anticipated the Sleeping beauty to have higher duration, as the maturity is higher for this
bond given all other parameters fixed.
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5. What would be the cost of these two bonds if the prevailing yield increases by 1%? Compare this change
with what the duration formula would have predicted. For which bond is the mistake larger? Why is it so?
The results can be found in the following table:
Price at 8% Price at 9% Change, % Change predicted by duration
Sleeping beauty 94.377 83.891 -11.11% -12.03%
Napping beauty 96.942 90.569 -6.57% -6.62%
As the duration is only the first moment, the results obtained by using the approximation for price
change with duration are not precise. The mistake is larger for the sleeping beauty both in absolute and
relative terms, because the curvature is greater for a 100 years bond (convexity should be taken into
account to get more precise forecast for the change).
6. Which bond is the most sensitive to interest rate fluctuations? Why?
The sleeping beauty is more sensitive to interest rate fluctuations, because it has a higher maturity and
consequently a higher duration. In particular, the present value of cash flows at years far away from now
is very sensitive to the change in interest rates, as the discount factors change significantly as a reaction
to a slight change in discount rates.
7. Let us look at the call feature now.
a) What does it mean?
The call feature means that the issuer has a right to repurchase the bond before the maturity.
b) Do you think that this feature will impact the sleeping beauties price much?
As long as fall in interest rates is not expected the price will not be affected much by the call feature.
c) Why did Disney bother then?
Disney tried to insure himself against a severe drop in interest rates. So he could buy back the bonds
and refinance the loan at lower interest rate, thus avoiding the losses.
8. Let us now compare the Sleeping beauties without callable option (called SBno) and the Sleeping beauties
with callable option (SByes).
a) Imagine that you think that the market is incorrect about where interest rates will be in the future. In
particular, you think that they will be higher than what the market believes. Which bond do you prefer?
SByes or SBno?
I would prefer to buy a callable bond, as it might be traded at a discount compared to a non-callable
one. If Im sure that the rates will go up then the issuer will not use his callable option and I get the same
cash flows for the lower price.
b) If, in the future, a piece of news indicates that the future level of interest rates is more uncertain. How
will the relative pricing of SByes and SBno be affected?
If the future interest rates become more uncertain, then the risk of lower interest rates is higher, then
there is a higher probability that the issuer will call the bonds. Thus the prices will diverge.

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9. Suppose the following table shows yields to maturity of zero coupon U.S. Treasury securities as of January
1, 2006:
Term to Maturity
(Years)
Yield to
Maturity
End 2006 3.50%
2007 4.50%
2008 5.00%
2009 5.50%
2010 6.00%
2011 6.20%
2012 6.40%
2013 6.50%
a) Based on the data in the table, calculate the implied forward 1-year rate of interest at January 1,
2009, January 1, 2010, January 1, 2011 January 1, 2012 and January 1, 2013.

The 1-year forward rates are:
2009 7.01%
2010 8.02%
2011 7.21%
2012 7.61%
2013 7.20%
b) What is the price of the Sleeping beauties as of January 1, 2006?
Given the current yield curve we can assume that the Yield is flat for all years following 2013 at a rate of
6.5%. Thus we can apply given yields to get the present value of the bond.
Discount factor PV
2006 3.775 3.50% 0.98 3.71
2006 3.775 3.50% 0.97 3.65
2007 3.775 4.50% 0.94 3.53
2007 3.775 4.50% 0.92 3.46
2008 3.775 5.00% 0.89 3.34
2008 3.775 5.00% 0.86 3.26
2009 3.775 5.50% 0.83 3.13
2009 3.775 5.50% 0.81 3.05
2010 3.775 6.00% 0.77 2.90
2010 3.775 6.00% 0.75 2.82
2011 3.775 6.20% 0.72 2.71
2011 3.775 6.20% 0.70 2.63
2012 3.775 6.40% 0.67 2.52
2012 3.775 6.40% 0.65 2.45
Sum PV 43.16
Scaled price at 01.01.2013 (calculated using Excel function) 116.06
PV of scaled price at 01.01.2013 75.18
Scaled Price at 01.01.2006 118.34


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10. Show the value of your position in Sleeping beauties on July 16, 2023 for different level of yields to
maturity. Comments.
If I initially invested 50000 in the Sleeping beauties, then my position on July 16, 2023 will depend on
YTM, but as we know that the bonds are callable so they can be priced a bit differently from non-
callable bonds at times when the rates are higher than 7.55%. As the rates go down there is a
probability that the Disney will call back the bonds. Im not sure that they will do it at 7%, because we
should also take into account future expectations and transaction costs to refinance the debt, but at
lower rates they will certainly call the bonds, so my position in bonds by this time will be zero.
Nevertheless, if the company calls back the bonds they repurchase them at 103.2%of it face value,
so I receive 50000*1.0302=51510 in cash.
Yield Price Position in bonds
0-5% - 0*
6% - 0?*
7% Probably max 107.8 probably max 53 896.6
8% max 94.4 max 47 198.9
9% max 83.9 max 41 961.2
10% max 75.5 max 37 763.0
11% max 68.7 max 34 326.6
12% max 62.9 max 31 463.3
13% max 58.1 max 29 041.2
14% 53.9 26 965.7
15% 50.3 25 167.3
16% 47.2 23 593.9

* the company is likely to call the bonds and well be left with 51510 cash.
If we consider high yields, then its clear that the price will be very close to the price of non-callable
bonds. As yields grow, the position value diminishes.
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B. CFA questions (based on 6th edition)
Ch. 14, question 7
a.
i. Current yield =70/960 =7.2916%
ii. Yield to maturity =8%(7.986%)
iii. Realised Compounded rate =8.498%(given the coupon reinvestment rate is EAR of 6%)
time payment FV
0.5 35.00 40.49
1 35.00 39.33
1.5 35.00 38.20
2 35.00 37.10
2.5 35.00 36.03
3 1 035.00 1 035.00
FV sum 1 226.15
PV 960.00

b. Major shortcomings:
i. Current yield is not useful in the analysis
ii. YTM reflects the yield if the bond is kept till maturity and coupons are reinvested at the
same rate
iii. Realized compound yield - impossible to predict, as it depends on the market price and
actual reinvestment rates
Ch. 14, question 31
a. 3
b. 3
c. 2
d. 3
e. 2
f. 3
Ch. 15, question 15
Zero coupon stripped US Treasuries can yield more because of the uncertainty about the future. There
is a risk that interest rates will go up (and actually in a given case they are expected to do so). In case
with coupon bonds the decrease in price can be at least partially offset by higher reinvestment rate for
the coupons, with zero coupon bond you can not do that.
Ch. 15, question 20
a. Given the Par coupon and YTM we can solve for the 5-year spot rate:
CF Spot rates PV
70 5% 66.66667
70 5.21% 63.23886
70 6.05% 58.69026
70 7.16% 53.08444
1070 7.129% 758.3198
Price = 1000

So the 5-year spot rate is 7.129%.
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Then the forward price can be easily calculated: f5=1.07129^5/1.0716^4-1=1.07-1=7%
i. YTM - the interest rate that makes the present value of a bonds payments equal to its
price. The investor receives this yield if keeps the bond to maturity and reinvests
coupon payments at the same rate.
ii. Spot rate The yield to maturity on zero-coupon bonds that prevails today for a period
corresponding to the maturity
iii. Forward rate - the interest rate for a given time interval in the future
The rates listed above are closely interconnected, as the no arbitrage condition to hold. For
example, given spot rates determine the forward rates, if it was not the case the arbitrage
would be possible.
Ch. 15, question 25
a. i. The annualized forward rate for 2 years (years 4-5) is 6.0674%
ii. The expectations hypothesis states that the forward rate equals the market consensus
expectation of the future short interest rate (liquidity premiums are zero). So in this case it is
possible to extract the forward rate from the given spot rates.
b. Price =987.09711
CF Discount factor
90 0.8849558
90 0.7971939
90 0.7311914
90 0.6830135
1090 0.6499314
Price 987.09711

Ch. 16, question 8
a. 4
b. 2
c. 1
d. 1
e. 3
f. 1
g. 1
h. 3
Ch. 16, question 10
a. Modified duration =10/1.08 =9.259 years
b. At the time moment equal to duration the bond price is almost non sensitive to interest
movements. Maturity itself doesnt possess a lot of information about sensitivity to interest
rates, as the coupons and there timing may be different.
c. i. If the coupons were 4%instead of 8%the duration would be higher, as the relative PV of
coupons goes down, while the relative PV of final payment increases.
ii. If the maturity was 7 years instead of 15 years the duration would be much lower (less than 7
years).
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d. Convexity is the curvature of the price-yield curve. It can be used with duration to predict bond
sensitivity to interest rates in the following way:

The equation above is nothing more than the approximation up to the second moment.
Ch. 16, question 32
The first approximation using the Modified Duration gives the following price changes:
Portfolio 1: 0.0075*4.83*0.5 0.005*23.81*0.5 =-0.0414125 =-4.1412%
Portfolio 2: -0.0025*14.35 =-0.035875 =-3.5875%
So the first portfolio seems to be more sensitive to this type of interest changes.

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C. Additional exercises

1) To find the Realized Compound Return we need the PV of our initial investments (974.69) and the
FV of the received cash flows (1261). So we easily find it using the following calculations:
Realized Compound Return =(1261.34/974.69)^(1/3) =8.97%
PV 974.69
year CF FV
1 80 93.82
2 80 87.52
3 1080 1080
1261.34

Realised return 8.97%

2) As we can see the coupon rate is less than YTM, so the price of this bond will go up provided the
constant YTM.
In this particular case we have P0=96.43 and P1=98.15.

3)
Year Forward Rate
old
Forward Rate
new
2001 5%
2002 6% 6%
2003 6.5% 6.5%

As the term structure changed only one year from now the current spot rate for year 1 was not
changed. We also know that the forward rates for the 2 remaining years are 6%and 6.5%
correspondingly.
In these circumstances we should conclude that the holding period return for year 1 is simply
5%.
We can spot it easily if we write the explicit formula for price at moment 0 and moment 1.
=
+ + +
= =
+ + + +
g g
g g
0
1 2 3
1
2 3 1 2
100
(1 ) (1 ) (1 )
100 100
(1 ) (1 ) (1 ) (1 )
new new
P
f f f
P
f f f f

So the holding period return is 5%



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VARIANT 2
= + +
= =
+ + +
= = =
+ + + +
= =
g g
g g
1 1 2
0
1 2 3
1
1 2
(1 )(1 ) 1 5.5%
100
84.36
(1 ) (1 ) (1 )
100 100
89
(1 0.055) (1 0.065) (1 ) (1 )
89/ 84.36 1 5.5%
new
new new
s s f
P
s f f
P
s f
Holdingperiodreturn