MA 155

PROBLEM SET: Bond Pricing

Exercise 1. Slim Pickens [4]
T-bone Pickins brother Slim thinks that the takeover business it too risky, so he wants to invest in Treasury
bonds.
He can invest in the following bonds:
Bond
1
2
3

Annual
coupon rate
10%
5%
0%

Face value
$1,000
$1,000
$1,000

Maturity
5 years
5years
5 years

Coupon payments are made semi-annually and the face value is paid at the maturity date.
1. Suppose the annual opportunity cost of capital (the current interest rate) is 8.16%. What are the
market prices of these three bonds?
2. If the interest rate is not supposed to change, what are the expected coupon yields, capital gain returns
and total returns on these three bonds over the next 6 months?
3. Recalculate the numbers assuming the annual interest rate is 8%.
Exercise 2. Zero Coupon Bonds (RWJ 5.1) [2]
Price a tenyear, pure discount bond that pays $1,000 at maturity to yield the following rates:
1. 5 percent.
2. 10 percent.
3. 15 percent.
Exercise 3. [3]
Consider the following prices of zero-coupon bonds with nominal value of $1,000 and maturites T = 1, 2, 3, 4:
P0,1 = 968.52. P0,2 = 929.02. P0,3 = 915.15. P0,4 = 905.95. Disounting in discrete, annual.
1. Compute the spot rates implied by these prices, and plot the yield curve.
2. Use the information in the above bond prices to find the price of a coupon bond with maturity 4 years
from now, annual coupon rate c = 7% and face value $1000. Is the bond selling a premium, par or
discount?
Exercise 4. Treasuries [3]
A treasury zero coupon bill that pays 100 one period from now is priced at 95.
A treasury zero coupon bill that pays 100 two periods from now is priced at 90.
1. Determine the price of a two year treasury bond. The bond has a face value of 1000, and pays 10%
annual interest.
Exercise 5. Duration [3]
Suppose you are trying to determine the interest rate sensitivity of two bonds. Bond 1 is a 12% coupon
bond with a 7-year maturity and a $1000 principal. Bond 2 is a zero-coupon bond that pays $1120 after 7
year. The current interest rate is 12%.
1

1. Determine the duration of each bond.

2. If the interest rate increases 100 basis points (100 basis points = 1%), what will be the capital loss on
each bond?
Exercise 6. Duration [2]
Suppose the term structure is flat. Which bond has the highest duration?
1. A twenty year bond with a 2% coupon or a twenty year pure discount bond?
2. A ten year bond with a 10% coupon or a ten year bond with a 5% coupon?
3. A 10% coupon bond with a ten year maturity or a 10% bond with an 11 year maturity?
Exercise 7. Term structure [2]
You have estimated spot interest rates as follows:
Year
1
2
3
4
5

Spot Rate, Percent

r(0, 1) = 5.00
r(0, 2) = 5.40
r(0, 3) = 5.70
r(0, 4) = 5.90
r(0, 5) = 6.00

1. Suppose that someone told you that the 6-year spot interest rate was 4.80 percent.
(a) Why would you not believe him?
(b) How could you make money if he was right?
(c) What is minimum sensible value for the 6-year spot rate?
Exercise 8. Term structure [2]
The term structure is upward sloping.
1. Is the yield on a ten year coupon bond higher than the ten year zero rate.
Exercise 9. [3]
Assume today is 1 jan 98. The yield compounding frequency is considered annually. A risk free pure discount
bond with face value $1,000 maturing on 12 dec 98 is selling today at $940. The forward rate for the period
1 jan 99 to 30 jun 99 is 7%. Compute the price of a pure discount bond maturing on 30 jun 99, with a $1,000
face value.
Exercise 10. Portfolio Duration [1]
A company invests $1,000 in a five-year zero coupon bond and $4,000 in a ten-year zero-coupon bond.
1. What is the duration of the portfolio?

Empirical
Solutions
MA 155
PROBLEM SET: Bond Pricing
Exercise 1. Slim Pickens [4]

P0 =

T
X
t=1

Ct
FT
+
(1 + r)t
(1 + r)T

If the coupon payments Ct are fixed, this is an annuity



1
1
1
FT
P0 = C

+
T
r
(1 + r) r
(1 + r)T
Here
T = 10 periods, since we have a bond with maturity 5 years paying off semi-annually, and r =

1.0816 1 = 4%.
1. Price: Bond 1:

Bond 2:


1
1
1000
1
P0 = $50

+
= 1081.11
10
0.04 (1 + 0.04) 0.04
(1 + 0.04)10

1
1
1000
1

+
= 878.34
P0 = $25
0.04 (1 + 0.04)10 0.04
(1 + 0.04)10


Bond 3:
P0 =

1000
= 675.56
(1 + 0.04)10

2. To find the returns, we first need to find the price next period. Bond 1:


1
1
1000
1

+
= 1074.35
P1 = $50
0.04 (1 + 0.04)9 0.04
(1 + 0.04)9
Bond 2:


P1 = $25


1
1
1
1000

+
= 888.47
0.04 (1 + 0.04)9 0.04
(1 + 0.04)9

Bond 3:
P1 =

1000
= 702.59
(1 + 0.04)9

Definitions:
Coupon Yield =
Capital Gain Return =
Bond
1
2
3

Coupon
Yield
4.62%
2.85%
0%

C
P0
P 1 P0
P0

Capital Gain
return
-0.62%
1.15%
4%

Total
return
4%
4%
4%

3. If 8% is the annual rate, the biannual interest rate will be

(1 + r)2 = 1.08 r = 1.08 1 = 3.92%

Using this interest rate gives
Bond

P0

P1

1
2
3

1087.95
884.37
680.783

1080.6
894.03
707.47

Biannual
Coupon
5
2.5
0

Coupon
Yield
4.59%
2.82%
0

Capital Gain
return
-0.676%
1.09%
3.92%

Total
return
3.91%
3.91%
3.92%

Exercise 2. Zero Coupon Bonds (RWJ 5.1) [2]

The price today is the present value of the principal:
P0 =

$1, 000
(1 + r)10

For the various values of r, get the prices:

1. 5%: P0 = 613.91
2. 10%: P0 = 385.54
3. 15%: P0 = 247.18
Exercise 3. [3]
First calculate discount factors (zero coupon prices)
> P=[968.52 929.02 915.15 905.95]
P =
968.52 929.02 915.15 905.95
> C=[1000 1000 1000 1000]
C =
1000 1000 1000 1000
> d=P./C
d =
0.96852 0.92902 0.91515 0.90595
To check that this gives the right answer, consider the repricing of the bonds with the calculated discount
factors d.
> d.*C
ans =
968.52

929.02

915.15

905.95

Now calculate spot rates

> r=(1.0./d).^(1./t)-1
r =
0.032503 0.037498 0.029997

0.025000

Price the bond

> Cflow=[70 70 70 1070]

Cflow =
70
70
70 1070
> B = Cflow * (1./(1+r).^t)
B = 1166.3
octave> B = Cflow * d
B = 1166.3
The bond is a premium bond, which is obvious given that the highest spot rate is 3.25%, while the bond
coupon is 7%.
Exercise 4. Treasuries [3]
The zero prices can be viewed as discount factors
d1 =

95
= 0.95
100

90
= 0.90
100
B0 = d1 100 + d2 1100
d2 =

Giving a bond price:

>> [0.95 0.9]*[100 1100]
ans = 1085
Alternatively one need to find the spot rate curve:
t=[1 2]
t =
1
2
>> r=[0.95 0.9].^(-1./t)-1
r =
0.052632
0.054093
>> [100 1100]*[(1.+r).^-t]
ans = 1085
B0 = 1085
Exercise 5. Duration [3]
1. Duration
Year
1
2
3
4
5
6
7
7
P0

Cash Flow
Bond 1 Bond 2
120
0
120
0
120
0
120
0
120
0
120
0
120
0
1000
1000

PV(r=12%)
Bond 1 Bond 2
107.14
95.66
85.41
76.26
68.09
60.80
54.28
452.34
452.34
1000.00 452.34

Duration bond 1:
[107.14 + 95.66 2 + 85.41 3 + 76.26 4 + 68.09 5 + 60.80 6 + 507.63 7]
= 5.11139
1000
Duration bond 2:

452.34 7
=7
452.34
Bond 2 will be more sensitive to interest rate changes.
2. If the interest rate increases 100 basis points to 13%, the new prices of each bond will be:
Price Bond 1 =

T
X
$1000
$120
+
= $955.77
t
(1.13)
(1.13)7
t=1

1120
= 476.07
1.137
Capital Loss Bond 1 = 1000 955.77 = 44.23
Price Bond 2 =

44.23
= 4.423%
1000
Capital Loss Bond 2 = 506.63 476.07 = 30.56
Percentage Loss Bond 1 =

30.56
= 6.032%
506.63
Note: The percentage loss on each bond is approximately equal to
Percentage Loss Bond 2 =

Percentage Loss

Duration
r
1+r

5.11139
0.01 = 4.563%
1.12
7.0
0.01 = 6.25%
Percentage Loss Bond 2
1.12

Percentage Loss Bond 1

Exercise 6. Duration [2]

(a)
D0%
(b)
D10%
(c) D10%,t=10

>
<
<

D2%
D5%
D10%,t=11

Exercise 7. Term structure [2]

1.
f (0, 5, 6) =

(1.048)6
1 = 0.01 = 1%
(1.06)5

A negative nominal interest rate does not make sense, the minimum should be what you can get by
just salting away your money, 0%. Find the spot rate that solves f (0, 5, 6) = 0%:
(1 + r(0, 6))6
1=0
(1.06)5

Exercise 8. Term structure [2]

r(0, 6) = 0.0497 = 4.97%

1. No, the ten year zero rate is higher.

Exercise 9. [3]
As stated, the problem does not have a solution. The problem is the period between 12 dec 98 and 1 jan 99.
Without knowledge of this we can not solve the problem. We would either need the forward rate between 12
dec 98 and 1 jan 99, or the spot rate on 1 jan 99. As a practical matter we would here have to interpolate
rates, either forward rates or short rates.
Exercise 10. Portfolio Duration [1]
9 years.
Duration of zero coupon bonds equal maturity.
1000
4000
5+
10 = 9
5000
5000