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CHAPTER 5: BOND RISK

PROBLEMS AND QUESTIONS WITH SOLUTIONS

1. The table below shows the historical cumulative probabilities for corporate bonds
with quality ratings of AA and B:

Cumulative Probabilities (%)

a. Determine the unconditional and conditional default probabilities from the


cumulative probabilities shown in the table.
b. What is the relation between conditional probabilities and credit spreads.

a
Probabilities (%)

Probabilities (%)

b. A credit spread on a bond can be thought of as bond investors expected loss from
the principal from default. For bonds with no option or liquidity risk, the expected
loss from the principal from default is equal to the conditional probability times
one minus the recovery rate: Conditional probability (1 recovery rate). To see
this, consider a portfolio of 5-year BBB bonds trading at a 2% credit spread. The
2% premium that investors receive from the bond portfolio represents their
compensation for an implied expected loss of 2% per year of the principal from
the defaulted bonds. If the spread were 2% and bond investors believed that the
expected loss from default on such bonds would be only 1% per year of the
principal, then the bond investors would want more BBB bonds, driving the price
up and the yield down until the premium reflected a 1% spread. Similarly, if the
spread were 2% and bond investors believed the default loss on a portfolio of

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BBB bonds would be 3% per year, then the demand and price for such bonds
would decrease, increasing the yield to reflect a credit spread of 3%. Thus, in an
efficient market, the credit spread on bonds and the equilibrium spreads represent
the markets implied expectation of the expected loss per year from the principal
from default.

2. Given the following:


The yield on a five-year, risk-free Treasury-note = 5%
The yield on a five-year, BB-quality bond = 8%, with the 3% spread reflecting
only credit risk
The credit spread on a five-year CDS on the 5-year, BB-quality bond of 2%

a. Explain how a bond investor looking for a five-year, risk-free investment


could gain a 1% yield over the risk-free investment by using a CD.
b. Explain what an arbitrageur would do.
c. Comment on the impact the actions by investors and arbitragers would have
on determining the equilibrium spread on a CDS.

a. An investor looking for a five-year, risk-free investment would find it


advantageous to create the synthetic risk-free investment with the BB bond and
the CDS. That is, the investor could earn 1% more than the yield on the Treasury
by buying the five-year, BB corporate yielding 8% and purchasing the CDS on
the underlying credit at a 2% spread.

b. An arbitrager could realized a free lunch equivalent to a five-year cash flow of 1%


of the par value of the bond by shorting the Treasury at 5% and then using the
proceeds to buy the BB corporate and then buying the CDS.

c. Collectively, the actions of the investors and arbitrageur would have the effect of
pushing the spread on CDS from 2% to 3%the same spread as the BB-bond.

3. Given the following:


The yield on a five-year, risk-free Treasury-note = 5%
The yield on a five-year, BB-quality bond = 8%, with the 3% spread reflecting
only credit risk
The credit spread on a five-year CDS on the five-year, BB-quality bond of 4%

a. Explain how a bond investor looking to invest in the 5-year, BB-rated bond
could gain a 1% yield over that investment by using a CDS.
b. Explain what an arbitrageur would do.
c. Comment on the impact the actions by investors and arbitragers would have
on determining the equilibrium spread on a CDS.

a. The investor looking to invest in five-year BB bonds could earn 1% more than the
8% on the BB bond by creating a synthetic 5-year BB bond by purchasing the

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five-year Treasury at 5% and selling the CDS at 4%.

b. An arbitrager could realized a free lunch equivalent to a five-year cash flow of 1%


of the par value on the bond by shorting the BB-bond, selling the CDS, and then
using proceeds to purchase five-year Treasuries. With these positions, the
arbitrageur would receive for each of the next five years 5% from her Treasury
investment and 4% from her CDS, while paying only 8% on her short BB bond
position. Furthermore, the arbitrageurs holdings of Treasury securities would
enable her to cover her obligation on the CDS if there was a default. That is, in the
event of a default, she would be able to pay the CDS holder from the net proceed
from selling her Treasuries and closing her short BB bond by buying back the
corporate bonds at their defaulted recovery price.

c. Collectively, the actions of the investors and arbitrageur would have the effect of
pushing the spread on CDS from 4% to 3%the same spread as the BB bond.

4. Given a discount rate of 5%, determine the present value of the payments on a five-
year CDS with a spread of 3% and a NP of $1. If the recovery rate on the
underlying credit is 30%, what is the probability intensity implied by the spread?

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(.03)($1)
PV(CDS Payments) (1.05) t
$0 .129884
t 1

The implied probability is obtained by solving for the p that makes the present value of
the expected payout equal to present value of the payments of $0.129884. In this
problem, the implied probability is .042857:

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PV (Expected Payout) PV (Payments)
M
p NP(1 RR ) M
Z NP

t 1 (1 R ) t
(1 R )
t 1
t

Z
p
(1 RR )

.03
p .042857
(1 .30)
M
p NP(1 RR )
PV (Expected Payout)
t 1 (1 R ) t
5
(.042857) ($1)(1 .30)
PV (Expected Payout) t 1 (1.05) t
$0.129884

5. What impact does the exercising of a call option by an issuer generally have on the
investors rate of return earned for the period from the purchase of the bond to its
call and the rate for the investors horizon period?

Since the call price is typically above the bond's face value, the actual rate of return the
investor earns for the period from the purchase of the bond to its call generally is greater
than the yield on the bond at the time it was purchased. However, if an investor
originally bought the bond because its maturity matched her horizon date, then she will
be faced with the disadvantage of reinvesting the call proceeds at lower market rates.
Moreover, this second effect, known as reinvestment risk, often dominates the first
effect, resulting in a rate of return over the investor's horizon period that is lower than
the promised YTM when the bond was bought.

6. Explain the relationship between call risk premiums and the level of interest rates in
the economy.

When interest rates are high and expected to fall, bonds are more likely to be called in
the future; as a result, in a period of high interest rates, a lower demand and higher
rate on callable over noncallable bonds would occur. Thus, in a period of high rates
the call risk premium would be relatively large. In contrast, when interest rates are
low and expected to rise, we would expect the effect of call provisions on interest
rates to be negligible. Thus, in a period of low rates the call risk premium would be
relatively small.

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7. Explain how interest rate changes affect a bonds return?

A change in interest rates has two effects on a bond's return. First, there is a price effect
in which a change in interest rates affects the price of a bond. If the investor's horizon is
different from the bond's maturity date, then the investor will be uncertain about the
price he will receive from selling the bond (HD < M), or the price he will have to pay for
a new bond (HD > M). Secondly, there is a reinvestment effect in which interest rate
changes affect the return the investor expects from reinvesting the coupons. One way an
investor can eliminate market risk is to purchase a zero-discount bond with a maturity
that is equal to the investor's horizon.

8. The AIF Company issued a 10-year bond at par (F = $1,000) that pays a coupon of
11% on an annual basis, and is callable at $1,100. Suppose you bought the bond
when it was issued, and at the time of your purchase suppose the yield curve was
flat and continued to remain at that level during years 1-4. However, at the start of
year 5 (or end of year 4), suppose the yield curve dropped to 8% and AIF called the
bond. Assume you reinvest your investment funds in a new six-year bond at par
and the yield curve remains flat at 8%. What is your total return for the call
period? What is your total return for the 10-year period? How do the total returns
compare to the YTM when you purchased the bond?

Call Date Value : 110 (1.11) 3 110 (1.11) 2 110 (1.11) 110 1100 1618 .07

1/ 4
1,618.07
TR 4 1 .1278448
1000
1 / 10
1,618.07(1.08) 6
TR 10 1 .09889
1000
TR 10 [(1.1278448 ) 4 (1.08) 6 ]1 / 10 1 .09889

The total return for the 10-year period is 9.889%, which is 1.111% less than the initial
YTM on the bond of 11%.

9. Suppose you have a horizon of 10 years and bought an 8-year, 8% coupon bond at
par (F = $1,000) that pays coupons semiannually and is callable at a call price of
$1,100. Assume the yield curve is flat at an 8.16% effective yield (or 4%
semiannual yield) and remains constant for three years. At the end of year 3,
suppose the yield curve drops to an effective yield of 5.0625% (2.5% semiannual)
and the issuer calls the bond. Assume you reinvest your investment funds in a new
seven-year bond paying coupons semiannually and the yield curve remains flat at
5.0625%. What is your semiannual rate of return and effective annual rate of
return for the call period? What is your semiannual and effective annual rate for

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the 10-year period? How do your rates compare to the YTM when you purchased
the bond?

6 1
(1.04) 6 1
Coupon values at call date 40 (1.04) t 40 265.32
t 0 .04
Call date value 265.32 1100 1,365.32
1/ 6
1,365.32
Semiannual rate 1 .053268
1000
Effective annualized rate (1.053268) 2 1 .10937
1 / 20
1,365.32(1.025)14
Semiannual rate for period 1 .0334
1,000
Semiannual rate for period [(1.053268) 6 (1.025)14 ]1 / 20 1 .0334
Effective annualized rate (1.0334) 2 1 [(1.10937 ) 3 (1.050625)]1 / 10 1 .0679

The total return for the 10-year period is 6.79%, which is 1.37% less than the initial
YTM on the bond of 8.16%.

10. The yield curve for AA-rated bonds is presently flat at a promised YTM of 9%. You
buy a 10-year, 8% coupon bond with face value of $1000 and annual coupon
payments. Suppose your horizon date is at the end of four years. What would your
total return be given the following cases:
a. Immediately after you buy the bond the yield curve drops to 8% and
remains there until you sell the bond at your horizon date.
b. Immediately after you buy the bond the yield curve increases to 10% and
remains there until you sell the bond at your horizon date.
c. What type of risk is your investment subject to? How could the risk be
minimized?
a.

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Current Pr ice :
10
80 1000
P0 (1.09)
t 1
t

(1.09)10
1 (1 / 1.09)10 1000
80 935.82
.09 (1.09)10
HD Value :
Coupon Value : 80(1.08) 3 80(1.08) 2 80(1.08) 80 360.49
6
1000 80
Pr ice : P6
t 1
(1.08)
(1.08) 6
1000 t

HD Value 1,000 360.49 1,360.49


1/ 4
1,360.49
TR 4 1 .09806
935.82
b.

Current Pr ice :
10
80 1000
P0 (1.09)
t 1
t

(1.09)10
1 (1 / 1.09)10 1000
80 935.82
.09 (1.09)10
HD Value :
Coupon Value : 80(1.10) 3 80(1.10) 2 80(1.10) 80 371.28
6
1000 80
Pr ice : P6
t 1
(1.10)
(1.10) 6
912.89 t

HD Value 912.89 371.28 1,284.17


1/ 4
1,284.17
TR 4 1 .08232
935.82
c. This is an example of market risk. The risk could be minimized by buying a bond
with duration equal to the investors horizon of 4 years.

11. Suppose you have a horizon at the end of 6 years and buy an 8-year, 8.5% coupon
bond with face value of $1,000 and annual coupon payments when the applicable
yield curve is flat at 10%. What would your total return be given the following
cases:
a. Immediately after you buy the bond the yield curve drops to 8% and
remains there until you sell the bond at your horizon date.
b. Immediately after you buy the bond the yield curve increases to 12% and
remains there until you sell the bond at your horizon date.
c. Is there any market risk? If not, why?

a.
Current Pr ice :
8
85 1,000
P0 (1.10)
t 1
t

(1.10)10
7
1 (1 / 1.10) 8 1000
85 919.98
.10 (1.10) 8
b.

c. Since the total return stays at 10% at the different rates, there is no market risk. In this
case, we have a bond with price and interest-on-interest effects that are of the same
magnitude in absolute value given the horizon date; thus, when rates change the two
effects cancel each other out.
HD Value at 8% :
6 1
(1.08) 6 1
Coupon Value 85 (1.08) t 85 623.55
t 0 .08
2
85 1,000
Pr ice : P2 t
1,008.92
HD Value att 121 (1.08)
%: (1.08) 2
HD Value 1,008.92 623.55 1,632.47
6 1
1t/ 6
(1.12) 6 - 1
Coupon Value =85 (1
1,632.47 .12 ) = 85 = 689.79
TR 6 t = 0 1 . 10 .12
919.98
2 85 1,000
Pr ice : P2 = t + = 940.85
t =1 (1.12) (1.12) 2
HD Value = 940.85 + 689.79 = 1,630.64
1/ 6
1,630.64
TR 6 = 1 = .10
919.98

12. Calculate both Macaulay and modified durations for the 8-year, 8.5% coupon bond
in Question 11 given a flat yield curve at 10%. Given your answers in Question 11,
comment on duration, horizon date, and bond immunization.

The 8-year, 8.5% coupon bond given a flat yield curve at 10% has Macaulay duration
of 6.03.

The bonds modified duration is 5.482:

1
Modified Duration Macaulay' s Duration
(1 y)
1
Modified Duration 6.03 5.482
(1.10)
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Alternatively, given the bond pays a principal at maturity, its modified duration and
Macaulay duration can be also be found using the following formula:

C 1 M[ F(C / y )]
2
1 M

y (1 y ) (1 y ) M 1
Modified Duration
P0b
85 1 8[1000 (85 / .10)]
2
1 8

.10 (1.10) (1.10) 9
Modified Duration
919.98
Macaulay' s Duration (1 y) Modified Duration
Macaulay' s Duration (1.10) 5.482 6.03
Comment: The problem illustrates how an investor with six-year horizon can eliminate, or
at least minimize, market risk by buying a bond that has a duration equal to the HD of 6.
Bond immunization is a strategy in which the objective is to minimize market risk. One
way to achieve this goal is to select a bond or portfolio of bonds with a duration matching
the investor's horizon date.

13. Assume the following yield curve for zero-coupon bonds:

Maturity YTM
1 year 5%
2 years 6%
3 years 7%
4 years 8%
5 years 9%

a. What is the Macaulay duration of each of the bonds?


b. Assume your HD is three years and you want to buy bonds with one- and four-
year maturities. What percentage investment should be made in each to assure
a fully immunized portfolio?

a. For zero-coupon bond, Macualays duration is equal to the bonds maturity.

b. Bond immunization requires constructing a bond portfolio with a duration equal to


your horizon date of 3 years: HD = Dp:

HD = Dp
3 = w1 D1 + w2 D2
3 = w1 D1 + (1-w1) D2
3 = w1 (1) + (1-w1) (4)

w1 = 1/3
w2 = 2/3

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14. Calculate Macaulays duration, the modified duration, and the convexity of the
following bonds (annualize the parameters). Assume all of the bonds pay principal
at their maturity.
a. Four-year, 9% coupon bond with a principal of $1,000 and annual coupon
payments trading at par.
b. Four-year, zero coupon bond with a principal of $1,000 and priced at $708.42
to yield 9%.
c. Five-year, 9% coupon bond with a principal of $1,000 and annual coupon
payments trading at par.
d. Ten-year, 7% coupon bond with a principal of $1,000 and semiannual coupon
payments (3.5%) and priced at par.
e. Three-year, 7% coupon bond with a principal of $1,000 and semiannual
coupon payments (3.5%) and priced at par.
f. Three-year zero-coupon bond with a principal of $1,000 and priced at $816.30
to yield 7%.

15. Given your duration and convexity calculations in Question 14, answer the
following:
a. Which bond has the greatest price sensitivity to interest rate changes?
b. For an annualized 1% decrease in rates what would be the approximate
percentage change in the prices of Bond d and Bond e?
c. Which bond has the greatest non-symmetrical capital gain and capital loss
feature?

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d. If you were a speculator and expected yields to decrease in the near future by
the same amount across all maturities (a parallel downward shift in the yield
curve), which bond would you select?
e. If you were a bond portfolio manager and expected yields to increase in the
near future by the same amount across all maturities (a parallel upward shift in
the yield curve), which bond would you select?
f. Comment on the relation between maturity and a bonds price sensitivity to
interest rate changes.
g. Comment on the relation between coupon rate and a bonds price sensitivity to
interest rate changes.

a. Bond d has the greatest duration and therefore has the greatest price sensitivity to
interest rate changes.

b. Using the modified duration, a 1% percent decrease in yields would lead to an


approximate 7% increase in the price for Bond d and 2.66% increase in price for
Bond e.

c. Bond d has the greatest convexity and therefore non-symmetrical gain and loss
feature.

d. You would select bond dthe one with the greatest duration; if yields decrease, bond
d would have the greatest percentage increase in price.

e. You would select bond ethe one with the smallest duration; if yields increase, bond
e would have the smallest percentage decrease in price.

f. The greater a bond's maturity, the greater its duration, and therefore the greater its
price sensitivity to interest rates changes.

g. The smaller a bond's coupon rate, the greater its duration, and therefore the greater its
price sensitivity to interest rate changes.

16. Short-Answer Questions:


1) Define market risk.
2) Define call risk.
3) Define default risk.
4) Define liquidity risk.
5) Explain the difference between the default rate, recovery rate, and default loss
rate.
6) Define a rating transitions matrix.
7) When would there be a direct relation between the total return and interest rate
changes?
8) When would there be an inverse relation between the total return and interest rate
changes?

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9) When would the total return be invariant to interest rate changes?

1) The possibility that the actual rate of return realized from a bond will differ from
the expected rate because interest rates could change in the future, affecting the
price of the bond and the return earned from reinvesting coupons.
2) The possibility that the actual rate of return realized from a bond will differ from the
expected rate because the issuer/borrower could call the bond back, forcing the
investor to reinvest in a market with lower interest rates.
3) The possibility that the actual rate of return realized from a bond will differ from the
expected rate because the issuer/borrower could fail to meet the contractual
obligations specified in the indenture.
4) Liquidity risk is the uncertainty that market trading conditions will change, making
the bond harder to trade, and in turn, causing the bonds price to decrease and its
yield to increase.
5) Holders of defaulted bonds usually recover a percentage of their investment
recovery rate. As a result, the default loss rate from an investment is lower than the
default rate:
Default Loss Rate = Default Rate (1 Recovery Rate)
6) Ratings transition matrix is defined in terms of the quality ratings at the beginning of
the year and the ratings at the end of the year.
7) There is a direct relation when the direct interest-on-interest effect dominates the
inverse price effect.
8) There is an inverse relation when the inverse price effect dominates the direct
interest-on-interest effect dominates.
9) The total return would be invariant to interest rate changes when the inverse price
effect and the direct interest-on-interest effect exactly offset each other; this
occurs when the bonds duration is equal to the investors horizon date.

17. A 10-year, 5% coupon bond making annual payments has a Macaulay duration of
8 years if the bond is priced at 92.64 per 100 face value to yield 6%. Show how
classical immunization works by showing the target value and TR for an 8-year
horizon date from an investment in the 10-year, 5% bond are approximately the
same given different yield curve shifts. Specifically, assume there is a one-time shift
in the yield curve to 4% and to 8% just after the investment is made (and the
duration of the bond still matches the duration of the liabilities). Assume the yield
curve is flat and use annual compounding.

Cash Flow at Year 8 at 4% Cash Flow at Year 8 at 8%


Price = 92.64 Price = 92.64
5(1.04)7 = 6.58 5(1.08)7 = 8.57
5(1.04)6 = 6.33 5(1.08)6 = 7.93
5(1.04)5 = 6.08 5(1.08)5 = 7.35
5(1.04)4 = 5.85 5(1.08)4 = 6.80
5(1.04)3 = 5.62 5(1.08)3 = 6.30
5(1.04)2 = 5.41 5(1.08)2 = 5.83

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5(1.04)1 = 5.20 5(1.08)1 = 5.40
5 (1.04)0 = 5.00 5 (1.04)0 = 5.00
5 105 5 105
P8 101.89 P8 94.65
1.04 (1.04) 2 1.08 (1.08) 2
Target Value = 147.96 Target Value = 147.83
TR = .0603 TR = .0602

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