FINS2624

PROBLEM SET 1 SOLUTIONS

Question 1.

Zero Coupon Bond:

FV = $100 t=0 t=1
P0 = $90.09

-$90.09 $100

𝐹𝑉
𝑃0 =
1+𝑦

𝐹𝑉
→ 𝑦= −1
𝑃0

100
𝑦=
90.09

∴ 𝑦 ≈ 11%
 Question 2.

Coupon Bond:
CR = 25% t=0 t=1 t=2
FV = $100
P0 = $121.97
TTM = 2yrs -P0 = -$121.97 $25 $125

𝐶𝑜𝑢𝑝𝑜𝑛 = 𝐶𝑅 × 𝐹𝑉 = 0.25 × 100 = $25

𝑐 𝑐 + 𝐹𝑉
𝑃0 = +
1 + 𝑦𝑡𝑚 (1 + 𝑦𝑡𝑚)2

25 125
∴ 121.97 = +
1 + 𝑦𝑡𝑚 (1 + 𝑦𝑡𝑚)2

1
𝐿𝑒𝑡 =𝑥
1 + 𝑦𝑡𝑚

121.97 = 25𝑥 + 125𝑥 2

125𝑥 2 + 25𝑥 − 121.97 = 0

By the quadratic formula: a=125

−𝑏 − √𝛥 −𝑏 + √𝛥 b=25
𝑥1 = 𝑎𝑛𝑑 𝑥2 = , 𝑤ℎ𝑒𝑟𝑒
2𝑎 2𝑎 c=-121.97
𝛥 = b2 – 4ac
−25 − √252 − 4 × 125 × −121.97
∴ 𝑥1 = ≈ −1.09
2 × 125

−25 + √252 − 4 × 125 × −121.97

𝑎𝑛𝑑 𝑥2 = ≈ 0.892854
2 × 125

Since ytm > 0, x > 0

∴ 𝑥 = 𝑥2 ≈ 0.892854

1
𝑆𝑖𝑛𝑐𝑒 = 𝑥,
1 + 𝑦𝑡𝑚

1 1
𝑦𝑡𝑚 = −1= − 1 ≈ 12%
𝑥 0.892854

Alternatively, you can set up an excel file as shown below:

 Question 3.

The cash flow diagram of this bond is:

FV = $100
CR = 10% t=0 1 2 3
P0 = $119.80
TTM = 3yrs
-P = -$119.80 c1 = $10 c2 = $10 c3 = $10
FV = $100
𝑐1 𝑐2 𝑐3 𝐹𝑉
𝑃= 1
+ 2
+ 3
+
(1 + 𝑦) (1 + 𝑦) (1 + 𝑦) (1 + 𝑦)3

METHOD 1: If you know how to solve cubic equations, then you can directly apply the cubic
equation solver to obtain the value of y, which is the yield-to-maturity under question.

METHOD 2: You can use a numeric solution (trial and error) to obtain the approximate
value of y.

Step 1: Take an initial value of y

Since P > FV (bond trades at premium), so y < C = 10%. Let’s take the starting value of y as
9% and calculate the price when y = 9%.
P(9%) = $102.53

Step 2: Adjust y until the calculated price crosses the actual price of $119.80
Since P(9%) = $102.53 < 119.80, we should further decrease y, until the calculated price is
close or below the actual price.

P(3%) =$119.8003
And P(2%) = 123.07

So we conclude that the actual y should be 3% (close enough to the true value)

Step 3 (if necessary): Interpolation to get the answer

For the purpose of demonstration, assume that the actual price is 121.44, and you are asked
to get an answer of y in percentage (rounded to first decimal).
Since P(2%) = $123.07 >$121.40, and P(3%) = $119.80 < $121.40, the actual y should lie
between 2% and 3%. So we can obtain the approximate value of y by interpolation.

y1 = 2% y=? y2 = 3%
P1 = $123.07 P = $121.44 P2 = $119.80

Hence:
121.44 − 119.80 123.07 − 121.44
𝑦 ≈ 2% × + 3% × = 2.5%
123.07 − 119.80 123.07 − 119.80

As you can see, the weight on a rate (e.g. 2%) is actually the relative distance between the
actual price ($121.44) and the price calculated from the other rate (P(3%) = $119.80). The
idea is that the further away the price of 3% is from the actual price, the closer the actual y to
2%.
Additional Note:
With hindsight, this question is not well designed – you need to try too many times with
hypothetical ys until the calculated price crosses the actual price. In the exam, if I decide to
include YTM calculation (I have not decided yet), I will choose numbers you don’t have to try
too many times. And as I indicated in the lecture note, at most I will set the maximum time
periods up to T = 3. And if I require you to do the interpolation to get the answer, I will put a
note and specify to what decimals the answer should be.

METHOD 3: Set up an excel spreadsheet as shown in Question 2. A reminder that the

formula to be used in excel is: “=RATE(NPeriods, CR x FV, -P0, FV)”
 Question 4.

FV = 100
C = 20% ⟹ coupon = $20
T=3
y0 = 4%
P0 = 144.40

Cash Flows if bond held to maturity:

t=0 1 2 3

-P0 $20 $20 $120

Cash Flows if bond sold after 1 period:

t=0 1 2 3

-P0 $20
P1 Price at which bond is sold
at t = 1

Holding period return (HPR):

Uncertain at t = 0
𝑃0 (1 + 𝐻𝑃𝑅) = 20 + 𝑃1

Initial (accumulated) cash

Investment inflows from investment

a) If at t = 1, ytm on bond = 4%

20 120
𝑃1 = + ≈ 130.1775
1 + 4% (1 + 4%)2

20 + 𝑃1
∴ 𝐻𝑃𝑅 = − 1 = 4%
𝑃0

b) If at t = 1, ytm on bond = 5%

20 120
𝑃1 = + ≈ 127.8912
1 + 5% (1 + 5%)2

20 + 𝑃1
∴ 𝐻𝑃𝑅 = − 1 = 2.41%
𝑃0

c) If at t = 1, ytm on bond = 3%
 20 120
𝑃1 = + ≈ 132.529
1 + 3% (1 + 3%)2

20 + 𝑃1
∴ 𝐻𝑃𝑅 = − 1 = 5.63%
𝑃0

d)

Δ𝐻𝑃𝑅(𝑏)−(𝑎) ≈ −1.59% 𝑤ℎ𝑒𝑛 Δ𝑦(𝑏)−(𝑎) = 1%

Δ𝐻𝑃𝑅(𝑐)−(𝑎) ≈ 1.63% 𝑤ℎ𝑒𝑛 Δ𝑦(𝑐)−(𝑎) = −1%

Bond price more sensitive to

decreases in the yield than
equivalent increase in yield
(from a given point)

x>y
 Question 5.

Cash Flows from bond (FV = 100, c = 5%):

t=0 1 2

$5 $105

Bond pricing using no-arbitrage condition:

𝐶𝑜𝑢𝑝𝑜𝑛 𝐶𝑜𝑢𝑝𝑜𝑛 + 𝐹𝑉
𝑃0 = + = $94.65
1+𝑖 (1 + 𝑖)2

If the bond price was > $94.65, one could short sell the bond at time 0, and lend the full $
amount to the bank at 8%

If the bond price was < $94.65, one could borrow from the bank at 8% an amount equivalent
to the bond price and buy the bond at time 0.

In both cases, the strategy is (theoretically) riskless and generates infinite profit in a perfect
world.
 Question 6.

Market price of bond = $92

Cost of replicating strategy = $94.65

Market price ($92) is < $94.65 → Buy the bond (underpriced)

105
At time 0, borrow (2 year maturity): 1.082 = $90.02 to match the second year bond cash flow

5
At time 0, borrow (1 year maturity): = $4.63 to match the first year bond cash flow
1.08

Total borrowed at time 0: $94.65

Cash Flow Overview:

Time 0 1 2
Buy Bond -$92 $5 $105.0
Borrow $90.02 @ 8% (2 year $105/1.082 = $0 -$105.0
maturity) => FV = $105 $90.02
Borrow $4.63 @ 8% (1 year $5/1.08 = $4.63 -$5
maturity) => FV = $5
Total $2.65 $0 $0
NPV $2.65
Questions 7.

Cash flows from risk-free goldmine:

t=0 1 2 3 4 5 6
4 5 6 7

-P0 -P1 $100 $100 $100 $100 $100

y = 8%

Value of CFs at t = 1: PV of annuity paying $X

every period for n period at
1 5
1 − (1.08) discount rate i:
𝑃1 = 100 [ ]
0.08
1 𝑛
1 − (1 + 𝑖 )
𝑃1 ≈ 399.27 𝑃𝑉 = 𝑋 [ ]
𝑦

Value at t = 0:
𝑃1
𝑃0 = ≈ 369.70
1.08
Question 8 (Essential to cover)

A 2-year bond with par value of $1000 making annual coupon payments of $100 is priced at
$1000. What is the yield to maturity of the bond (without any calculation, are you able to
answer this question?)? What will be the realized compound yield to maturity if the 1-year
interest rate next year turns out to be: a) 8%, b) 10%, c) 12%?

Solution:

The cash flow diagram of this bond is:

-P = -1000 c1 = 100 c2 = 100

FV = 1000

P = c1 /(1 + y)1 + c2 /(1 + y)2 + FV/(1 + y)2 (1)

[1] yield to maturity

Since P = FV, so y = C = 10%.

[2] Realized compound yield – let’s take 8% 1-year interest rate next year for illustration

Step1: To calculate realized compound yield, you will first need to reinvest all interim cash
flows (coupon payments in this question) to the maturity at the interest rate at the time of
coupon payment.

-P = -1000 c1 = 100 c2 = 100

FV = 1000

So the cash flow at the end of maturity (time 2) from reinvesting c1 = 100*(1+8%) = 108.

Step 2: calculate the total cash flow (with reinvestment) at the end of maturity
So the total cash flow at the end of maturity (time 2) of this bond = 108+100+1000 = 1208.

Step 3: calculate total realized return and annualize it

Total (realized) return (R) = total cash flows at maturity/price – 1 = 1208/1000 – 1
Annualize total return to annual return: r = (1+R)1/T – 1 = (1208/1000) ½ - 1 = 9.9%

You can replicate the calculation above to 10% and 12% of 1-year interest rate next year. You
will find that realized compound yield = 10% if the reinvestment rate = 10%, and above 10%
if the reinvestment rate = 12%. So YTM (10% in this question) equals to realized compound
yield if all interim cash flows could be reinvested at YTM (which is unlikely the case).

Additional Note:
The calculation is very simple for the two-year bonds in our example. But the same
calculation process could be easily applied to more general case. For example, in the general
bond example below (T-year maturity), to calculate the cash flow at the maturity (time T)
from reinvesting the first coupon payment, you will need to reinvest c1 first to end of time 2
(using the 1-year return at time 1), then reinvest the proceedings at the end of time 2 further
to time 3 (using the 1-year return at time 2), so on so forth, until the end of time T. Similarly,
you will need to reinvest all other cash flows to the end of maturity. Finally, you sum up all
reinvestment cash flows and the final payment (coupon and face value) to obtain the
aggregate cash flows from this bond – based on which you can calculate total return over
these T years and annualize it to realized compound yield.

But don’t worry, if I really decide to test on the realized compound yield, I will set T = 2 so
that you only need to reinvest one cash flow (for one year), given that the logic is the same
and making T bigger just makes things more complex (rather than more challenging).

-P c1 c2 ct cT
FV
Selected end-of-chapter questions.
BKM Chapter 14

3. Zero coupon bonds provide no coupons to be reinvested. Therefore, the investor's

proceeds from the bond are independent of the rate at which coupons could be
reinvested (if they were paid). There is no reinvestment rate uncertainty with zeros.

4. A bond’s coupon interest payments and principal repayment are not affected by
changes in market rates. Consequently, if market rates increase, bond investors in
the secondary markets are not willing to pay as much for a claim on a given
bond’s fixed interest and principal payments as they would if market rates were
lower. This relationship is apparent from the inverse relationship between interest
rates and present value. An increase in the discount rate (i.e., the market rate.
decreases the present value of the future cash flows.

8. The bond price will be lower. As time passes, the bond price, which is now above
par value, will approach par.

9. Yield to maturity: Using a financial calculator, enter the following:

n = 3; PV = −953.10; FV = 1000; PMT = 80; COMP i
This results in: YTM = 9.88%
Realized compound yield: First, find the future value (FV. of reinvested coupons
and principal:
FV = ($80 * 1.10 *1.12. + $80 * 1.12. + $1,080) = $1,268.16
Then find the rate (yrealized . that makes the FV of the purchase price equal to $1,268.16:
$953.10 × (1 + yrealized .3 = $1,268.16 ⇒ yrealized = 9.99% or approximately 10%

Using a financial calculator, enter the following: N = 3; PV = −953.10; FV = 1,268.16;

PMT = 0; COMP I. Answer is 9.99%.
Note: financial calculator is not allowed in the exam. So please solve the equation with
numerical method.
13.
Maturity Bond Equivalent
Price (years. YTM
$400.00 20.00 4.688%
500.00 20.00 3.526
500.00 10.00 7.177
385.54 10.00 10.000
463.19 10.00 8.000
400.00 11.91 8.000

31. a. Initial price P0 = $705.46 [n = 20; PMT = 50; FV = 1000; i = 8]

Next year's price P1 = $793.29 [n = 19; PMT = 50; FV = 1000; i = 7]
$50 + ($793.29 − $705.46)
HPR = = 0.1954 = 19.54%
$705.46