Problems and Solutions
3 CHAPTER 3—Problems
Exercise 3.1 We consider three zerocoupon bonds (strips) with the following features:
Bond Maturity (years) Price
Bond 1 1 96.43
Bond 2 2 92.47
Bond 3 3 87.97
Each strip delivers $100 at maturity.
1. Extract the zerocoupon yield curve from the bond prices.
2. We anticipate a rate increase in one year so the prices of strips with residual
maturity 1 year, 2 years and 3 years are respectively 95.89, 90.97 and 84.23.
What is the zerocoupon yield curve anticipated in one year?
Solution 3.1 1. The 1year zerocoupon rate denoted by R(0, 1) is equal to 3.702%
R(0, 1) =
100
96.43
−1 = 3.702%
The 2year zerocoupon rate denoted by R(0, 2) is equal to 3.992%
R(0, 2) =
_
100
92.47
_
1/2
−1 = 3.992%
The 3year zerocoupon rate denoted by R(0, 3) is equal to 4.365%
R(0, 2) =
_
100
87.97
_
1/3
−1 = 4.365%
2. The 1year, 2year and 3year zerocoupon rates become respectively 4.286%,
4.846% and 5.887%.
Exercise 3.3 We consider the following decreasing zerocoupon yield curve:
Maturity (years) R(0, t ) (%) Maturity (years) R(0, t ) (%)
1 7.000 6 6.250
2 6.800 7 6.200
3 6.620 8 6.160
4 6.460 9 6.125
5 6.330 10 6.100
where R(0, t ) is the zerocoupon rate at date 0 with maturity t .
1. Compute the par yield curve.
2. Compute the forward yield curve in one year.
3. Draw the three curves on the same graph. What can you say about their relative
position?
16
Problems and Solutions
Solution 3.3 1. Recall that the par yield c(n) for maturity n is given by the formula
c(n) =
1 −
1
(1+R(0,n))
n
n
i=1
1
(1+R(0,i))
i
Using this equation, we obtain the following par yields:
Maturity (years) c(n) (%) Maturity (years) c(n) (%)
1 7.000 6 6.293
2 6.807 7 6.246
3 6.636 8 6.209
4 6.487 9 6.177
5 6.367 10 6.154
2. Recall that F(0, x, y −x), the forward rate as seen from date t = 0, starting at
date t = x, and with residual maturity y −x is deﬁned as
F(0, x, y −x) ≡
_
(1 +R(0, y))
y
(1 +R(0, x))
x
_ 1
y−x
−1
Using the previous equation, we obtain the forward yield curve in one year
Maturity (years) F(0, 1, n) (%) Maturity (years) F(0, 1, n) (%)
1 6.600 6 6.067
2 6.431 7 6.041
3 6.281 8 6.016
4 6.163 9 6.000
5 6.101 — —
3. The graph of the three curves shows that the forward yield curve is below the
zerocoupon yield curve, which is below the par yield curve. This is always the
case when the par yield curve is decreasing.
5.75
6.00
6.25
6.50
6.75
7.00
7.25
1 2 3 4 5 6 7 8 9 10
Maturity
Y
i
e
l
d
(
%
)
Par yield curve
Zerocoupon yield curve
Forward yield curve
17
Problems and Solutions
Exercise 3.8 When the current par yield curve is increasing (respectively, decreasing), the cur
rent zerocoupon rate curve is above (respectively, below) it, so as to offset the fact
that the sum of the coupons discounted at the coupon rate is inferior (respectively,
superior) to the sum of the coupons discounted at the zerocoupon rate. Give a
proof of this assertion.
Solution 3.8 Let us denote by c(i) , the par yield with maturity i and by R(0, i), the zerocoupon
rate with maturity i.
Let us assume for k < n that c(n) > c(k)
At the ﬁrst rank, we have R(0, 1) = c(1)
At the second rank,
c(2)
1 +c(2)
+
1 +c(2)
(1 +c(2))
2
=
c(2)
1 +R(0, 1)
+
1 +c(2)
[(1 +R(0, 2)]
2
Let us do a limited development at the ﬁrst order of this last expression. Then
c(2).(1 −c(2)) +(1 +c(2)).(1 −2c(2)) = c(2).(1 −R(0, 1))
+(1 +c(2)).(1 −2R(0, 2))
R(0, 2) −c(2) =
1
2
.
c(2)
1 +c(2)
.(c(2) −c(1))
As c(2) > c(1), R(0, 2) > c(2).
The proposition is true at the ﬁrst and second ranks. Let us assume that it is
true at rank n −1 and let us prove it at rank n.
n
k=1
c(n)
(1 +c(n))
k
+
1
(1 +c(n))
n
=
n
k=1
c(n)
(1 +R(0, k))
k
+
1
(1 +R(0, n))
n
Let us do again a limited development at the ﬁrst order. Then
n
k=1
c(n).(1 −kc(n)) +1 −nc(n) =
n
k=1
c(n).(1 −kR(0, k)) +1 −nR(0, n)
After simpliﬁcation
R(0, n) −c(n) =
1
n
.
c(n)
1 +c(n)
.
_
n
k=1
k.(c(n) −c(k)) +
c(n −1)
1 +c(n −1)
n−1
k=1
c(k)
_
as
c(n−1)
1+c(n−1)
n−1
k=1
c(k) can be considered negligible since
c(n−1)
1+c(n−1)
is close to
zero, we can make the following approximation:
R(0, n) −c(n) =
1
n
.
c(n)
1 +c(n)
.
n
k=1
k.(c(n) −c(k))
As c(n) > c(k), we obtain R(0, n) > c(n), which proves the assertion.
Exercise 3.11 At date t = 0, we observe the following zerocoupon rates in the market:
18
Problems and Solutions
Maturity ZeroCoupon Maturity ZeroCoupon
(years) Rate (%) (years) Rate (%)
1 5.00 4 6.80
2 6.00 5 7.00
3 6.50
1. What are the 1year maturity forward rates implied by the current term structure?
2. Over a long period, we observe the mean spreads between 1year maturity for
ward rates and 1year maturity realized rates in the future. We ﬁnd the following
liquidity premiums:
• L
2
= 0.1%
• L
3
= 0.175%
• L
4
= 0.225%
• L
5
= 0.250%
Taking into account these liquidity premiums, what are the 1year maturity
future rates expected by the market?
Solution 3.11 1. 1year maturity forward rates are given by the following formula:
[1 +R(0, T )]
T
= [1 +R(0, T −1)]
T −1
. [1 +F(0, T −1, 1)]
where R(0, T ) is the zerocoupon rate at date t = 0 with T year maturity
and F(0, T − 1, 1) is the 1year maturity forward rate observed at date t = 0,
starting at date t = T −1 and maturing one year later.
F(0, 4, 1) is obtained by solving the following equation:
F(0, 4, 1) =
(1 +7%)
5
(1 +6.8%)
4
−1 = 7.804%
Using the same equation, we obtain
Forward Rates
F(0, 1, 1) 7.009%
F(0, 2, 1) 7.507%
F(0, 3, 1) 7.705%
2. 1year maturity future rates expected by the market are given by the following
formula:
[1 +R(0, T )]
T
= [1 +R(0, T −1)]
T −1
.[1 +F
a
(0, T −1, 1) +L
T
]
where F
a
(0, T −1, 1) is the 1year maturity future rate expected by the market
at date t = 0, starting at date t = T −1 and ﬁnishing one year later.
Using the last equation, we ﬁnd the relation between the forward rate and
the future rate expected by the market
F
a
(0, T −1, 1) = F(0, T −1, 1) −L
T
19
Problems and Solutions
We ﬁnally obtain
Expected Future Rates
F
a
(0, 1, 1) 6.909%
F
a
(0, 2, 1) 7.332%
F
a
(0, 3, 1) 7.480%
F
a
(0, 4, 1) 7.554%
Exercise 3.12 Monetary policy and longterm interest rates
Consider an investor with a 4year investment horizon. The shortterm (long
term respectively) yield is taken as the 1year (4year respectively) yield. The
mediumterm yields are taken as the 2year and 3year yields. We assume, fur
thermore, that the assumptions of the pure expectations theory are valid.
For each of the following ﬁve scenarios, determine the spotyield curve at
date t = 1. The yield curve is supposed to be initially ﬂat at the level of 4%, at
date t = 0.
(a) Investors do not expect any Central Bank rate increase over four years.
(b) The Central Bank increases its prime rate, leading the shortterm rate
from 4 to 5%. Investors do not expect any other increase over four years.
(c) The Central Bank increases its prime rate, leading the shortterm rate from
4 to 5%. Investors expect another shortterm rate increase by 1% at the beginning
of the second year, then no other increase over the last two years.
(d) The Central Bank increases its prime rate, leading the shortterm rate
from 4 to 5%. Nevertheless, investors expect a shortterm rate decrease by 1% at
the beginning of the second year, then no other change over the last two years.
(e) The Central Bank increases its prime rate, leading the shortterm rate
from 4 to 5%. Nevertheless, investors expect a shortterm rate decrease by 1%
each year, over the following three years.
What conclusions do you draw from that as regards the relationship existing
between monetary policy and interest rates?
Solution 3.12 Let us denote F
a
(1, n, m), the myear maturity future rate anticipated by the mar
ket at date t = 1 and starting at date t = n, and R(1, n) the nyear maturity
zerocoupon rate at date t = 1.
In each scenario, we have
Scenario a Scenario b Scenario c Scenario d Scenario e
% % % % %
R(1, 1) 4.00 5.00 5.00 5.00 5.00
F
a
(1, 2, 1) 4.00 5.00 6.00 4.00 4.00
F
a
(1, 2, 2) 4.00 5.00 6.00 4.00 3.00
F
a
(1, 2, 3) 4.00 5.00 6.00 4.00 2.00
Using the following equation:
1 +R(t, n) = [(1 +R(t, 1))(1 +F
a
(t, t +1, 1))(1 +F
a
(t, t +2, 1)) . . .
(1 +F
a
(t, t +n −1, 1))]
1/n
20
Problems and Solutions
we ﬁnd the spot zerocoupon yield curve in each scenario.
Scenario a Scenario b Scenario c Scenario d Scenario e
% % % % %
R(1, 1) 4.00 5.00 5.00 5.00 5.00
R(1, 2) 4.00 5.00 5.50 4.50 4.50
R(1, 3) 4.00 5.00 5.67 4.33 4.00
R(1, 4) 4.00 5.00 5.75 4.25 3.49
In the framework of the pure expectations theory, monetary policy affects
longterm rates by directly impacting spot and forward shortterm rates, which
are supposed to be equal to market shortterm rate expectations. But what about
these expectations? The purpose of the exercise is to show that market short
term rate expectations play a determining role in the response of the yield curve
to monetary policy. More meaningful than the Central Bank action itself is the
way market participants interpret this action. Is it a temporary action or rather the
beginning of a series of similar actions. . . ? We can draw three conclusions from
the exercise.
First, the direction taken by interest rates compared with that of the Cen
tral Bank prime rate depends on the likelihood, perceived by the market, that the
Central Bank will question its action in the future through reversing its stance.
Under the (b) and (c) scenarios, the Central bank action is perceived to either fur
ther increase its prime rate or leave things as they are. Consequently, longterm
rates increase following the increase in the prime rate. Under the (d) scenario, the
Central Bank is expected to exactly offset its increasing action in the future. Nev
ertheless, its action on shortterm rates still remains positive over the period. As
a result, longterm interest rates still increase. In contrast, under the (e) scenario,
the Central Bank is expected to completely reverse its stance through a decreas
ing action in the future, that more than offsets its initial action. Consequently,
longterm interest rates decrease.
Second, the magnitude of the response of longterm rates to monetary pol
icy depends on the degree of monetary policy persistence that is expected by the
market. Under the (b) and (c) scenarios, the Central Bank action is viewed as rel
atively persistent. Consequently, the longterm interestrate change either reﬂects
the instantaneous change in the prime rate or exceeds it. Under the (d) scenario, as
the Central Bank action is perceived as temporary, the change in longterm rates
is smaller than the change in the prime rate.
Third, the reaction of longterm rates to monetary policy is more volatile
than that of shortterm rates. That is, the signiﬁcance of the impact of market
expectations on interest rates increases with the maturity of interest rates. These
expectations only play a very small role on shortterm rates. As illustrated by
the exercise, the variation margin of the 2year interest rate following a 100bps
increase of the Central Bank prime rate is contained between 50 and 150 bps, while
the variation margin of the 4year interest rate is more volatile (between −50 bp
and +175 bps).
21
Problems and Solutions
Exercise 3.13 Explain the basic difference that exists between the preferred habitat theory and
the segmentation theory.
Solution 3.13 In the segmentation theory, investors are supposed to be 100% riskaverse. So
risk premia are inﬁnite. It is as if their investment habitat were strictly con
strained, exclusive.
In the preferred habitat theory, investors are not supposed to be 100% risk
averse. So, there exists a certain level of risk premia from which they are ready
to change their habitual investment maturity. Their investment habitat is, in this
case, not exclusive.
4 CHAPTER 4—Problems
Exercise 4.1 At date t = 0, we consider ﬁve bonds with the following features:
Annual
Coupon Maturity Price
Bond 1 6 1 year P
1
0
= 103
Bond 2 5 2 years P
2
0
= 102
Bond 3 4 3 years P
3
0
= 100
Bond 4 6 4 years P
4
0
= 104
Bond 5 5 5 years P
5
0
= 99
Derive the zerocoupon curve until the 5year maturity.
Solution 4.1 Using the noarbitrage relationship, we obtain the following equations for the ﬁve
bond prices:
_
¸
¸
¸
¸
_
¸
¸
¸
¸
_
103 = 106B(0, 1)
102 = 5B(0, 1) +105B(0, 2)
100 = 4B(0, 1) +4B(0, 2) +104B(0, 3)
104 = 6B(0, 1) +6B(0, 2) +6B(0, 3) +106B(0, 4)
99 = 5B(0, 1) +5B(0, 2) +5B(0, 3) +5B(0, 4) +105B(0, 5)
which can be expressed in a matrix form as
_
_
_
_
_
_
103
102
100
104
99
_
_
_
_
_
_
=
_
_
_
_
_
_
106
5 105
4 4 104
6 6 6 106
5 5 5 5 105
_
_
_
_
_
_
×
_
_
_
_
_
_
B(0, 1)
B(0, 2)
B(0, 3)
B(0, 4)
B(0, 5)
_
_
_
_
_
_
We get the following discount factors:
_
_
_
_
_
_
B(0, 1)
B(0, 2)
B(0, 3)
B(0, 4)
B(0, 5)
_
_
_
_
_
_
=
_
_
_
_
_
_
0.97170
0.92516
0.88858
0.82347
0.77100
_
_
_
_
_
_
22
Problems and Solutions
and we ﬁnd the zerocoupon rates
_
_
_
_
_
_
R(0, 1) = 2.912%
R(0, 2) = 3.966%
R(0, 3) = 4.016%
R(0, 4) = 4.976%
R(0, 5) = 5.339%
_
_
_
_
_
_
Exercise 4.3 Suppose we know from market prices, the following zerocoupon rates with matu
rities inferior or equal to one year:
Maturity Zerocoupon Rate (%)
1 Day 3.20
1 Month 3.30
2 Months 3.40
3 Months 3.50
6 Months 3.60
9 Months 3.80
1 Year 4.00
Now, we consider the following bonds priced by the market until the 4year matu
rity:
Maturity Annual Coupon (%) Gross Price
1 Year and 3 Months 4 102.8
1 Year and 6 Months 4.5 102.5
2 Years 3.5 98.3
3 Years 4 98.7
4 Years 5 101.6
The compounding frequency is assumed to be annual.
1. Using the bootstrapping method, compute the zerocoupon rates for the follow
ing maturities: 1 year and 3 months, 1 year and 6 months, 2 years, 3 years and
4 years.
2. Draw the zerocoupon yield curve using a linear interpolation.
Solution 4.3 1. We ﬁrst extract the 1yearand3month maturity zerocoupon rate. In the ab
sence of arbitrage opportunities, the price of this bond is the sum of its future
discounted cash ﬂows:
102.8 =
4
(1 +3.5%)
1/4
+
104
(1 +x)
1+1/4
where x is the 1yearand3month maturity zerocoupon rate to be determined.
Solving this equation (for example with the Excel solver), we obtain 4.16% for
x. Applying the same procedure with the 1year and 6month maturity and the
2year maturity bonds, we obtain respectively 4.32% and 4.41% for x. Next,
23
Problems and Solutions
we have to extract the 3year maturity zerocoupon rate, solving the following
equation:
98.7 =
4
(1 +4%)
+
4
(1 +4.41%)
2
+
104
(1 +y%)
3
y is equal to 4.48% and ﬁnally, we extract the 4year maturity zerocoupon rate
denoted by z, solving the following equation:
101.6 =
5
(1 +4%)
+
5
(1 +4.41%)
2
+
5
(1 +4.48%)
3
+
105
(1 +z%)
4
z is equal to 4.57%.
2. Using the linear graph option in Excel, we draw the zerocoupon yield
curve
3.00
3.20
3.40
3.60
3.80
4.00
4.20
4.40
4.60
4.80
0 1 2 3 4
Maturity
Z
e
r
o

c
o
u
p
o
n
r
a
t
e
(
%
)
Exercise 4.4 1. The 10year and 12year zerocoupon rates are respectively equal to 4% and
4.5%. Compute the 11
1/4
and 11
3/4
year zerocoupon rates using linear inter
polation.
2. Same question when you know the 10year and 15year zerocoupon rates that
are respectively equal to 8.6% and 9%.
Solution 4.4 Assume that we know R(0, x) and R(0, z) respectively as the xyear and the
z year zerocoupon rates. We need to get R(0, y), the yyear zerocoupon rate
with y ∈ [x; z]. Using linear interpolation, R(0, y) is given by the following for
mula:
R(0, y) =
(z −y)R(0, x) +(y −x)R(0, z)
z −x
1. The 11
1/4
and 11
3/4
year zerocoupon rates are obtained as follows:
R(0, 11
1/4
) =
0.75 ×4%+1.25 ×4.5%
2
= 4.3125%
24
Problems and Solutions
R(0, 11
3/4
) =
0.25 ×4%+1.75 ×4.5%
2
= 4.4375%
2. The 11
1/4
and 11
3/4
year zerocoupon rates are obtained as follows:
R(0, 11
1/4
) =
3.75 ×8.6%+1.25 ×9%
5
= 8.70%
R(0, 11
3/4
) =
3.25 ×8.6%+1.75 ×9%
5
= 8.74%
Exercise 4.7 From the prices of zerocoupon bonds quoted in the market, we obtain the follow
ing zerocoupon curve:
Maturity (years) Zerocoupon Rate R(0, t ) (%) Discount Factor B(0, t )
1 5.000 0.95238
2 5.500 0.89845
3 5.900 0.84200
4 6.200 0.78614
5 ? ?
6 6.550 0.68341
7 6.650 0.63720
8 ? ?
9 6.830 0.55177
10 6.900 0.51312
where R(0, t ) is the zerocoupon rate at date 0 for maturity t , and B(0, t ) is the
discount factor at date 0 for maturity t .
We need to know the value for the 5year and the 8year zerocoupon rates.
We have to estimate them and test four different methods.
1. We use a linear interpolation with the zerocoupon rates. Find R(0, 5), R(0, 8)
and the corresponding values for B(0, 5) and B(0, 8).
2. We use a linear interpolation with the discount factors. Find B(0, 5), B(0, 8)
and the corresponding values for R(0, 5) and R(0, 8).
3. We postulate the following form for the zerocoupon rate function
−
R(0, t ):
−
R(0, t ) = a +bt +ct
2
+dt
3
Estimate the coefﬁcients a, b, c and d, which best approximate the given zero
coupon rates using the following optimization program:
Min
a,b,c,d
i
(B(0, i) −
−
B(0, i))
2
where B(0, i) are the zerocoupon rates given by the market.
Find the value for R(0, 5) =
−
R(0, 5), R(0, 8) =
−
R(0, 8), and the corre
sponding values for B(0, 5) and B(0, 8).
25
Problems and Solutions
4. We postulate the following form for the discount function
−
B(0, t ):
−
B(0, t ) = a +bt +ct
2
+dt
3
Estimate the coefﬁcients a, b, c and d, which best approximate the given
discount factors using the following optimization program:
Min
a,b,c,d
i
(B(0, i) −
−
B(0, i))
2
where B(0, i) are the discount factors given by the market.
Obtain the value for B(0, 5) =
−
B(0, 5), B(0, 8) =
−
B(0, 8), and the corre
sponding values for R(0, 5) and R(0, 8).
5. Conclude.
Solution 4.7 1. Consider that we know R(0, x) and R(0, z) respectively as the xyear and the
zyear zerocoupon rates and that we need R(0, y), the yyear zerocoupon rate
with y ∈ [x; z]. Using linear interpolation, R(0, y) is given by the following
formula:
R(0, y) =
(z −y)R(0, x) +(y −x)R(0, z)
z −x
From this equation, we ﬁnd the value for R(0, 5) and R(0, 8)
R(0, 5) =
(6 −5)R(0, 4) +(5 −4)R(0, 6)
6 −4
=
R(0, 4) +R(0, 6)
2
= 6.375%
R(0, 8) =
(9 −8)R(0, 7) +(8 −7)R(0, 9)
9 −7
=
R(0, 7) +R(0, 9)
2
= 6.740%
Using the following standard equation in which lies the zerocoupon rate R(0, t )
and the discount factor B(0, t )
B(0, t ) =
1
(1 +R(0, t ))
t
we obtain 0.73418 for B(0, 5) and 0.59345 for B(0, 8).
2. Using the same formula as in question 1 but adapting to discount factors
B(0, y) =
(z −y)B(0, x) +(y −x)B(0, z)
z −x
we obtain 0.73478 for B(0, 5) and 0.59449 for B(0, 8).
Using the following standard equation
R(0, t ) =
_
1
B(0, t )
_
1/t
−1
we obtain 6.358% for R(0, 5) and 6.717% for R(0, 8).
3. Using the Excel function “Linest”, we obtain the following values for the param
eters:
26
Problems and Solutions
Parameters Value
a 0.04351367
b 0.00720757
c −0.000776521
d 3.11234E05
which provide us with the following values for the zerocoupon rates and asso
ciated discount factors:
Maturity R(0, t ) (%)
−
R(0, t ) (%) B(0, t )
−
B(0, t )
1 5.000 4.998 0.95238 0.95240
2 5.500 5.507 0.89845 0.89833
3 5.900 5.899 0.84200 0.84203
4 6.200 6.191 0.78614 0.78641
5 ? 6.403 ? 0.73322
6 6.550 6.553 0.68341 0.68330
7 6.650 6.659 0.63720 0.63681
8 ? 6.741 ? 0.59339
9 6.830 6.817 0.55177 0.55237
10 6.900 6.906 0.51312 0.51283
4. We ﬁrst note that there is a constraint in the minimization because we must
have
B(0, 0) = 1
So, the value for a is necessarily equal to 1.
Using the Excel function “Linest”, we obtain the following values for the
parameters:
Parameters Value
a 1
b −0.04945479
c −0.001445358
d 0.000153698
which provide us with the following values for the discount factors and associ
ated zerocoupon rates:
Maturity B(0, t )
−
B(0, t ) R(0, t ) (%)
−
R(0, t ) (%)
1 0.95238 0.94925 5.000 5.346
2 0.89845 0.89654 5.500 5.613
3 0.84200 0.84278 5.900 5.867
4 0.78614 0.78889 6.200 6.107
5 ? 0.73580 ? 6.328
6 0.68341 0.68444 6.550 6.523
7 0.63720 0.63571 6.650 6.686
8 ? 0.59055 ? 6.805
9 0.55177 0.54988 6.830 6.871
10 0.51312 0.51461 6.900 6.869
27
Problems and Solutions
5. The table below summarizes the results obtained using the four different meth
ods of interpolation and minimization
— Rates Interpol. DF Interpol. Rates Min. DF Min.
R(0, 5) 6.375% 6.358% 6.403% 6.328%
R(0, 8) 6.740% 6.717% 6.741% 6.805%
B(0, 5) 0.73418 0.73478 0.73322 0.73580
B(0, 8) 0.59345 0.59449 0.59339 0.59055
“Rates Interpol.” stands for interpolation on rates (question 1). “DF Interpol.”
stands for interpolation on discount factors (question 2). “Rates Min” stands for
minimization with rates (question 3). “DF Min.” stands for minimization with
discount factors (question 4).
The table shows that results are quite similar according to the two methods
based on rates. Differences appear when we compare the four methods. In par
ticular, we can obtain a spread of 7.5 bps for the estimation of R(0, 5) between
“Rates Min.” and “DF Min.”, and a spread of 8.8 bps for the estimation of R(0, 8)
between the two methods based on discount factors. We conclude that the zero
coupon rate and discount factor estimations are sensitive to the method that is used:
interpolation or minimization.
Exercise 4.8 From the prices of zerocoupon bonds quoted in the market, we obtain the follow
ing zerocoupon curve:
Maturity (years) R(0, t ) (%) Maturity (years) R(0, t ) (%)
0.5 7.500 5 8.516
1 7.130 6 8.724
1.25 7.200 7 8.846
2 7.652 8 8.915
3 8.023 10 8.967
4 8.289
where R(0, t ) is the zerocoupon rate at date 0 with maturity t , and B(0, t ) is the
discount factor at date 0 with maturity t .
We need to know the value for R(0, 0.8), R(0, 1.5), R(0, 3.4), R(0, 5.25),
R(0, 8.3) and R(0, 9), where R(0, i) is the zerocoupon rate at date 0 with maturity
i. We have to estimate them, and test two different methods.
1. We postulate the following form for the zerocoupon rate function
−
R(0, t ):
−
R(0, t ) = a +bt +ct
2
+dt
3
(a) Estimate the coefﬁcients a, b, c and d, which best approximate the given
zerocoupon rates using the following optimization program:
Min
a,b,c,d
i
(R(0, i) −
−
R(0, i))
2
28
Problems and Solutions
where R(0, i) are the zerocoupon rates given by the market. Compare these
rates R(0, i) to the rates
−
R(0, i) given by the model.
(b) Find the value for the six zerocoupon rates that we are looking for.
(c) Draw the two following curves on the same graph:
• The market curve by plotting the market points.
• The theoretical curve as derived from the prespeciﬁed functional
form.
2. Same question as the previous one. But we now postulate the following form
for the discount function
−
B(0, t ):
−
B(0, t ) = a +bt +ct
2
+dt
3
Estimate the coefﬁcients a, b, c and d, which best approximate the given
discount factors using the following optimization program:
Min
a,b,c,d
i
(B(0, i) −
−
B(0, i))
2
where B(0, i) are the discount factors given by the market.
3. Conclude.
Solution 4.8 1. (a) Using the Excel function “Linest”, we obtain the following values for the
parameters
Parameters Value
a 0.070774834
b 0.00254927
c 0.000175503
d −2.44996E05
which provide us with the theoretical values for the zerocoupon rates
−
R(0, t )
given by the model and compared with the market values R(0, t )
Maturity (years) R(0, t ) (%)
−
R(0, t ) (%)
0.5 7.500 7.209
1 7.130 7.348
1.25 7.200 7.419
2 7.652 7.638
3 8.023 7.934
4 8.289 8.221
5 8.516 8.485
6 8.724 8.710
7 8.846 8.882
8 8.915 8.986
10 8.967 8.932
29
Problems and Solutions
(b) We ﬁnd the value for the six other zerocoupon rates we are looking for in
the following table:
Maturity (years)
−
R(0, t ) (%)
0.8 7.291
1.5 7.491
3.4 8.051
5.25 8.545
8.3 9.002
9 9.007
(c) We now draw the graph of the market curve and the theoretical curve. We
see that the threeorder polynomial form used to model the zerocoupon rates
is not well adapted to the market conﬁguration, which is an inverted curve
at the shortterm segment.
7.00
7.50
8.00
8.50
9.00
0 1 2 3 4 5 6 7 8 9 10
Maturity
Z
e
r
o

c
o
u
p
o
n
r
a
t
e
s
(
%
)
2. (a) We ﬁrst note that there is a constraint in the minimization because we must
have
B(0, 0) = 1
So the value for a is necessarily equal to 1.
Using the Excel function “Linest”, we obtain the following values
for the parameters:
Parameters Value
a 1
b −0.06865628
c −0.000397845
d 0.000151057
which provide us with the following values for the discount factors and
associated zerocoupon rates:
30
Problems and Solutions
Maturity (years) B(0, t )
−
B(0, t ) R(0, t ) (%)
−
R(0, t ) (%)
0.5 0.96449 0.96559 7.500 7.254
1 0.93345 0.93110 7.130 7.400
1.25 0.91676 0.91385 7.200 7.473
2 0.86289 0.86230 7.652 7.689
3 0.79333 0.79453 8.023 7.968
4 0.72721 0.72868 8.289 8.235
5 0.66456 0.66565 8.516 8.480
6 0.60541 0.60637 8.724 8.695
7 0.55248 0.55172 8.846 8.867
8 0.50501 0.50263 8.915 8.979
10 0.42369 0.42471 8.967 8.941
(b) By using the standard relationship between the discount factor and the zero
coupon rate
−
R(0, t ) =
_
1
−
B(0, t )
_
1/t
−1
we ﬁnd the value for the six other zerocoupon rates we are looking for in
the following table:
Maturity (years)
−
B(0, t )
−
R(0, t ) (%)
0.8 0.94490 7.342
1.5 0.89663 7.545
3.4 0.76791 8.077
5.25 0.65045 8.537
8.3 0.48912 8.998
9 0.45999 9.012
(c) We now draw the graph of the market curve and the theoretical curve. We
can see that the threeorder polynomial form used to model the discount
function is not well adapted to the market conﬁguration considered.
7.00
7.50
8.00
8.50
9.00
0 1 2 3 4 5 6 7 8 9 10
Maturity
Z
e
r
o

c
o
u
p
o
n
r
a
t
e
s
(
%
)
31
Problems and Solutions
3. Note ﬁrst that this is a case of an inverted zerocoupon curve at the shortterm
end. We conclude that the two functional forms we have tested are unadapted
to ﬁt with accuracy the observed market zerocoupon rates.
Exercise 4.10 Consider the Nelson and Siegel model
R
c
(0, θ) = β
0
+β
1
_
1 −exp
_
−
θ
τ
_
θ
τ
_
+β
2
_
1 −exp
_
−
θ
τ
_
θ
τ
−exp
_
−
θ
τ
_
_
Our goal is to analyze the impact of the parameter 1/τ on the zerocoupon
curve for three different conﬁgurations, an increasing curve, a decreasing curve
and an inverted curve at the shortterm end.
1. We consider the increasing curve corresponding to the following basecase
parameter values: β
0
= 8%, β
1
= −3%, β
2
= 1% and 1/τ = 0.3. We give
successively ﬁve different values to the parameter 1/τ: 1/τ = 0.1, 1/τ = 0.2,
1/τ = 0.3, 1/τ = 0.4 and 1/τ = 0.5. The other parameters are ﬁxed. Draw
the ﬁve different yield curves to estimate the effect of the parameter 1/τ.
2. We consider the decreasing curve corresponding to the following basecase
parameter values: β
0
= 8%, β
1
= 3%, β
2
= 1% and 1/τ = 0.3. We give
successively ﬁve different values to the parameter 1/τ: 1/τ = 0.1, 1/τ = 0.2,
1/τ = 0.3, 1/τ = 0.4 and 1/τ = 0.5. The other parameters are ﬁxed. Draw
the ﬁve different yield curves to estimate the effect of the parameter 1/τ.
3. We consider the inverted curve corresponding to the following basecase param
eter values: β
0
= 8%, β
1
= −1%, β
2
= −2% and 1/τ = 0.3. We give suc
cessively ﬁve different values to the parameter 1/τ: 1/τ = 0.1, 1/τ = 0.2,
1/τ = 0.3, 1/τ = 0.4 and 1/τ = 0.5. The other parameters are ﬁxed. Draw
the ﬁve different yield curves to estimate the effect of the parameter 1/τ.
Solution 4.10 1. The following graph shows clearly the effect of the parameter 1/τ in the ﬁve
different scenarios for an increasing curve. The parameter 1/τ affects the slope
of the curve. The higher the 1/τ, the more rapidly the curve goes to its longterm
level (8% in the exercise).
0.05
0.055
0.06
0.065
0.07
0.075
0.08
0 5 10 15 20 25 30
Maturity
Z
e
r
o

c
o
u
p
o
n
r
a
t
e
1/t = 0.1
1/t = 0.2
1/t = 0.3
1/t = 0.4
1/t = 0.5
32
Problems and Solutions
2. The following graph shows clearly the effect of the parameter 1/τ in the ﬁve
different scenarios for a decreasing curve. The parameter 1/τ affects the slope of
the curve. The higher 1/τ, the more rapidly the curve goes to its longterm level
(8% in the exercise). The effect for a decreasing curve is exactly symmetrical
to the effect for an increasing curve.
0.08
0.085
0.09
0.095
0.1
0.105
0.11
0 5 10 15 20 25 30
Maturity
Z
e
r
o

c
o
u
p
o
n
r
a
t
e
1/t = 0.1
1/t = 0.2
1/t = 0.3
1/t = 0.4
1/t = 0.5
3. The following graph shows clearly the effect of the parameter 1/τ in the ﬁve
different scenarios for an inverted curve. The parameter 1/τ affects the slope
of the curve, and the maturity point where the curve becomes increasing. The
higher 1/τ, the lower the maturity point where the curve becomes increasing.
For example, this maturity point is around 1.5 years for 1/τ equal to 0.5, and
around 8 years for 1/τ equal to 0.1.
Maturity
Z
e
r
o

c
o
u
p
o
n
r
a
t
e
0.068
0.069
0.07
0.071
0.072
0.073
0.074
0.075
0.076
0.077
0.078
0 5 10 15 20 25 30
1/t = 0.1
1/t = 0.2
1/t = 0.3
1/t = 0.4
1/t = 0.5
33
Problems and Solutions
Exercise 4.15 Consider the Nelson and Siegel Extended model
R
c
(0, θ) = β
0
+β
1
_
_
1 −exp
_
−
θ
τ
1
_
θ
τ
1
_
_
+β
2
_
_
1 −exp
_
−
θ
τ
1
_
θ
τ
1
−exp
_
−
θ
τ
1
_
_
_
+β
3
_
_
1 −exp
_
−
θ
τ
2
_
θ
τ
2
−exp
_
−
θ
τ
2
_
_
_
with the following basecase parameter values: β
0
= 8%, β
1
= −3%, β
2
= 1%,
β
3
= −1%, 1/τ
1
= 0.3 and 1/τ
2
= 3.
We give successively ﬁve different values to the parameter β
3
: β
3
=
−3%, β
3
= −2%, β
3
= −1%, β
3
= 0% and β
3
= 1%. The other parameters are
ﬁxed. Draw the ﬁve different yield curves to estimate the effect of the curvature
factor β
3
.
Solution 4.15 The following graph shows clearly the effect of the curvature factor β
3
for the ﬁve
different scenarios:
0.04
0.045
0.05
0.055
0.06
0.065
0.07
0.075
0.08
0 5 10 15 20 25 30
Maturity
Z
e
r
o

c
o
u
p
o
n
r
a
t
e
b
3
= −3%
b
3
= −2%
base case
b
3
= 0%
b
3
= 1%
Exercise 4.16 Deriving the Interbank Zerocoupon Yield Curve
On 03/15/02, we get from the market the following Euribor rates, futures
contract prices and swap rates (see Chapters 10 and 11 for more details about
swaps and futures)
34
Problems and Solutions
Maturity Euribor Contract Futures Maturity Swap
Rate Maturity Price Maturity Rate (%)
03/22/02 4.07% 06/15/02 95.2 03/15/04 5.20
03/29/02 4.11% 09/15/02 95.13 03/15/05 5.36
04/15/02 4.15% 12/15/02 94.93 03/15/06 5.49
05/15/02 4.26% 03/15/03 94.79 03/15/07 5.61
06/15/02 4.34% 06/15/03 94.69 03/15/08 5.71
07/15/02 4.44% 09/15/03 94.54 03/15/09 5.75
08/15/02 4.53% — — 03/15/10 5.79
— — — — 03/15/11 5.82
— — — — 03/15/12 5.84
Note that the underlying asset of the futures contract is a threemonth Euribor
rate. For example, the ﬁrst contract matures on 06/15/02, and the underlying asset
matures three months later on 09/15/02.
1. Extract the implied zerocoupon rates from market data.
2. Draw the zerocoupon yield curve by building a linear interpolation between
the implied zerocoupon rates.
Solution 4.16 1. We ﬁrst extract the implied zerocoupon rates from the Euribor rates using the
following formula:
R
_
0,
x
365
_
=
_
1 +
x
360
.Euribor
x
_365
x
−1
where R
_
0,
x
365
_
and Euribor
x
are respectively the zerocoupon rate and the
Euribor rate with residual maturity x (as a number of days).
We obtain the following results:
x Euribor
x
(%) R
_
0,
x
365
_
(%)
7 4.07 4.211
14 4.11 4.252
31 4.15 4.290
61 4.26 4.398
92 4.34 4.473
122 4.44 4.569
153 4.53 4.654
We now extract the implied zerocoupon rates from the futures price using
the following formula:
B
f
_
0,
x
365
,
y
365
_
=
B
_
0,
y
365
_
B
_
0,
x
365
_
35
Problems and Solutions
which transforms into
_
1 +(100 −Futures Price)%.
_
y −x
360
__
=
B
_
0,
x
365
_
B
_
0,
y
365
_
and ﬁnally enables to obtain
R
_
0,
y
365
_
=
_
1
B
_
0,
x
365
_ .
_
1 +(100 −Futures Price)%.
_
y −x
360
__
_365
y
−1
where B(0, t ) is the discount factor with maturity t and B
f
(0, t, T ) the forward
discount factor determined at date 0, beginning at date t and ﬁnishing at date T .
Using the last equation, we obtain the following results (FP stands for
Futures Price)
x y B
_
0,
x
365
_
FP R
_
0,
y
365
_
(%)
92 184 0.98903 95.2 4.714
184 275 0.97705 95.13 4.819
275 365 0.96516 94.93 4.923
365 457 0.95308 94.79 5.016
457 549 0.94056 94.69 5.096
549 640 0.92797 94.54 5.175
Detailing the calculations for the ﬁrst line of the previous table, we obtain
x = number of days between the “03/15/02” and the “06/15/02”
y = number of days between the “03/15/02” and the “09/15/02”
B
_
0,
x
365
_
=
1
(1 +4.473%)
92/365
= 0.98903
FP = 95.20
R
_
0,
y
365
_
= 4.714%
We now extract the implied zerocoupon rates from the swap rates using
the following formula:
SR(n)
1 +R(0, 1)
+
SR(n)
(1 +R(0, 2))
2
+· · · +
1 +SR(n)
(1 +R(0, n))
n
= 1
which enables us to obtain
R(0, n) =
_
_
_
_
1
1 −
SR(n)
1+R(0,1)
−· · · −
SR(n)
(1+R(0,n−1))
n−1
_
_
×(1 +SR(n))
_
_
1
n
−1
where SR(n) is the swap rate with maturity n.
36
Problems and Solutions
We then obtain the following results:
n SR(n) (%) R(0, n) (%)
2 5.20 5.207
3 5.36 5.374
4 5.49 5.512
5 5.61 5.642
6 5.71 5.753
7 5.75 5.795
8 5.79 5.839
9 5.82 5.872
10 5.84 5.893
2. We obtain the following interbank zerocoupon yield curve:
4.00
4.20
4.40
4.60
4.80
5.00
5.20
5.40
5.60
5.80
6.00
0 1 2 3 4 5 6 7 8 9 10
Maturity
Z
e
r
o

c
o
u
p
o
n
r
a
t
e
(
%
)
5 CHAPTER 5—Problems
Exercise 5.1 Calculate the percentage price change for 4 bonds with different annual coupon
rates (5% and 10%) and different maturities (3 years and 10 years), starting with
a common 7.5% YTM (with annual compounding frequency), and assuming suc
cessively a new yield of 5%, 7%, 7.49%, 7.51%, 8% and 10%.
Solution 5.1 Results are given in the following table: