# UNIVERSITY OF ILLINOIS AT URBANA-CHAMPAIGN Actuarial Science Program DEPARTMENT OF MATHEMATICS

Math 210 Theory of Interest Prof. Rick Gorvett Fall, 2011

Homework Assignment # 9 (max. points = 10) Due at the beginning of class on Tuesday, December 6, 2011 You are encouraged to work on these problems in groups of no more than 3 or 4. However, each student must hand in her/his own answer sheet. Please show your work – enough to show that you understand how to do the problem – and circle your final answer. Full credit can only be given if the answer and approach are appropriate. Please give answers to two decimal places – e.g., xx.xx% and \$xx,xxx.xx . Note: Homework assignments are due at the beginning of the class. If you arrive at the class after it has started, you must hand in your assignment upon entering the classroom. Assignments will not be accepted at the end of the class period.

1) Let X be the Macaulay duration of a 30-year 10% annual coupon bond, and let Y be the modified duration of that same bond. Assume an effective annual interest rate of 10%. Determine the value of the difference, X – Y. 2) Find the modified duration of a 10-year zero-coupon bond. Assume an effective annual interest rate of 12%. 3) Determine the modified duration of a share of common stock (where the price of the stock is determined according to the Dividend Discount Model (also known as the Gordon Growth Model)). Make the following assumptions: the first dividend is payable 12 months from now, and dividends will be paid annually after that; the annual growth rate of the dividends is 2%; and the interest rate is 10%. 4) Suppose that a perpetuity will pay you 100 annually, beginning with the first payment 12 months from now. The effective annual interest rate is 20%. Find the convexity of this perpetuity. 5) An insurance company accepts an obligation to pay \$ 5,000 one year from now, and \$ 10,000 two years from now. The insurance company purchases a combination of the following two bonds (both with \$ 1,000 par and redemption values) in order to exactly match its obligation: Bond A: A 1-year 4% annual coupon bond with a yield rate of 6%. Bond B: A 2-year 8% annual coupon bond with a yield rate of 9%.

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the expected 3-year spot rate starting one year from now – express it as an annual rate). A three-year zero-coupon bond has a price of 77. of the two-year zero-coupon bond.46.. 10) You are given the following term structure (yield curve) of interest rates: Years 1 2 3 Annual Spot Rate 4.8% Find the expected cost. X..8% 6.5% 5.4% Find the 3-year forward rate one year from now (i.Determine how many (the numbers need not be integers) units of each bond the insurer must purchase to exactly match its obligations.43. 2 . the interest rate anticipated between time-points 2 and 3). 8) A one-year zero-coupon bond has a price of 93. 6) You are given the following term structure (yield curve) of interest rates: Years 1 2 3 Annual Spot Rate 7% 6% 5% Find the one-year forward rate two years from now (i. find the total cost. Then. of a 2-year 1. All these bonds have face (and redemption) values of 100. 7) You are given the following term structure (yield curve) of interest rates: Years 1 2 3 4 Annual Spot Rate 4.75.0% 5. now.0% 5. one year from now. Find the price.000 par value zero-coupon bond.2% 5. 9) Find the yield-to-maturity on the bond in problem (8) above. A three-year 10% annualcoupon bond has a price of 103.e. A two-year zero-coupon bond has a price of X.e. to the insurer of purchasing the needed number of bonds.