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Solutions for Chapter 11 of Theory of Interest by Kellison

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Chapter 11

1. A generalized version of formula (11.2) would be

d=

v t1 Rt1 + v t2 Rt2 +

+ tn v tn Rtn

+ v tn Rtn

t

where 0 < t1 < t2 < < tn . Now multiply numerator and denominator by (1 + i ) 1 to

obtain

d=

t1 Rt1 + t2 v t2 t1 Rt2 +

Rt1 + v t2 t1 Rt2 +

i

v 0

t1 Rt1

Rt1

+ tn v tn t1 Rtn

+ v tn t1 Rtn

= t1.

2. We can apply the dividend discount model and formula (6.28) to obtain

P (i ) = D (i k ) .

1

2

P ( i ) D ( i k )

=

v =

P ( i ) D ( i k )1

1

= ( i k ) = (.08 .04 ) .

Finally, we apply formula (11.5)

d = v (1 + i ) =

1.08

= 27.

.08 .04

d=

n

0

n

0

tv t dt

tv t dt

( I a )n

an

v=

d

v ( I a )n

=

.

1+ i

an

126

Chapter 11

1

a = .

i

The modified duration of the perpetuity is

v=

d

=

1+ i

v tv t

t =1

v ( Ia )

a

t =1

v / id v v 1

= = = .

1/ i

d iv i

d=

=

6. (a) We have v =

so that

10 ( Ia )8 + 800v8

at i = 8%

10a8 + 100v8

= 5.99.

(10 )( 5.74664 ) + 100 (.54027 )

P ( i )

d

=

P (i ) 1 + i

650

d

and d = 6.955.

=

100 1.07

(b) We have P ( i + h ) P ( i ) [1 hv ]

so that P (.08 ) P (.07 ) [1 .01v ]

7. Per dollar of annual installment payment the prospective mortgage balance at time

t = 3 will be a12 .06 = 8.38384 . Thus, we have

tv R

d=

v R

t

=

(1.06 )1 + 2 (1.06 )2 + 9.38384 (1.06 )3

26.359948

= 2.71.

9.712246

127

8. We have P ( i ) = R (1 + i )

Chapter 11

P ( i ) = R (1 + i )

3

P ( i ) = 2 R (1 + i )

3

2

P ( i ) 2 R (1 + i )

2

and c =

=

= 2 (1 + i ) =

= 1.715.

1

P (i )

(1.08 )2

R (1 + i )

9. (a) Rather than using the definition directly, we will find the modified duration first

and adjust it, since this information will be needed for part (b). We have

1

2

P ( i ) = 1000 (1 + i ) + (1 + i )

2

3

P ( i ) = 1000 (1 + i ) 2 (1 + i )

3

4

P ( i ) = 1000 2 (1 + i ) + 6 (1 + i ) .

2

3

P ( i ) (1.1) + 2 (1.1)

1.1 + 2

=

=

Now, v =

1

2

P (i )

(1.1)2 + 1.1

(1.1) + (1.1)

and d = v (1 + i ) =

1.1 + 2 3.1

=

= 1.48.

1.1 + 1 2.1

(b) We have

3

4

P ( i ) 2 (1 + i ) + 6 (1 + i )

=

c=

P (i )

(1 + i )1 + (1 + i )2

4

and multiplying numerator and denominator by (1 + i )

2 (1 + i ) + 6

2 (1.1) + 6

8.2

=

=

= 3.23.

3

2

3

2

2.541

(1 + i ) + (1 + i ) (1.1) + (1.1)

10. When there is only one payment d is the time at which that payment is made for any

dd dv

force of interest. Therefore,

=

= 2 = 0.

d d

1

2

3

11. (a) P ( i ) = 1000 (1 + i ) + 2 (1 + i ) + 3 (1 + i )

1

2

3

= 1000 (1.25 ) + 2 (1.25 ) + 3 (1.25 ) = $3616.

1

2

3

1000 (1.25 ) + 4 (1.25 ) + 9 (1.25 ) 7968

=

= 2.2035.

(b) d =

1

2

3

1000 (1.25 ) + 2 (1.25 ) + 3 (1.25 ) 3616

128

(c) v =

Chapter 11

d

2.2035

=

= 1.7628.

1+ i

1.25

3

4

5

P ( i ) 2 (1 + i ) + 12 (1 + i ) + 36 (1 + i )

(d) c =

=

P (i )

(1 + i )1 + 2 (1 + i )2 + 3 (1 + i )3

3

=

3.616

= 4.9048.

1

P ( i ) = (1 + i ) + (1 + i ) +

+ (1 + i )

P ( i ) = (1)( 2 ) (1 + i ) + ( 2 ) ( 3)(1 + i ) +

+ ( n )( n + 1)(1 + i )

n2

If i = 0, the convexity is

c=

=

P ( 0 ) 1 2 + 2 3 + + n ( n + 1)

=

P (0)

1+1+ +1

(12 + 22 + + n 2 ) + (1 + 2 + + n )

n

1 (

1

n n + 1)( 2n + 1) + n ( n + 1)

n ( n + 1)( 2n + 1) + 3n ( n + 1)

2

=6

=

n

6n

n ( n + 1)( 2n + 4 ) 1

=

= ( n + 1)( n + 2 ) .

6n

3

13. We have

P (i ) = D (i k )

P ( i ) = 2 D ( i k )

so that c =

3

P ( i ) 2 D ( i k )

2

2

=

=

=

= 1250.

2

1

P (i )

( i k ) (.08 .04 )2

D (i k )

dv

2

2

= v 2 c or 800 = ( 6.5 ) c or c = 800 + ( 6.5) = 842.25.

di

129

Chapter 11

h2

P ( i + h ) P ( i ) 1 hv + c

(.01)2

( 842.25 )

P (.08 ) 100 1 (.01)( 6.5 ) +

2

= 97.71.

15. (a) From formula (11.19)

P ( i h ) P ( i + h ) 101.6931 100.8422

=

2hP ( i )

2 (.001)(101.2606 )

= 4.20.

de =

P (i h ) 2P (i ) + P (i + h )

h2 P ( i )

101.6931 2 (101.2606 ) + 100.8422

=

= 139.24.

(.001)2 (101.2606 )

ce =

h2

P ( i + h ) P ( i ) 1 hd e + ce

(.0075 )2

(139.24 )

= 101.2606 1 (.0075 )( 4.20 ) +

2

= $98.47.

16. We have:

P (.09 ) =

100, 000

10

a10 .08 + (1.08 ) a10 .09

a20 .08

= 98, 620.43.

P (.08 ) = 100,000.00.

10

100, 000 (1.08 )10 100,000

s10 .08 a5 .07 (1.08 )

a

100, 000

20 .08

P (.07 ) =

a10 .08 +

a20 .08

a5 .08

= 100,852.22.

130

Chapter 11

(a) We have

P ( i h ) P ( i + h ) 100,852.22 98,620.43

=

= 1.12

2hP ( i )

2 (.01) (100,000 )

de =

(b) We have

P (i h ) 2P (i ) + P (i + h )

h2 P ( i )

100,852.22 2 (100, 000 ) + 98, 620.43

=

= 52.73

(.01)2 (100, 000 )

ce =

2

(.01)

P (.09 ) 100,000 1 (.01)(1.116 ) + 2 ( 52.734 ) = $98, 620

2

(.01) (

(

)

(

)(

)

P .07 100,000 1 .01 1.116 + 2 52.734 ) = $100,852

Then P ( i )

P ( i )

. Let i = h.

P (i )

P ( i )

, so that

i

P ( i )

=

P ( i ) 2 P ( i )

=

i i

( i )2

[ P ( i + h ) P ( i )] [ P ( i ) P ( i h )]

and c =

( i )2

P (i h ) 2P (i ) + P (i + h)

.

h2 P ( i )

980 + 1015 + 1000

= 16.77.

131

Chapter 11

= .9366.

d=

1

2

1 + (1.1) + (1.1)

Time 1 after payment is made:

d=

= 1.4762.

(1.1)1 + (1.1)2

Jump = 1.4762 .9366 = .540.

(b) Time 2 before payment is made:

= .4762.

1

1 + (1.1)

d=

(1) (1.1)1

d=

= 1.0000

(1.1)1

Jump = 1.0000 .4762 = .524.

(c) The numerator is the same before and after the jump. The denominator is one

less after the jump than before. The effect is greater when the numerator is greater.

21. Treasury bills have a stated rate at simple discount, which can be considered to be a

discount rate convertible quarterly as they rollover from quarter to quarter. We have

2

( )

d ( 4)

i2

1

1

=

+

4

2

( 2)

i

.06

1

=1+

4

2

( )

i 2 = .0613775.

( )

2

d ( 4)

.0513775

( )

, so d L4 = .0504.

1

=1+

4

2

d ( 4)

.0713775

( )

, so d H4 = .0695.

1

=1+

4

2

132

Chapter 11

22. Macaulay convexity equals to the square of Macaulay duration for single payments.

Thus, we have

Macaulay

Duration

Convexity

2

4

5

25

10

100

Bond 1

Bond 2

Bond 3

Amount

10,000

20,000

30,000

= 59.

10, 000 + 20,000 + 30, 000

23. We set

CF1 = 1,105,383

CF2 = 1,149,598

CF3 = 1,195,582

and obtain IRR = 8.18% using a financial calculator.

24. We have

+

+

= $2,977,990.

1.0875

(1.08 )2

(1.07 )3

25. Using absolute matching with zero-coupon bonds, we have

1000 2000

+

= $2503.48.

1.1 (1.12 )2

26. Let F1 and F2 be the face amount of 1-year and 2-year bonds. At the end of the

second year

F2 = 9433.96.

133

Chapter 11

9071.12 (104 )

= 8984.73.

105

The price of the 2-year bond is

1.06

.06

9433.96

+

= 9609.38.

2

1.05 (1.05 )

The total price is 8984.73 + 9609.38 = $18,594 to the nearest dollar.

2000

= 1951.220

1.025

in order to meet the payment due in one year. The amount of Bond A is

= 914.634

1.04

in order to meet the payment due in 6 months. The cost of Bond B is

1.025

.025

PB = 1951.220

+

= 1914.153.

2

1.035 (1.035 )

The cost of Bond A is

1.04

PA = 914.634

= 923.514.

1.03

Thus, the total cost to the company is

(b) The equation of value is

1

semiannual interest rate. Thus, the nominal IRR convertible semiannually is

2 j = 2 (.03402 ) = .0680, or 6.80%.

28. (a) The liability is a single payment at time t = 1, so d = 1 . We then have

v=

d

1

=

= .090909

1 + i 1.10

134

Chapter 11

(b) We have

P ( i ) = 1100 (1 + i )

1

3

P ( i ) = 2200 (1 + i ) .

Thus, the convexity of the liability is

3

P (.10 ) 2200 (1.1)

=

c=

P (.10 ) 1100 (1.1)1

2

=

= 1.65289

(1.1)2

2

1

29. (a) P ( i ) = 600 + ( 400 )(1.21)(1 + i ) 1100 (1 + i )

2

(2) P (.10 ) = 600 + 484 (1.10 ) 1100 (1.10 ) = 0

2

2

1

(b) P ( i ) = 400 + ( 600 )(1.21)(1 + i ) 1100 (1 + i )

(2) P (.10 ) = 400 + 726 (1.10 ) 1100 (1.10 ) = 0

2

(c) In Example 11.14 P ( i ) > 0 for a 1% change in i going in either direction, since the

portfolio is immunized with 500 in each type of investment. If the investment

allocation is changed, the portfolio is no longer immunized.

30. (a) From formula (11.27) we have

1

5

2

4

6

P ( i ) = A1 (1 + i ) + A5 (1 + i ) 100 (1 + i ) + (1 + i ) + (1 + i ) .

5

Now multiplying by (1 + i ) and setting i = .1

4

3

1

A1 (1.1) + A5 = 100 (1.1) + 1.1 + (1.1)

or 1.4641A1 + A5 = 334.01.

From formula (11.28) we have

2

6

3

5

7

P ( i ) = A1 (1 + i ) 5 A5 (1 + i ) + 100 2 (1 + i ) + 4 (1 + i ) + 6 (1 + i ) .

135

Chapter 11

6

Now multiplying by (1 + i ) and setting i = .1

4

3

1

A1 (1.1) + 5 A5 = 100 2 (1.1) + 4 (1.1) + 6 (1.1)

or 1.4641A1 + 5 A5 = 1251.65.

Solving two equations in two unknowns, we have A1 = $71.44 and A5 = $229.41

(b) Testing formula (11.29) we have

3

7

4

6

8

P ( i ) = 2 A1 (1 + i ) + 30 A5 (1 + i ) 100 6 (1 + i ) + 20 (1 + i ) + 42 (1 + i )

and

3

7

P (.10 ) = ( 2 ) ( 71.44 )(1.1) + ( 30 )( 229.41)(1.1)

4

6

8

100 ( 6 )(1.1) + ( 20 )(1.1) + ( 42 ) (1.1)

= 140.97 > 0.

31. Adapting formulas (11.30) and (11.31) to rates of interest, we have:

5

5

A (1.1) + B (1.1) 10, 000 = 0

5

5 A (1.1) 5 B (1.1) = 0

5

(a) A = $3104.61.

(b) B = $8052.56.

32. Again adapting formulas (11.30) and (11.31) to rates of interest, we have:

2

a

a

or

a

aA (1.1) = 9917.36

a

A (1.1) = 5041.32.

(a) A = 5041.32(1.1) 1.96721 = $4179.42.

(b) a =

9917.36

= 1.967 .

5041.32

136

Chapter 11

or p1 < .6980 .

If f = .09 and k1 = .90 , we have

or p1 < .6130 .

Thus, choose p1 so that 0 < p1 < .6980 .

(b) If f = .065 and k1 = .10 , we have

or p1 < .4561 .

If f = .10 and k1 = .90 , we have

or p1 > .6613 .

Thus, no solution exists.

34. (a) If f = .07 and k1 = .20 , we have

or p1 < .5931 .

If f = .095 and k1 = .80 , we have

or p1 > .2186 .

Thus, choose p1 so that .2186 < p1 < .5931 .

(b) If f = .07 and k1 = 0 , we have

or p1 < .5006 .

If f = .095 and k1 = 1 , then

137

Chapter 11

or p1 > .7767 .

Thus, no solution exists.

35. The present value of the liability at 5% is

The present value of the bond at 5% is 1,000,000.

If interest rates decrease by %, the coupons will be reinvested at 4.5%. The annual

coupon is 822,703(.05) = 41,135 . The accumulated value 12/31/z+4 will be

822,703 + 41,135s4

.045

= 998,687

$1313.

If the interest rates increase by %, the accumulated value 12/31/z+4 will be

822,703 + 41,135s4

.055

= 1, 001,323

36. (a) Under Option A, the 20,000 deposit grows to 20,000(1.1) = 22,000 at time t = 1 .

Half is withdrawn, so that 11,000 continues on deposit and grows to

11,000(1.1) = 12,100 at time t = 2 . The investment in two-year zero coupon bonds

to cover this obligation is 12,100(1.11) 2 = 9802.63 . Thus, the profit at inception is

10, 000 9802.63 = $179.37 .

(b) Using the principles discussed in Chapter 10, we have

f =

(1.11) 2

= .1201 , or 12.01%.

1.10

The present value the liability cash outflow is

PL (i ) = 85,000(1.08)10 (1 + i ) 10 .

138

Chapter 11

PA (i ) = 5(35,000)(1.08)5 (1 + i ) 6 4000i 2

PL (i ) = 10(85,000)(1.08)10 (1 + i ) 11

PA(i ) = (5)(6)(35, 000)(1.08)5 (1 + i )7 + 8000i 3

PL(i ) = (10)(11)(85,000)(1.08)10 (1 + i ) 12 .

If i = .08 , we have the following:

vA =

PA '(.08) 787,037.04

=

= 9.2593

PA (.08) 85,000.00

vL =

=

= 9.2593

PL (.08) 85, 000.00

cA =

=

= 196.18

PA (.08)

85, 000

cL =

PL ''(.08) 8,016,118

=

= 94.31.

PL (.08)

85, 000

(2) v A = v L

(3) c A > c L

38. This is a lengthy exercise and a complete solution will not be shown. The approach is

similar to Exercise 37. A sketch of the full solution appears below.

When the initial strategy is tested, we obtain the following:

PA (.10) = 37,908

v A = 2.7273

PL (.10) = 37,908

v L = 2.5547

The superior strategy lets x, y, z be amounts invested in 1-year, 3-year, 5-year bonds,

respectively. The three immunization conditions are set up leading to two equations

and one inequality in three unknowns.

y = $15, 061

z = $9624

139

Chapter 11

d=

=

i (v + 2v 2 + 3v 3 +

i (v + v 2 + v 3 +

i ( Ia ) n + nv n

ian + v n

+ nv n ) + nv n

+ vn ) + vn

an nv n + nv n

1 vn + vn

= an .

40. (a) We have

1+ i

P (i + h ) P ( i )

1+ i + h

so that

d

1.08

1.08

P (.09) P (.08)

= (1)

1.09

1.09

(b) The error in this approach is

140

7.2469

= .9354.

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