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# Investments: Problem Set

## Zero Coupon Bonds & Credit Risk

Problem 1 Part B
1. Calculate the price of a zero coupon with 10-year maturity, par value 100\$
assuming that the 10-year zero coupon rate is 5% (per annum)
Solution: 100/(1 + 0.05)10 = 61.3913
2. A 10-year zero coupon with a par value of 1\$ is sold for 0.90\$. What is the
implied 10-year zero rate?
 1/10
1
Solution: r0,10 = (0.90) 1 = 0.0105917 = 1.05917%

3. Suppose all the interest rates are zero. Do you still need to know both the
maturity and the face value of a zero bond to compute its price?
Solution: No, (1 + 0)T = 1T but 1x = 1 for all values x, the only thing you need
to know is the Par value: the price is equal to the Par value.
4. Why the price of all bonds at maturity is equal to the Par value?
Solution: Because 1\$ today is equal to 1\$, and because y/(1 + x)0 = y for all
values x because k 0 is always 1 for all values of k
5. Calculate the price of a zero coupon with 10 years maturity, par value 100\$
assuming that the 10-year zero coupon rate is 5%, the default and recover
probabilities are 50%, and recovery rate of 50%. Is the price lower or higher of
the same bond in the previous point? Why?
Solution: P = 100 (1 0.5 (1 0.5 0.5))/(1 + 0.05)10 = 38.36957. The
price is lower because the default probability is higher and investors require an
6. Lets consider the same bond but with default probability of 0%, recover prob-
ability of 100% and recovery rate of 50%. Is the price the same? Why?
Solution: P = 100 (1 0 (1 1 0.5))/(1 + 0.05)10 = 61.39132. The price is
the same because the default probability is 0%
7. Suppose you have bought 2 Italian bonds with Face Value of 105\$ for 100\$
and one Greek bond for 50\$. Assume that the probability of default for both
countries is 50%, compute the expected credit loss
Solution: you can not compute it because you also need the Recovery Rate.
Problem 3 2

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Problem 2 Part A
Suppose that a life insurance company has guaranteed a payment of \$14 million to a
pension fund 5.5 years from now. If the life insurance company receives a premium of
\$10.4 million from the pension fund and can invest the entire premium for 5.5 years
at an annual interest rate of 6.35%, will it have sufficient funds from this investment
to meet the \$14 million obligation?
Solution: To determine the future value of any sum of money invested today, we
can use the future value equation, which is: Pn = P0 (1 + r)n where n = number of
periods, Pn = future value n periods from now (in dollars), P0 = original principal
(in dollars) and r = interest rate per period (in decimal form). Inserting in our
values, we have: P5.5 = \$10,400,000(1.0635)5.5 = \$14,591,151.19. Thus, it will have
sufficient funds to meet the \$14 million obligation, and it would remain \$14,591,151.19
? \$14,000,000 = \$591,151.19.

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Problem 3 Part A
Suppose that the 1-year interest rate today is 3% pa and that 6 months from now
you will observe the following interest rates

## 3-month interest rate is 1.5% pa

and that 3 months from now you will observe the following interest rates

## 3-month interest rate is 2.5% pa

1. What would be the price of a 1-year zero coupon bond with par-value of 100\$
issued today on the primary market?
P v1 100
Solution: P0 = (1+r 01 )
= (1+0.03) = 97.0874

2. What would be the price of the bond six months from now?
Solution: 6 months from now the bond will have 6 months left to maturity and
we have to use the 6-month interest rate. Using the notation we adopted in
class P6/12 = (1+rP6v1)6/12 = (1+0.02)
100
6/12 = 99.0148
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## Investments Problem Set: Zero Coupon Bond and Credit Risk

Problem 5 3

3. Compute the yield-to-maturity of such bond today and 6 months from now
Solution: today is simply r01 = 0.03, six months from now r 6 1 = 0.02
12

4. Will the price of this bond be below par, at par or above par 3 months from
now?
Solution: 3 months from now the bond will have 9 months left to maturity and
we have to use the 9-month interest rate. Using the notation we adopted in
(1)
class P3/12 = (1+rP3v1)9/12 = (1+0.035)
100
9/12 = 97.4529 which is below par
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Problem 4 Part A
Credit quants infer default probabilities from prices. Suppose two bonds have been
just issued, they both have face value of \$100 and a maturity of 5 years. But the
first is risk-free (and has a price of \$70) while the second has recovery probability
and recovery rate equal to 50% (and is sold for \$40). The spread between the interest
rates of the the risky bond and the default-free bond is 4%. Which is the implied
default probability of the risky bond?
 1
P vT T
Solution: First we compute the interest rate for the safe bond r0T = P0 1 =
  15
100
70
1 = 0.073940, we know the spread between the risky r0T and the safe bond

is r0T r0T = s = 0.04, To find d (default probability) we have to solve this equation

r0T r0T = s r0T = r0T + s

r0T =r0T + s
 P v [1 d(1 mR)]  T1
T
1 =r0T + s
P0
 P v [1 d(1 mR)] 
T
=(1 + r0T + s)T
P0
P0
d(1 mR) = 1 + (1 + r0T + s)T
P vT
1 PPv0T (1 + r0T + s)T
d=
(1 mR)
40
1 100 (1 + 0.073940924 + 0.04)5
d= = 0.5571
(1 0.5 0.5)
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Problem 5 Part A
We can price a coupon bond as a portfolio of zero coupon bonds, lets see how and
why. Suppose the following assets exist

## Investments Problem Set: Zero Coupon Bond and Credit Risk

Problem 5 4

1-year zero coupon bond with par value of 1,000\$ selling for 952.3810\$
2-year zero coupon bond with par value of 1,000\$ selling for 889.9964\$
3-year zero coupon bond with par value of 1,000\$ selling for 816.2979\$
coupon bond with 3-year maturity, and 10% coupon rate
Find the price of the coupon bond by pricing each coupon as a zero-coupon bond.
Suppose the price of the coupon bond is 1, 000\$, do you see any arbitrage ?
Solution:
First, find the three spot rates (r01 ,r02 and r03 ) needed to price each coupon:
 1/1
1,000\$
r01 = 952.3810 1 = 0.05
 1/2
1,000\$
r02 = 889.9964 1 = 0.06
 1/3
1,000\$
r03 = 816.2979 1 = 0.07

## Second, each coupon is equal to 100\$ (C = P vT cr = 1000\$ 0.1 = 100\$ where

cr is the coupon rate). The price of the coupon bond is therefore
C C C + P vT
P0 = + 2
+
(1 + r01 ) (1 + r02 ) (1 + r03 )3
100 100 100 + 1000
= + 2
+
(1 + 0.05) (1 + 0.06) (1 + 0.07)3
=95.23809\$ + 88.99964\$ + 897.9277\$
=1, 082.16540\$
95.23809\$ is the price of a 1-year zero coupon bond with face value of 100\$ and
5% interest rate (per annum), 88.99964\$ is the price of a 2-year zero coupon
bond with face value of 100\$ and 6% interest rate (per annum), 897.9277\$ is
the price of a 3-year zero coupon bond with face value of 1100\$ and 7% interest
rate (per annum),
Third, if the price of the coupon bond was 1, 000\$ < 1, 082.16540\$. You could
Buy the coupon bond for 1,000\$
Sell the three zero coupon bonds a) 1-year zero coupon bond with par value
of 100\$ and interest rate 5% for 95.23809\$, b) 2-year zero coupon bond
with par value of 100\$ and interest rate 6% for 88.99964\$ c) 3-year zero
coupon bond with par value of 1, 100\$ and interest rate 7% for 897.9277\$
Pocket the difference -1,000\$ + (95.23809\$+88.99964\$+897.9277) =82.165\$
It looks a tiny difference...but it is not if you trade millions of dollars.

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