Duc Bui 4348282

1. Yields and Bills

A.
Redemption yield – Also known as Yield-to-maturity, which represents the annual return of the
bond or other fixed income securities. It is the expected capital gain (or loss) from holding the
bond until maturity.

Par Yield – It is basically the yield (or expected return of a bond) when the price of a bond is
equal to its par value.

Yield to put – Bondholder with yield to put tends to have a lower coupon payment because it is
an effective annual rate of return a bond earns assuming that the bondholders only hold it until
the put date, instead of to maturity. Once the put date is exercise, the bondholders are required
to sell back to the insurer and reinvest elsewhere.

Yield to worst - The lowest yield a bondholder can get when investing in a callable bond.

B.
Both zero-coupon bond and maturity-matched level-coupon bond will not have the same
duration because duration measures a bond’s sensitivity to changes in interest rates. The
difference between zero-coupon bond and level-coupon bond is that the former does not make
periodic interest payments to the bondholders and only the face value is repaid at maturity,
while the latter makes coupon payments semi-annually or annually. Hence, level-coupon bond
might have higher or lowest duration compare to zero-coupon bond due to changes in interest
rates.

C.
Treasuries are usually quoted in 32nds, hence the price of this quotation is shown in the formula
below:
8
𝑃𝑟𝑖𝑐𝑒 = 98 + ( ) = 98 + 0.25 = $98.25
32

Bond equivalent yield (BEY) is shown in the formula below:

𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 − 𝑃𝑟𝑖𝑐𝑒 365

𝐵𝐸𝑌 = ∗
𝑃𝑟𝑖𝑐𝑒 𝐷𝑎𝑦𝑠 𝑢𝑛𝑡𝑖𝑙 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦
100 − 98.25 365
= ∗
98.25 90

= 𝟎. 𝟎𝟕𝟐𝟐 ∗ 𝟏𝟎𝟎
= 7. 22%

1
Duc Bui 4348282

D.

𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 − 𝑃𝑟𝑖𝑐𝑒 360

𝐵𝐸𝑌 = ∗
𝑃𝑟𝑖𝑐𝑒 𝐷𝑎𝑦𝑠 𝑢𝑛𝑡𝑖𝑙 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦
100 − 98.25 360
= ∗
98.25 90
= 𝟎. 𝟎𝟕𝟏𝟐 ∗ 𝟏𝟎𝟎
= 7. 12%

E.
Convexity measures the curvature in the relationship between bond price and its yield. Since
the yield is affected changes interest rates, convexity is used to measure how the duration of a
bond changes as the interest rate changes, thus making it as a risk-management tool to
manage a portfolio’s exposure to market risk.

2. Term Structure of Interest Rates

A.
The formula I used to calculate the forward rate is shown below:

B.

2
Duc Bui 4348282

C.
The relationship between US sovereign and Corporate AAA yield curve is that they are tied to
the changes in the U.S economy, resulted in similar yield curve. However, the reason for a
difference in yield by maturity is because UST is the safest investment because it is issued by
the government, therefore the default risk is extremely low. On the other hand, corporate AAA
bond is riskier because it is issued by individual corporation that has other factors such as firm-
specific risk. Therefore, investor demands higher premium for taking that risk. The market use
this information to see how changes in bond ratings affect changes in yield to maturity and bond
price.

D.
Quantitative easing is a monetary policy used by the central bank to spur economic growth. In
order to stimulate economic growth, the central bank has to make it easier for businesses to
borrow money to purchase financial assets, thus by lowering the interest rate, it would lower the
cost of borrowing. The Fed’s tapering announcement to bring its policy of quantitative easing to
an end would drive the interest rate up, making it more expensive for businesses to borrow
money.

3. Interest-Rate Risk Management

A.
The Modified Duration formula relates changes in fixed-income price to interest rate variability.
Since bond price volatility is proportional to the bond’s duration, it is one of the most effective
measures of interest rate risk exposure. Based on the formula, the percentage change in bond
price is the product of modified duration and the change in the bond’s yield to maturity.

3
Duc Bui 4348282

B.

C.
A&L management is the process of managing cash flows in assets to make sure the payments
for liabilities are on time. The bank is exposed to interest rate risk when the company managers
failed to ensure that assets are available to pay down debts as they come due. Hedging interest
rate risk is important for TSTR Banks because, similar to other banking institution, it charges a
rate of interest on loans (assets) and pays interest on deposits (liabilities). Hence, duration gap
would be an effective measurement because it examines the sensitivity of the market value of
the financial institution’s net worth to changes in interest rates. The wider the gap, the more
expose TSTR is to changes in interest rates. In order to shorten the gap the firm can use
duration matching.

4
Duc Bui 4348282

The problem with this strategy is that duration is only an approximation of interest rate
exposure. It is not able to capture big changes interest rate in the economy, thus the calculation
won’t be as accurate.

D.
A strategy to neutralize the effect of interest-rate changes on the balance sheet is immunization.

Duration gap analysis:

DA = 3 years
DL = 1.5 years
Assets (Loan portfolio) = 100
Liabilities (Deposits and bonds) = 99
K = Liabilities/Assets = 99/100 = 0.99

𝐷𝐺𝐴𝑃 = 𝐷𝐴 − (𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠/𝐴𝑠𝑠𝑒𝑡𝑠) ∗ 𝐷𝐿
= 3 − (99/100) ∗ 1.5 = 1.515

Since TSTR has a positive duration, an increase in interest would decrease the market value
TSTR’s net worth. For example, a 1% increase in interest rate would lower the equity value by
1.49%.

△ 𝐸 = − (𝐷𝐴 − 𝐷𝐿 𝐾) 𝐴𝑠𝑠𝑒𝑡 (△ 𝑅/1 − 𝑅)

= −(3 − (1.5 ∗ 0.99) ∗ 100(−0.01/(1 + 0.0192))
= −1.49%

I wouldn’t advise the firm raise equity to immunize the balance sheet because it would dilute the
ownership of the shareholders. However, TSTR could hedge against the interest rate risk by
increasing average duration of its liabilities.

4. Commercial Banking
A.
I would suggest the client to enter a future contract with the buyer, in which the client would sell
a piece of customized machinery at a specified price one year from today. This way they can
lock in a price they will sell at to hedge against price volatility.

B.
To calculate the return for the preceding investment suggestion, I use the forward rate formula
to calculate the return of 8.01%.

5
Duc Bui 4348282

C.
The alternative investment I would suggest my client is to enter a forward contract. This contract
is very similar to the future contract, in which two parties can buy or sell an asset at a specified
price on a future date. This contract also help the clients to hedge against changes in price by
locking in a specific price under a written contract. The difference between the two contracts is
that forward contracts are not market to market, as future contracts are. In addition, the forward
contract would be traded in OTC markets, rather than on centralized exchanges.

D.
The forward curve shows the price at which it is possible to buy or sell futures contracts for a
forward date at a price agreed today. It is a very poor indicator because there are other factors
that affect the future price price such as interest rates, market liquidity, inflation, etc.

5. Funding Positions
A.
The invoice price would be the Dirty Bid Price, which is $101.8911

B.

6
Duc Bui 4348282

Starting with $100M repo principal, a 2% margin allows the junior trader to borrow $99.893M at
the repurchase price of $99.89. The equity stake on this position would be $2.029M, which is
the amount of cash to raise to support this position. The trader has to pay a one day interest
payment for this one-day loan. The interest payment would be $3052.29 at the lower repo rate
of 1.10% to $3468.52 at the higher repo rate of 1.25%.

C.
At the expiration of 1D repo (next day), the bond has a new dirty bid price of $101.92 and a new
dirty ask price at 101.95, thus creating a new Bid/Ask spread amount of $31,250. In addition,
the accrued interest for one day is $82.87. As a result, the Total Net Loss with low repo interest
payment is $34,219.42, while the Total Net Loss with high repo interest payment is $34,635.65.

D.
The Fed Fund Rate is the interest rate that Bank A charges Banks B for lending Bank B money
from their reserve balance overnight. The reason why banks lend each other money is because

7
Duc Bui 4348282

it is required by law that banks must maintain a reserve in their balance sheet, which is equal to
a certain percentage of their deposits. The difference between repo rate and Fed fund rate is
that repos are short-term loans mainly used by banks in their daily bond trading and brokerage
businesses, therefore the repo rate is usually higher, making it more expensive to borrow.

E. There are a few ways that repo can fail. The repo fails if the seller fails to deliver its end of
the bargain, similar to when the buyers default on the repo deal. An advantage is that the seller
can collect the collateral stated in the deal. Regarding the buyers, they can end the contract at
any time, thus the seller has to pay the repo right before maturity.

6. Swap Valuation
A.
The 5Y plain vanilla swap for the fixed-rate payer is equivalent to being long a Floating Rate
Bond and short a fixed coupon bond with same cash-flow dates (Maturity of 1 to 5 years)

B. The value of the swap is its market value at any point in time. At inception, the value of an
interest rate swap is zero, because the present value of the fixed payments is equal to the
present value of the floating payments.

C.
The Bid/Ask spread is calculated by taking the difference between Swap Rate and the first year
Floating Rate → 5.7971% - 4.83 = 0.9643%.

D.
The first strategy is to use Floating-to-fixed rate swap, which is an agreement two parties that an
issuer converts variable rate debt to fixed rate debt through an interest rate swap. The issue will
make payments at a fixed rate, while the other party makes payments on a floating rate. The
second strategy to hedge interest rate exposure is to enter a forward rate agreement (FRA). It is
a contract between two counterparties to exchange a fixed interest payment for a floating
interest payment on a single date.

7. Treasury Inflation-Protected Securities

8
Duc Bui 4348282

A.
The rationale to invest in TIPS is to hedge against a rise in inflation rate. TIPS are directly linked
to inflation because its principal is adjusted by changes in the Consumer Price Index (CPI). The
investment asset is still hold today because the latest update on the Bureau Labor of Statistics
website shows that the CPI increased 0.4% in the month of October 2019. Hence, TIPS is a
great investment to hold for the long-term to hedge against inflation.

B.
The nominal UST carries a higher yield compares to that of TIPS because UST yield is
calculated by the sum of real yield and compensation for expected inflation until maturity. The
real yield reflects the growth rate of the U.S. economy, whereas inflation compensation is the
annualized percentage rate that reflects the market’s inflation forecast through maturity.
However, TIPS doesn’t take into account the inflation compensation, therefore it tends to have a
lower yield compared to UST yield.

C.
Yes, the yield to maturity of a TIPS can become negative. The reason for that is because TIPS
yield equals UST yield minus rate of expected inflation (inflation compensation), therefore if UST
yield is below the rate of expected inflation, TIPS can fall into negative territory.

D.
Based on the US Treasury auction results, I discovered that the investors have been willing to
pay 0.21% premium for 10-Year TIPS over 10-Year Treasury Note. Similarly, the investors were
willing to pay 0.72% premium for 9-Year 10-Month TIPS over 9-Year 10-Month Treasury Note.

9
Duc Bui 4348282

E. *Bonus*

8. Corporates, M&A, and Callability

A.
CVS price was around $75 in November 28, 2018 when the merger deal finally closed. The
price plummeted to its lowest at $52.36 in March 7, 2019. However, that was the turning point
for CVS as it continues to integrate Aetna’s business model to CVS’s. Over the past 6 months,
CVS has been performing very well, as it beats Wall Street’s estimate for three consecutive
quarters. Recent third quarter earnings report shows that CVS-Aetna merger generated $17
billion for the firm. The financing of $40 billion dollar was for CVS’s acquisition of Aetna.

To finance the acquisition, the company issued 9 long-term bonds with an aggregate of $40.0
billion in principal amount of the 2018 Notes. The 2018 Notes are comprised of two Floating rate
notes and seven Fixed rate notes. The table below is found in CVS 10K report

In addition to the 2018 Notes, CVS also takes on other debts to finance the Aetna Acquisition.
According to the CVS 2018 Annual Report, on December 15, 2017, the firm entered into a $5.0

10
Duc Bui 4348282

billion term loan agreement, which consists of a $3.0 billion three-year tranche and a $2.0 billion
five-year tranche. The structure of the loan agreement allows CVS to borrow at various rates
depending on its debt ratings.

B.
According to the prospectus, if the merger does not go through before September 3, 2019, 2020
notes and 2021 notes will be redeemable, in whole or in part at any time plus accrued and
unpaid interest. The difference between the callability of corporate bonds and the ones in this
case is that they are in connection with Aetna Acquisition. If the deal doesn’t fall through by the
specified time on the Prospectus, the company has an option to call back the loan before the
maturity date to pay back the principal to its lenders.

C.
Source: https://www.moodys.com/research/Moodys-rates-CVS-proposed-Senior-unsecured-
notes-Baa1-remains-on--PR_380276
After the acquisition of Aetna, Moody’s downgraded its senior unsecured rating to Baa2 from
Baa1. A downgrade in CVS bond ratings increases the perceived credit risk because it has debt
about 4.5 times EBITDA. Moody’s said it might “downgrade CVS further if it looks like the
company won’t be able to reduce its debt to less than 3.75 times Ebitda in the next 18-24
months.” Therefore, the interest rate for the debt would increase, and the price of the bond
would decline.

D.
The final offering shows that on November 28, 2018, CVS closed the merger deal with Aetna at
$69 billion.

11