Interest rate risk II: Exercises

Price of Zero coupon bond = CF/ (1+r) t

Where
D = Duration in years
CFt = cash flow received on the security at the end of period t
N= last period in which the cash flow is received
DFt = discount factor
PVt = Present value of cash flow at the end of the period t

1. Suppose that the following bonds are zero coupon bonds. Bond A pays $1790.85 in five years.
Bond B pays $3207.14 in ten years, and both are currently priced at $1000. The interest rate is
charged at 12% per annum on a semi-annual basis for both bond A and B. Now suppose the
annual interest rate increases by 1%. What is the impact of the 1% change in interest rate on
the price of the bond?
The coupon payments are on semi-annual basis, therefore the number of discounting periods
should be Year x 2
Initial price Price if interest rate increased by 1%
10
Bond A= $1000 = $1790.85/ (1.06) Bond A= $954.03= $1790.85/ (1.065)10
20
Bond B= $1000 = $3207.14/ (1.06) Bond b= $910.18 = $3207.14/ (1.065)20

As you can see from the new price, the long-term bond (Bond B) price has declined more
than the decline in Bond A price. Therefore, the impact of a change in interest rate is higher
on longer maturity bonds.
2. Assume that ABC Bank has a zero coupon bond that pays $2,155 in six years. The interest rate
is charged at 10% per annum on a semi-annual basis. Now suppose the annual interest rate
decreased by 1%. What is the impact of the 1% change in interest rate on the price of the bond?

Current price of the bond = $2,155 / (1.05)12 = $1,200

If Interest rate decreased by 1%, the price of the bond will be = $2,155/ (1.045)12 = $1,270
If interest rate decreased by 1%, Bond price will increase by $70.

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3. Assume that XY Bank has a zero coupon bond that pays $8,108.5 in 15 years. The interest rate
is charged at 8% per annum on a semi-annual basis. Now suppose the annual interest rate
increased by 1.5%. What is the impact of the 1.5 % change in interest rate on the price of the
bond?

Current price of the bond = $8,108.5/ (1.04)30 = $2,500

If Interest rate increased by 1.5%, the price of the bond will be = $8,108.5/ (1.0475)30 =
$2,015.21
If interest rate increased by 1.5%, Bond price will decrease by $484.79.

4. Suppose a bank has a 3-year, 8% coupon bond selling at yield to maturity of 10%. What is
the duration of the bond?

Time Cash flow (CF) Discount factor CFt x DFt CFt x DFt x t
Coupon rate x 1000 (DF) = 1/(1+r)t
(A) (B) C=AxB Cxt
1 0.08 x 1000 = $80 1/(1.1)1 = 0.909 $72.727 72.727
2 0.08 x 1000 = $80 1/(1.1)2 = 0.826 $66.116 132.232
3 0.08 x 1000 = $80 1/(1.1)3= 0.751 $811.420 2,434.26
+ FV of the bond
$1000 = $1030
Total $950.263 2,639.219

∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡 𝑥 𝑡
Duration =
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡
= 2,639.219/950.263 = 2.78 years

5. Suppose a bank has a 5-year, 6% coupon bond selling at yield to maturity of 8%. What is the
duration of the bond?

Time Cash flow (CF) Discount factor CFt x DFt CFt x DFt x t
Coupon rate x 1000 (DF) = 1/(1+r)t
(A) (B) C=AxB Cxt
1 0.06 x 1000 = $60 1/(1.08)1 = 0.9259 $55.55 55.55
2 0.06 x 1000 = $60 1/(1.08)2 = 0.8573 $51.44 102.88

3 0.06 x 1000 = $60 1/(1.08)3= 0.7938 $47.63 142.89

4 0.06 x 1000 = $60 1/(1.08)4= 0.7350 $44.10 176.40

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 5 0.06 x 1000 = $60 1/(1.08)5= 0.6806 $680.60 3,403.0
+ FV of the bond
$1000 = $1060
Total $879.32 3,880.72

∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡 𝑥 𝑡
Duration =
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡
= 3,880.72 / 879.32 = 4.41 years

6. What is the duration for an 8% coupon four-year bond with a yield to maturity of 10%,

Time Cash flow (CF) Discount factor CFt x DFt CFt x DFt x t
Coupon rate x 1000 (DF) = 1/(1+r)t
(A) (B) C=AxB Cxt
1 0.08 x 1000 = $80 1/(1.1)1 = 0.9091 $72.73 72.73

2 0.08 x 1000 = $80 1/(1.1)2 = 0.8265 $66.12 132.24

3 0.08 x 1000 = $80 1/(1.1)3= 0.7513 $60.11 180.31

4 0.08 x 1000 = $80 1/(1.1)4= 0.6830 $737.66 2,950.62
+ FV of the bond
$1000 = $1080
Total $936.603 3,335.89

∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡 𝑥 𝑡
Duration =
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡
= 3,335.89 / 936.603 = 3.562 years

7. What is the duration for a zero-coupon bond of 3-year maturity with a yield to maturity of
10%?

Time Cash flow (CF) Discount factor CFt x DFt CFt x DFt x t
(DF)
1 0 1/(1.1)1 = 0.9091 0 0
2 0 1/(1.1)2 = 0.8265 0 0
3 $1,080 1/(1.1)3= 0.7513 811.404 2,434.212
Total 811.404 2,434.212

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Note: For Zero-coupon bond you can use the formula, CFt x DFt x t / CFt x DFt instead of a table,
because the payment is only once, by the end of the maturity period.
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡 𝑥 𝑡
Duration =
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡
= 2,434.212 / 811.404 = 3 years

8. What is the duration for a zero-coupon bond of 5-year maturity with a yield to maturity of
9%?. If you are receiving $1080 in five years, what is the duration of the bond.
• The face value of the bond is $1000.
• Because it is a zero-coupon bond, the cash flow is only once, which is by the end of the maturity
period.
• Where, the Future value of the bond is $1,080, Face value $1000 + coupon payment $80.
$1080
( )𝑥 5 $3,509.63
(1.09)5
• 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = $1080
= = 5 𝑦𝑒𝑎𝑟𝑠
( ) $701.926
(1.09)5
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡 𝑥 𝑡
• Duration of the bond = Duration = = 3,509.63 / 701.926 = 5 years
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡

9. What is the duration for a zero-coupon bond of 2-year maturity with a yield to maturity of
8%? Assume the payment of the bond by the end of 2 years is $1000

$1000
( )𝑥2 $1,714.68
(1.08)2
• 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = $1000 = = 2 𝑦𝑒𝑎𝑟𝑠
( ) $857.34
(1.08)2

10. Suppose a 2-year bond has a coupon rate of 8% bond, face value of $1,000 and a yield to maturity of
12%. The bond pays semi-annual interest. What is the duration of the bond?

Time Period Cash Discount factor (DF) CFt x DFt CFt x DFt x t
In years flow C = 1/ (1+r)t D=BxC E=DxA
(A) (CF)
(B)
1 0.5 $40 1/(1.06)1 = 0.9434 $ 37.736 18.868

2 1 $40 1/(1.06)2 = 0.89 $35.600 35.600

3 1.5 $40 1/(1.06)3 = 0.8396 $33.585 50.378

4 2 $1,040 1/(1.06)4= 0.7921 $823.77 1,647.554

Total $930.698 1,752.40

Note: Semi-annual Cash flow = $1000 x 8%/2 = $40. The bond pays $40 semi-annual payments.

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 The annual Yield to maturity (YTM) or discount factor is 12% and the semi-annual
discount or will be 12% / 2 = 6%
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡 𝑥 𝑡
• Duration of the bond = Duration = = 1,752.4 / 930.698 = 1.88 years
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡

11. Suppose a 3-year bond has a coupon rate of 10% bond, face value of $1,000 and a yield to maturity of
10%. The bond pays semi-annual interest. What is the duration of the bond?

Time Period Cash Discount factor (DF) CFt x DFt CFt x DFt x t
In years flow C = 1/ (1+r)t D=BxC E=DxA
(A) (CF)
(B)
1 0.5 $50 1/(1.05)1 = 0.9524 $ 47.62 23.81

2 1 $50 1/(1.05)2 = 0.9070 $45.35 45.35

3 1.5 $50 1/(1.05)3 = 0.8638 $43.19 64.79

4 2 $50 1/(1.05)4 = 0.8227 $41.14 82.28

5 2.5 $50 1/(1.05)5 = 0.7835 $39.18 97.95

6 3 $1,050 1/(1.06)6= 0.7462 $783.51 2,350.53

Total $1000 2,664.71

Note: Semi-annual Cash flow = $1000 x 10%/2 = $50. The bond pays $50 semi-annual payments.
The annual Yield to maturity (YTM) or discount factor is 10% and the semi-annual
discount or will be 10% / 2 = 5%
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡 𝑥 𝑡
• Duration of the bond = Duration = = 2,664.71 / 1000 = 2.665 years
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡

12. Suppose a 4-year bond has a coupon rate of 6% bond, face value of $1,000 and a yield to maturity of
10%. The bond pays semi-annual interest. What is the duration of the bond?

Time Period Cash Discount factor (DF) CFt x DFt CFt x DFt x t
In years flow C = 1/ (1+r)t D=BxC E=DxA
(A) (CF)
(B)
1 0.5 $30 1/(1.05)1 = 0.9524 $ 28.57 14.29

2 1 $30 1/(1.05)2 = 0.9070 $27.21 27.21

3 1.5 $30 1/(1.05)3 = 0.8638 $25.91 38.89

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4 2 $30 1/(1.05)4 = 0.8227 $24.68 49.36

5 2.5 $30 1/(1.05)5 = 0.7835 $23.51 58.78

6 3 $30 1/(1.05)6 = 0.7462 $22.39 67.17

7 3.5 $30 1/(1.05)7 = 0.7107 $21.32 74.62

8 4 $1,030 1/(1.05)8= 0.6768 $697.10 2,788.40

Total $870.69 3,118.72

Note: Semi-annual Cash flow = $1000 x 6%/2 = $30. The bond pays $30 semi-annual payments.
The annual Yield to maturity (YTM) or discount factor is 10% and the semi-annual
discount or will be 10% / 2 = 5%
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡 𝑥 𝑡
• Duration of the bond = Duration = = 3,118.72 / 870.69 = 3.582 years
∑ 𝐶𝐹𝑡 𝑥 𝐷𝐹𝑡