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4.

Maturity

1

2

3

4

Price

Rs.943.40

898.47

847.62

792.16

YTM

6.00%

5.50%

5.67%

6.00%

Forward Rate

(1.0552/1.06) 1 = 5.0%

(1.05673/1.0552) 1 = 6.0%

(1.064/1.05673) 1 = 7.0%

5.

Beginning

of Year

Expected Price

792.16

6.

a.

(839.69/$792.16) 1 = 6.00%

1,000

= rs .839 .69 (881.68/$839.69) 1 = 5.00%

1.05 1.06 1.07

1,000

= Rs .881 .68

1.06 1.07

1,000

= Rs .934 .58

1.07

(934.58/$881.68) 1 = 6.00%

(1,000.00/$934.58) 1 = 7.00%

A 3-year zero coupon bond with face value $100 will sell today at a yield of

6% and a price of:

100/1.063 =R.s83.96

Next year, the bond will have a two-year maturity, and therefore a yield of 6%

(from next years forecasted yield curve). The price will be Rs.100/1.06 2

=

89.00, resulting in a holding period return of 6%.

b.

Year

2

3

Forward Rate

(1.052/1.04) 1 = 6.01%

(1.063/1.052) 1 = 8.03%

Using the forward rates, the forecast for the yield curve next year is:

Maturity YTM

1

6.01%

2

(1.0601 1.0803)1/2 1 = 7.02%

The market forecast is for a higher YTM on 2year bonds than your forecast.

Thus, the market predicts a lower price and higher rate of return.

7.

a.

P=9/1.07+109/1.082=Rs.101.86

b.

9

109

+

= Rs .101 .86

1 + y (1 + y ) 2

SHORT CUT FORMULA

c.The forward rate for next year, derived from the zero-coupon yield curve, is the

solution for f 2 in the following equation:

1+f2 =

(1.08 ) 2

= 1.0901 f 2 = 0.0901 = 9.01%.

1.07

Therefore, using an expected rate for next year of r2 = 9.01%, we find that the

forecast bond price is:

P=109/1.0901=Rs.99.9

d.

E(r2) = f2 liquidity premium = 9.01% 1.00% = 8.01%

The forecast of the bond price is:

$109

= Rs .100 .92

1.0801

8.

a.

85 0.94340) + (85 0.87352) + (1,085 0.81637) = Rs.1,040.20

This price implies a yield to maturity of 6.97%, as shown by the following:

[$85 Annuity factor (6.97%, 3)] + [$1,000 PV factor (6.97%, 3)] =

Rs.1,040.17

b.

If one year from now y = 8%, then the bond price will be:

[$85 Annuity factor (8%, 2)] + [$1,000 PV factor (8%,2)] = Rs.1,008.92

The holding period rate of return is:

[$85 + (1,008.92 1,040.20)]/1,040.20 = 0.0516 = 5.16%

9.

Year

1

2

3

Forward

Rate

5%

7%

8%

Re1/1.05 = 0.9524

1/(1.05 1.07) = 0.8901

1/(1.05 1.07 1.08) = 0.8241

b.

984.10 = [$60 Annuity factor (y, 3)] + [$1,000 PV factor (y, 3)]

This can be solved using a SHORT CUT FORMULA y = 6.60%

c.

Period

1

2

3

Payment received

at end of period:

60.00

60.00

1,060.00

Will grow by

a factor of:

1.07 1.08

1.08

1.00

To a future

value of:

69.34

64.80

1,060.00

1,194.14

1/ 3

$1,194 .14

$984 .10

1 + y realized =

d.

[60 Annuity factor (7%, 2)] + [1,000 PV factor (7%,2)] = Rs.981.92

Therefore, there will be a capital loss equal to: 984.10 981.92 = Rs.2.18

The holding period return is:

12.

a.

60 + ( 2.18 )

= 0.0588 = 5.88 %

984 .10

The one-year zero-coupon bond has a yield to maturity of 6%, as shown below:

94 .34 =

100

y1 = 0.06000 = 6.000%

1 + y1

84 .99 =

100

y2 = 0.08472 = 8.472%

(1 + y 2 ) 2

12

112

= 106 .51

The price of the coupon bond is: 1.06 +

(1.08472 ) 2

[SHORT CUT FORMULA: n = 2; PV = 106.51; FV = 100; PMT = 12]

b.

f2 =

(1 + y 2 ) 2

(1.08472 ) 2

1 =

1 = 0.1100 = 11.00%

1 + y1

1.06

c.Expected price = Rs .

112

= Rs .100 .90

1.11

(Note that next year, the coupon bond will have one payment left.)

Expected holding period return =

12 + (100 .90 106 .51)

= 0.0600 = 6.00 %

106 .51

This holding period return is the same as the return on the one-year zero.

d.

E(Price) =

112

> 100 .90

1 + E ( r2 )

E(HPR) > 6%

13.

a.

Maturity

1 year

2 years

3 years

b.

YTM

10%

11%

12%

Forward Rate

(1.112/1.10) 1 = 12.01%

(1.123/1.112) 1 = 14.03%

1,000/1.10 = Rs.909.09

1,000/1.112 = 811.62

1,000/1.123 = 711.78

We obtain next years prices and yields by discounting each zeros face value

at the forward rates for next year that we derived in part (a):

Maturity

1 year

2 years

Price

1,000/1.1201 = $892.78

1,000/(1.1201 1.1403) = $782.93

YTM

12.01

%

13.02

%

Note that this years upward sloping yield curve implies, according to the

expectations hypothesis, a shift upward in next years curve.

c. Next year, the 2-year zero will be a 1-year zero, and will therefore sell at a price

of: 1,000/1.1201 = Rs.892.78

Similarly, the current 3-year zero will be a 2-year zero and will sell for: Rs.782.93

Expected total rate of return:

2-year bond:

892 .78

1 = 1.1000 1 = 10 .00 %

811 .62

3-year bond:

782 .93

1 = 1.1000 1 = 10 .00 %

711 .78

d.

Current price = (120 0.90909) + (120 0.81162) + (1,120 0.71178)

= 109.0908 + 97.3944 + 797.1936 = Rs.1,003.68

Expected price 1 year from now = (120 0.89278) + (1,120 0.78293)

= 107.1336 + 876.8816 = Rs.984.02

Total expected rate of return =

$120 + ($ 984 .02 $1,003 .68 )

= 0.1000 = 10 .00 %

$1,003 .68

4.

a.

4

100 ,000

1 = 1.02412

97 ,645

b.

1 = 0.100 = 10 .0%

(1.05)2 1 = 0.1025 or 10.25%

Therefore the coupon bond has the higher effective annual interest rate.

5.

The effective annual yield on the semiannual coupon bonds is 8.16%. If the annual

coupon bonds are to sell at par they must offer the same yield, which requires an

annual coupon rate of 8.16%.

7.

Yield to maturity

n = 3, P=953.10 and M = 1000

This results in: YTM = 9.84%

Realized compound yield: First, find the future value (FV) of reinvested coupons

and principal:

FV = (80 1.10 1.12) + (80 1.12) + 1,080 = Rs.1,268.16

Then find the rate (yrealized ) that makes the FV of the purchase price equal to $1,268.16:

953.10 (1 + yrealized )3 = $1,268.16 yrealized = 9.99% or approximately 10%

9.

a.

the yield to maturity on a semi-annual basis is 4.26%. This implies a bond

equivalent yield to maturity equal to: 4.26% 2 = 8.52%

b.

Since the bond is selling at par, the yield to maturity on a semi-annual basis is

the same as the semi-annual coupon rate, i.e., 4%. The bond equivalent yield

to maturity is 8%.

Effective annual yield to maturity = (1.04)2 1 = 0.0816 = 8.16%

c.Keeping other inputs unchanged but setting P=1050, we find a bond equivalent

yield to maturity of 7.52%, or 3.76% on a semi-annual basis.

Effective annual yield to maturity = (1.0376)2 1 = 0.0766 = 7.66%

10. a) 8.51

b) 8%

c) 7.52

YTC=3.36

b) YTC=2.976%

c) YTC=3.031%

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