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## CH. 15 TERM STRUCTURE OF INTEREST RATE

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.

## Expected Rate of Return

(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.

## The forward rates based on todays yield curve are as follows:

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

## [Using a financial calculator, enter n = 2; M = 100; P=101.86; ] YTM = 7.958%

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.

## If the liquidity premium is 1% then the forecast interest rate is:

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.

## The current bond price is:

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%

## PV of Re1 received at period end

Re1/1.05 = 0.9524
1/(1.05 1.07) = 0.8901
1/(1.05 1.07 1.08) = 0.8241

b.

## To find the yield to maturity, solve for y in the following equation:

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

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.

## Next year, the price of the bond will be:

[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

## The yield on the two-year zero is 8.472%, as shown below:

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

## Therefore: yield to maturity for the coupon bond = 8.333%

[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.

## We obtain forward rates from the following table:

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%

## Price (for parts c, d)

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.

## Effective annual rate for 3-month T-bill:

4

100 ,000

1 = 1.02412
97 ,645

b.

1 = 0.100 = 10 .0%

## Effective annual interest rate for coupon bond paying 5% semiannually:

(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.

## n = 40; M = 1000; P=950

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.

## Effective annual yield to maturity = (1.0426)2 1 = 0.0870 = 8.70%

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%