Fixed Income - Part 1

Live Session Questions

1. The one-year to five-year spot rates are given in the table below. The spot rates shown are
effective annual rates.

Year Spot Rate

1 0.25%
2 0.50%
3 0.75%
4 1.00%
5 1.25%

(a) Calculate the following implied forward rates, 1 f1 , 2 f1 , 3 f1 and 4 f1 .

(b) Calculate the PVs of the following government bonds.
i. 0.5% annual coupon bond with a maturity of 5 years and a face value of £1,000.
ii. 1.5% annual coupon bond with a maturity of 5 years and a face value of £1,000.
(c) Calculate the yield to maturity of bonds i and ii. Explain intuitively why the yield to
maturity on the 1.5% coupon bond is less than that on the 0.5% coupon bond.
(d) Why is the 0.5% coupon bond selling at discount (price < face value) and the 1.5%
coupon bond selling at premium (price > face value)?

2. Bond A is a one-year zero coupon bond and is currently priced at £95.24. Bond B is a
two-year 10% annual coupon bond and is currently priced at £107.42. Bond C is a two-
year zero coupon bond. All bonds have a par value of £100 and are assumed to be issued
by the UK government and default risk-free. Calculate the the price of Bond C using the
replicating portfolio method, ie, use Bond A and Bond B to replicate Bond C’s cash flows
(do not calculate the price of Bond C using spot rates).

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3. You are a bond trader in the City of London and observe the following information on UK
default-free government bonds, where all bonds pay annual coupons and have a par value of
£100:

Price Maturity Coupon rate

Bond A £89.760 2 years 4%
Bond B £93.318 2 years 6%
Bond C 2 years 12%

(a) Using Bond A and Bond B, what is the current term structure of interest rates?
(b) Explain the current term structure of interest rates observed in (a) using term structure
theories.