FM405E - Fixed Income Securities and Credit Markets 2021/22

The London School of Economics

Problem Set 1
Duration hedging

Question 1

Consider the following US Treasuries issues:

Coupon Rate Maturity (Years) Price Yield to maturity

5.125% 2 100.54 4.838%
8.38% 10 114.34 6.410%

Table 1: US Treasuries issues.

The Macaulay Duration for a semi-annual coupon bond, with annualized coupon rate c, and
payment dates T1 , T2 , . . . , Tn = T is given by
n
−Py′ (y; T )  y X
DMac ≡ 1+ = ωTi · Ti + ω̂T · T,
Pc (y; T ) 2
i=1

where
1 c/2 × 100 1 100
ωTi = ; ω̂T = .
Pc (y; T ) 1 + y 2×Ti Pc (y; T ) 1 + y 2×T



2 2
where y is the annualized semi-annually compounded yield to maturity, P (y; T ) is the bond price,
and T is the maturity of the bond in years.

1. (10 points) Consider the 2-year bond in Table 1. This bond has an annualized coupon
rate c = 5.13% and is paying 4 cash flows, one every six months. Compute the Macaulay
duration, the (modified) duration and the $duration. How much will a bond value change
if rates change by 1 basis point?

2. (5 points) Consider the two securities described in Table 1. Describe qualitatively how you
would invest in the bonds if you thought the yield curve would decline at all maturities,
but more at the short end.

1
 3. (15 points) Suppose, instead, that you are confident that the yield curve will steepen, but
relatively agnostic about the overall level of interest rates. Describe how you might invest
to exploit this scenario. Specifically, given that the $ duration of the 10-year bond is 795.86,
construct a combination of the two bonds that profits from an increase in 10-year yields
relative to 2-years, but is not affected by equal changes in yields of both maturities. What
is the ratio of the number of 2-year bonds to 10-year bonds? Comment.

4. (30 points) Your risk management group estimates that the one-month standard deviations
of yield changes on the two bonds are Std (∆y2 ) = 0.114 (annual percent) for the 2-year
bond and Std (∆y10 ) = 0.066 (annual percent) for the 10-year bond, where we denote with
∆y the yield changes, and with y2 and y10 the yields associated to the 2-year and 10-year
bond, respectively. The correlation of yield changes is 0.531. With these numbers, compute

(a) (5 points) the standard deviation of the price change, in dollars, of $100 invested in
the 2-year bond;
(b) (5 points) the standard deviation of the price change, in dollars, of $100 invested in
the 10-year bond;
(c) (20 points) the standard deviation of the price change, in dollars, of $100 invested in
the yield spread trade constructed in the 3.

Comment on the differences.

Question 2

Consider two zero-coupon bonds: one zero-coupon maturing in one year, and one zero-coupon
bond maturing in three years. Assume that the spot yield curve is flat at the discretely com-
pounded rate of 4%, annualized.

1. (30 points) Determine the price and the modified duration of (i) the zero-coupon bond
expiring in one year, and (ii) the zero-coupon bond expiring in three years. Suppose that
you hold the zero-coupon bond expiring in three years. How would you proceed to immunize
the price of this zero-coupon bond against small and parallel changes in the spot yield curve?
Explain in detail.

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2. Suppose that an additional zero-coupon bond is available for trading: one zero-coupon bond
maturing in ten years. Suppose, also, that the zero-coupon bond expiring in three years is
a liability.

(a) (10 points) How would you use the additional ten year zero-coupon bond to implement
a barbell portfolio? In which particular yield curve scenario is a barbell portfolio likely
to generate positive profits? Explain in detail.
(b) (20 points) Compute the weights of the barbell portfolio.

3. (40 points) Compute the value of the barbell portfolio in the following two yield curve
scenarios:

- A “twist” scenario, in which the spot yield curve is: 4.5% (for the one year spot rate),
4.0% (for the three year spot rate), 3.5% (for the ten year spot rate).
- A “steepening” scenario, in which the spot yield curve is 3.5% (for the one year spot
rate), 4.0% (for the three year spot rate), 4.5% (for the ten year spot rate).

Interpret the results.