Tutorial 3 – Interest Rates and Interest Rate Management -

Problem 3.1.

The cash prices of six-month and one-year Treasury bills are 94.0 and 89.0. A 1.5-year bond that will
pay coupons of $4 every six months currently sells for $94.84. A two-year bond that will pay coupons
of $5 every six months currently sells for $97.12. Calculate the six-month, one-year, 1.5-year, and
two-year zero rates.

The 6-month Treasury bill provides a return of 6  94  6383% in six months. This is
2  6383  12766% per annum with semiannual compounding or 2 ln(106383)  1238% per
annum with continuous compounding. The 12-month rate is 11  89  12360% with annual
compounding or ln(11236)  1165% with continuous compounding.

For the 1 12 year bond we must have

4e0123805  4e011651  104e15 R  9484

where R is the 1 12 year zero rate. It follows that

376  356  104e15 R  9484

e15 R  08415
R  0115
or 11.5%. For the 2-year bond we must have

5e0123805  5e011651  5e011515  105e2 R  9712

where R is the 2-year zero rate. It follows that

e2 R  07977
R  0113
or 11.3%.

Problem 3.2.

What rate of interest with continuous compounding is equivalent to 15% per annum with monthly
compounding?

The rate of interest is R where:

 015 
12

e  1 
R

 12 
i.e.,

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  015 
R  12 ln 1  
 12 

 01491
The rate of interest is therefore 14.91% per annum.

Problem 3.3.

A deposit account pays 12% per annum with continuous compounding, but interest is actually paid
quarterly. How much interest will be paid each quarter on a $10,000 deposit?

The equivalent rate of interest with quarterly compounding is R where

4
012  R
e  1  
 4
or

R  4(e003  1)  01218

The amount of interest paid each quarter is therefore:

01218
10 000   30455
4
or $304.55.

Problem 3.4

Suppose that 6-month, 12-month, 18-month, 24-month, and 30-month zero rates are 4%, 4.2%,
4.4%, 4.6%, and 4.8% per annum with continuous compounding respectively. Estimate the cash price
of a bond with a face value of 100 that will mature in 30 months and pays a coupon of 4% per annum
semiannually.

The bond pays $2 in 6, 12, 18, and 24 months, and $102 in 30 months. The cash price is

2e00405  2e004210  2e004415  2e00462  102e004825  9804

Problem 3.5.

A three-year bond provides a coupon of 8% semiannually and has a cash price of 104. What is the
bond’s yield?

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The bond pays $4 in 6, 12, 18, 24, and 30 months, and $104 in 36 months. The bond yield is the
value of y that solves

4e05 y  4e 10 y  4e15 y  4e 20 y  4e25 y  104e 30 y  104

Using the Goal Seek or Solver tool in Excel y  006407 or 6.407%.

Problem 3.6.

Suppose that the 6-month, 12-month, 18-month, and 24-month zero rates are 5%, 6%, 6.5%, and 7%
respectively. What is the two-year par yield?

Using the notation in the text, m  2 , d  e0072  08694 . Also

A  e 00505  e00610  e006515  e00720  36935

The formula in the text gives the par yield as

(100  100  08694)  2

 7072
36935
To verify that this is correct we calculate the value of a bond that pays a coupon of 7.072% per year
(that is 3.5365 every six months). The value is

3536e00505  35365e00610  3536e006515  103536e00720  100

verifying that 7.072% is the par yield.

Problem 3.7

Suppose that zero interest rates with continuous compounding are as follows:

Maturity( years) Rate (% per annum)

1 2.0

2 3.0

3 3.7

4 4.2

5 4.5

Calculate forward interest rates for the second, third, fourth, and fifth years.

The forward rates with continuous compounding are as follows: to

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Year 2: 4.0%

Year 3: 5.1%

Year 4: 5.7%

Year 5: 5.7%

Problem 3.8.

Suppose that the Treasury bond futures price is 101-12. Which of the following four bonds is cheapest
to deliver?

Bond Price Conversion Factor

1 125-05 1.2131

2 142-15 1.3792

3 115-31 1.1149

4 144-02 1.4026

The cheapest-to-deliver bond is the one for which

Quoted Price  Futures Price  Conversion Factor

is least. Calculating this factor for each of the 4 bonds we get

Bond 1  12515625  101375  12131  2178

Bond 2  14246875  101375  13792  2652
Bond 3  11596875  101375  11149  2946
Bond 4  14406250  101375  14026  1874
Bond 4 is therefore the cheapest to deliver.

Problem 3.9

A five-year bond with a yield of 11% (continuously compounded) pays an 8% coupon at the end of
each year.

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 a) What is the bond’s price?
b) What is the bond’s duration?
c) Use the duration to calculate the effect on the bond’s price of a 0.2% decrease in its
yield.
d) Recalculate the bond’s price on the basis of a 10.8% per annum yield and verify that
the result is in agreement with your answer to (c).

a) The bond’s price is

8e011  8e0112  8e0113  8e0114  108e0115  8680

b) The bond’s duration is

1  011
8e  2  8e0112  3  8e0113  4  8e0114  5 108e0115 
8680 

 4256years

c) Since, with the notation in the chapter

B   BDy
the effect on the bond’s price of a 0.2% decrease in its yield is

8680  4256  0002  074

The bond’s price should increase from 86.80 to 87.54.

d) With a 10.8% yield the bond’s price is

8e0108  8e01082  8e01083  8e01084  108e01085  8754
This is consistent with the answer in (c).

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