1. A bond with 1 year to maturity has an 18% coupon and sells for $1036.16.

a. What is the bond’s yield to maturity?

b. Suppose you invested $1,036.16 in an account that offers the same yield as that calculated in
part A. How much would you have 1 year from today?
c. Reconsider the bond. If the coupon received 6 months from today is reinvested to earn the
yield to maturity, how much will you have 1 year from today? What if the coupon earns nothing (is not
reinvested)? What if the coupon is reinvested at a rate of 16% per year (expressed as a bond equivalent rate)?
Summarize your results. Under what circumstances will an investor’s realized yield be the same as the
bond’s yield to maturity?
2. What determines the equilibrium level of interest rates?
3. The stock market seems risky these days. I am going to put my money in safe, 30-year U.S. Treasury
bonds.” Evaluate this statement.
4. The stock market seems risky these days. I am going to put my money in safe, 30-year U.S. Treasury
bonds.” Evaluate this statement.
5. Suppose the only information you had regarding the current health of a country’s economy was its
credit spread between triple-B bonds and Treasury bonds. Specifically, the spread had recently widened
considerably. What would you infer?
6. Describe the impact of the call feature and the convertible feature on bond prices,
Answer:
The call feature causes bond prices to rise less as a comparable non-callable bond when interest rates
fall. The option to call a bond held by the issuer becomes more valuable when interest rates fall, because the
bonds can be refinanced at a lower rate. The conversion feature causes bonds to behave like the underlying
stock after the stock price has risen sufficiently.

7. What asset would you consider to be riskier, three-month Treasury bills or a 30-year Treasury bond
that matures in three months? Although the expectations of increases in future interest rates can result in an
upward sloping yield curve; an upward sloping yield curve does not in and of itself imply the expectations of
higher future interest rates. Explain.

Answer:
The effects of possible liquidity premiums confound any simple attempt to extract expectation from the term
structure. That is, the upward sloping yield curve may be due to expectations of interest rate increases, or
due to the requirement of a liquidity premium, or both. The liquidity premium could more than offset
expectations of decreased interest rates, and an upward sloping yield would result.
Feedback: The purpose of this question is to assure that the student understands the confounding of the
liquidity premium with the expectations hypothesis, and that the interpretations of term structure are not
clear-cut.

8. Suppose you are the chief financial officer of a large life insurance company. Looking at mortality tables,
you estimate that you will have to pay the insured families $100 million in each of the next five years and
$900 million in Year 6. What kind of bonds would you seek to make these payments? Would it make a
difference whether the yield curve is flat or upward sloping?

Answer:
As a CFO of a life insurance company, you must invest in a riskless investment to insure the payment to
families. Because you cannot take any risk, you must invest in Treasury bills that mature in one year in the
amount of $100 million, zero-coupon Treasuries in two years of $100 million, and so on. Alternatively, you can
invest in a very low-risk bond (AAA) that matures in six years with coupon payments of $100 million every year
and a par value of $800 million, so you can achieve the desired cash flow. The decision is not influences by the
shape of the yield curve, rather by the difference in the interest rates and credit risk.

9. Looking at the international financial statistics, we find that the interest paid to U.S. banks on loans to
some Latin American countries is about 32% per year. The interest within the United States is only 10%.
a. How can you explain the difference in interest rates if the loans are made in local currency?
 b. How can you explain the difference in interest rates when the loan is made in U.S. dollars?
After all, it is said, the government cannot go bankrupt. Why do U.S. banks receive such a high interest rate on
foreign loans?

Answer:
a. If the loan is made in the local currency, we have currency risk. If the rate of exchange between the
dollar and the local currency is expected to increase by 20%, in order to get a 10% interest rate in U.S. dollars,
you will have to loan at essentially 32% in the local currency.
b. If the loan is made in U.S dollars, the reason is the risk of this country. Due to revolution, war, or any
other crisis, there is a risk that the Latin American country will not repay on the loan.
7. 10. Firm plc. issues a 10-year zero-coupon bond which can be converted into 5 of their shares.
Comparable straight bonds have a yield to maturity of 10 %. The Firm’s share is currently trading at $25. Use
the face value of $100.
a. Calculate the conversion value and the conversion price of the bond.
b. If you had to convert now or never, what would you do?
c. If the convertible bond is trading at $52, what is the value of the call option?
d. That happens to the value of the convertible bond if the riskiness of the firm’s assets increases?

Answer:
a. The conversion ratio is 5, which means for every bond converted, the firm will issue 5 shares of
common stock.
Conversion value= Conversion Ratio  Current stock price = 5  $25 = $125
Conversion Price = Par/Conversion Ratio = $100/5 = $20
b. You should convert now as at the current stage price exceeds the conversion price.
c. The value of the zero-coupon bond without the warrant should be equal to its future discounted cash
flow, that is the repayment of the principal:
100
= $38.55
1.110
Hence, the value of the convertible option is equal to:
52 – 38.55 = $13.45
d. The value of the convertible bond will increase. Just like any other option, the value of the
option feature within the convertible depends positively on the risk of the underlying asset, i.e. share.

11. One year ago, you purchased a 5-year bond that pays annual coupons. The bond’s coupon rate is 6%, and
its par value is $1,000. When you bought the bond, its yield to maturity was 4%. Today, you received the
first coupon payment, and the bond’s yield to maturity is 3%. If you sell the bond today, what will be your
realized yield?
Answer:
We must first find out how much you paid for the bond 1 year ago. Since the bond pays annual
coupons, we use the following calculator inputs:
n = 5, i = 4%, PMT = $60, FV = $1,000. Solving, PV = $1,089.04.
Today, the bond has only 4 years remaining to maturity, and the value of the bond is
n = 4, i = 3%, PMT = $60, FV = $1,000. Solving, PV = $1,111.51.
Your realized return is ($1,111.51 + 60 – 1,089.04)/1,089.04 = 7.57%.
12. Find the convexity of a 3-yr Bond, 10% coupon, semiannual compounding, required yield 9%.
T
C t (t) (t + 1)
t=1 (1+ r )t+2
Answer: CONV = T
Where
m
2
 Ct
(1+ r )
t
t=1
Ct= Cash flow at time t
t= Period when the cash flow is expected to be received (t= 1, 2, . T)
T= Number of periods until maturity (i.e. the number of years to maturity times m)
m= Number of periods per year (ex. m = 2 for semiannual bonds)
r= Discount rate per period
 5 * 1* 2 5* 2* 3 5 * 3 * 4 5 * 4 * 5 5 * 5 * 6 105 * 6 * 7
3
+ 4
+ + + +
(1.045) (1.045 ) (1.045) 5 (1.045) 6 (1.045) 7 (1.045) 8
CONV = = 8.2135
4 * 102.58
Convexity = 3370.1271 / (102.5789*4) = 8.2135

Convexity Short Cut Calculation Formula:

 C
n ( n + 1)  PAR − 
2C  1  2C  n   r
1 −  − +
r 3  (1 + r ) n  r 2  (1 + r )n +1  (1 + r )
n+2

CONV =
m2 P
 5 
6 (7) 100 − 
2 (5)  1  2 (5)  6   0 .045 
3 
1− 6 
− 2  7 
+
0.045  (1.045)  (0.045)  (1.045)  (1.045) 8
CONV =
4 * 102.5789

= 8.2135

13. What is credit enhancement?

Answer: Credit enhancement is used to improve the credit quality of an ABS compared to that of the
underlying loans. This mechanism aims at protecting security hold- ers against adverse credit events such as
defaults. Credit enhancement can take several forms.

14. What does debt securitization consist in?

Answer: Debt securitization consists in transforming the illiquid assets of a financial com- pany into tradable
securities backed by these assets. When the resulting securities are backed by mortgage loans, they are called
Mortgage-Backed Securities; when they are backed by other types of loans, essentially installment loans and
revolving loans, they are called Asset-Backed Securities. The secured status of these bonds comes from the
fact that they are priority claims on the pool of the under- lying assets, which are isolated from the general
business assets of the financial company. Hence, the holders of these securities are protected against a default
of the company.

15. Choosing a Portfolio with the Maximum $ Duration or Modified Duration Possible Consider at date t, five
bonds delivering annual coupon rates with the following features:
Maturity ) CR (%) YTM (%) ) Price
(years)
5 7 4 113.355
7 4.5 6 108.839
15 8 5 131.139
20 5 5.25 96.949
22 7 5.35 121.042
CR stands for coupon rate and YTM for yield to maturity. A portfolio manager believes that
the YTM curve will very rapidly decrease by 0.3% in level. Which of these bonds provides
the maximum absolute gain? Which of these bonds provides the maximum relative gain?
Answer: We compute the modified duration and the $duration of these five bonds. In the
scenario anticipated by the portfolio manager, we then calculate the absolute gain and the
relative gain that the portfolio manager will earn with each of these five bonds
 Maturity MD Duration Absolute Relative
(years) gain gain (%)
5 4.258 −482.7 1.448 1.28
7 5.711 -621/62 1.865 1.71
15 9.52 -1248.4 3.745 2.86
20 11.322 -1194.6 3.584 3.70
22 12.095 −1,464 4.392 3.63

MD stands for modified duration and Dur for duration. If he wants to optimize his absolute
gain, the portfolio manager will choose the 22-year maturity bond. On the contrary, if he
prefers to optimize his relative gain, he will invest in the 20-year maturity bond.

16. Would you say it is easier to track a bond index or a stock index? Why or why not?

Answer: As is often the case, the answer is yes and no. On the one hand, it is harder to perform perfect
replication of a bond index compared to a stock index. This is because bond indices typically include a huge
number of bonds. Other difficulties include that many of the bonds in the indices are thinly traded and the fact
that the composition of the index changes regularly, as they mature. On the other hand, statistical replication
on bond indices is easier to perform than statistical replication of stock indices, in the sense that a significantly
lower tracking error can usually be achieved for a given number of instruments in the replicating portfolio. This
is because bonds with different maturities tend to exhibit a fair amount of cross-sectional correlation so that a
very limited number of factors account for a very large fraction of changes in bond returns. Typically, 2 or 3
factors (level, slope, curvature) account for more than 80% of these variations. Stocks typically exhibit much
more idiosyncratic risk, so that one typically needs to use a large number of factors to account for not much
more than 50% of the changes in stock prices.

17. On April 1, 2008, XYZ Ltd. issued ‘A’ rated bonds with 6-year maturity.
The face value of each bond is Rs.1, 000. It also proposed for the payment of different
coupons for different years and the basis for determining the coupon payments were
forward yields on zero coupon bonds. On April 1, 2008, the prices of zero coupon
bonds maturing in different years were as follows:
Maturity date Price of zero (Rs.)
1.04.2008 943.40
1.04.2009 898.42
1.04.2010 847.50
1.04.2011 792.16
1.04.2012 754.35
1.04.2013 713.03
The face value of each zero coupon bond is Rs.1000.
The coupon rates for different years on the bond were determined by loading 2.5% to
the corresponding forward yields obtained from the above prices of zero coupon
bonds. Furthermore, the coupon rate to be paid in a particular year is restricted to a
maximum of 9%. If Pure Expectations Hypothesis holds good, you are required to
determine the coupon rates.

18. Suppose the only information you had regarding the current health of a country’s economy was its credit
spread between triple-B bonds and Treasury bonds. Specifically, the spread had recently widened
considerably. What would you infer?
Answer:
A widening credit spread indicates that the market participants are demanding a larger default premium.
Hence, market participants are expecting more default suggesting a weakening economy.

19. Because of financial stress, the bonds of Intelo have been downgraded by Moody’s from A to BBB. What is
the predicted effect on the bonds’ price? What is the predicted effect on the bonds’ yield to maturity?
 Answer:
Telco’s bond price will probably fall as a result of the downgrade. Conversely, the yield to maturity will rise in
order to compensate for the reduction in price. The bond has more risk than before, and the company must
offer higher returns to entice investors.

20. A portfolio of zeros will pay Rs 3 million in 5 years, Rs 25 million in 10 years and Rs 2 million in 15 years. A
change of yield from 6% to 7% will cause how much % fall in its value?

21. A 6.25% yielding bond, with a duration of 2.5 is trading at Rs101.50. If the yield increases to 6.84%, what
will be the bond’s new price
22. What is “Yield Curve”? How does a risk free sovereign benchmark yield curve is plotted? Briefly explain the
uses of Yield Curve. What can be the reasons/ circumstances under which the shape of the Yield curve
becomes inverted?
23. Describe with example Yield and Price based auction methods of issue of Government Securities. What is
“winners curse”?

24. 91 days T Bills are issued on every Wednesday. What will be the yield of such a T bill (face value Rs 100)
on 22nd July 2011 if price on that day is Rs 98.50 and date of issue is 29th June 2011?

25. A 182 days T Bill was issued on20th May 2011. The Face value is Rs 100 and the cut-off yield in the auction
was 5.5%. How much amount would have to be paid by a successful bidder who had bided for T Bills of total
nominal amount of Rs 50 million

26. f a portfolio pays 20% of its present value in 3 years, 25% in 5 years, 15% in 10 years and remaining
amount in 12 years by how much % its value will decline if the yield changes from 6% to 7%?
27. Calculate the price of the bond if the required return is A) 6%, B) 8%, and C) 10%. What general
relationship between bond prices and yields is demonstrated by this problem?

Answer:
Use a financial calculator to find the bond’s prices at the various required returns:
n = 50, i = 3%, PMT = $40, FV = $1,000. Solving, PV = $1,257.30.
n = 50, i = 4%, PMT = $40, FV = $1,000. Solving, PV = $1,000.00.
n = 50, i = 5%, PMT = $40, FV = $1,000. Solving, PV = $817.44.

This problem demonstrates two principles of bond pricing. First, whenever the coupon rate is equal to
the required rate of return, the bond’s price is equal to par value (you should verify this with examples of your
own, varying the bond’s maturity). Second, there is an inverse relationship between bond prices and yields.
Whenever interest rates (required rates of return) increase, bond prices decrease, and vice versa.

It is common practice for issuers to price bonds at par when issued. Issuers achieve this by setting the
coupon yield equal to the current required rate of return. Thereafter, premium bond prices reveal that
required return has decreased since the bond was issued, and discount bond prices reveal that required return
has increased since the bond was issued.

28. Consider an 8% Treasury bond with a current price of $908 and a YTM of 9%. Calculate
the percentage change in price of both a 1% increase and a 1% decrease in YTM based on a
modified duration of 9.42 and a convexity of 68.33.

29. Describe the convexity measure of a bond and estimate a bond’s percentage price
change, given the bond’s duration and convexity and a specified change in interest rates.

Convexity is a measure of the curvature of the price-yield curve. The more curved the price-
yield relation is, the greater the convexity. A straight line has a convexity of zero. If the price-
yield curve were, in fact, a straight line, the convexity would be zero. The reason we care
about convexity is that the more curved the price-yield relation is, the worse our duration-
based estimates of bond price changes in response to changes in yield are.
 As an example, consider again an 8%, 20-year Treasury bond priced at $908 so that it has a
yield to maturity of 9%. We previously calculated the effective duration of this bond as 9.42.
Figure 4 illustrates the differences between actual bond price changes and duration-based
estimates of price changes at different yield levels.
Duration-Based Price Estimates vs. Actual Bond PricesFigure 4:
Based on a value of 9.42 for duration, we would estimate the new prices after 1% changes in
yield (to 8% and to 10%) as 1.0942 × 908 = $993.53 and (1 – 0.0942) × 908 = $822.47,
respectively. These price estimates are shown in Figure 4 along the straight line tangent to the
actual price-yield curve.
The actual price of the 8% bond at a YTMof 8% is, of course, par value ($1,000). Based on a
YTMof 10%, the actual price of the bond is $828.41, about $6 higher than our duration based
estimate of $822.47. Note that price estimates based on duration are less than the actual
prices for both a 1% increase and a 1% decrease in yield.
(i.e., if convexity were zero), duration alone would provide good estimates of bond price
changes for changes in yield of any magnitude. The greater the convexity, the greater the
error in price estimates based solely on duration.

Answer:
The duration effect, as we calculated earlier, is 9.42 × 0.01 = 0.0942 = 9.42%. The convexity
effect is 68.33 × 0.012 × 100 = 0.00683 × 100 = 0.683%. The total effect for a decrease in yield
of 1% (from 9% to 8%) is 9.42% + 0.683% = +10.103%, and the estimate of the new price of the
bond is 1.10103 × 908 = 999.74. This is much closer to the actual price of $1,000 than our
estimate using only duration.
The total effect for an increase in yield of 1% (from 9% to 10%) is –9.42% + 0.683% = –
8.737%, and the estimate of the bond price is (1 – 0.08737)(908) = $828.67. Again, this is much
closer to the actual price ($828.40) than the estimate based solely on duration.
8. 30. Briefly define each of the major types of international bond market instruments,
noting their distinguishing characteristics.

Answer: The major types of international bond instruments and their distinguishing
characteristics are as follows:
Straight fixed-rate bond issues have a designated maturity date at which the principal of the
bond issue is promised to be repaid. During the life of the bond, fixed coupon payments that
are some percentage rate of the face value are paid as interest to the bondholders. This is the
major international bond type. Straight fixed-rate Eurobonds are typically bearer bonds and
pay coupon interest annually.
Floating-rate notes (FRNs) are typically medium-term bonds with their coupon payments
indexed to some reference rate. Common reference rates are either three-month or six-
month U.S. dollar LIBOR. Coupon payments on FRNs are usually quarterly or semi-annual, and
in a accord with the reference rate.
A convertible bond issue allows the investor to exchange the bond for a pre-determined
number of equity shares of the issuer. The floor value of a convertible bond is its straight
fixed-rate bond value. Convertibles usually sell at a premium above the larger of their straight
debt value and their conversion value. Additionally, investors are usually willing to accept a
lower coupon rate of interest than the comparable straight fixed coupon bond rate because
they find the call feature attractive. Bonds with equity warrants can be viewed as a straight
fixed-rate bond with the addition of a call option (or warrant) feature. The warrant entitles
the bondholder to purchase a certain number of equity shares in the issuer at a pre-stated
price over a pre-determined period of time.
Zero coupon bonds are sold at a discount from face value and do not pay any coupon
interest over their life. At maturity the investor receives the full face value. Another form of
zero coupon bonds are stripped bonds. A stripped bond is a zero coupon bond that results
from stripping the coupons and principal from a coupon bond. The result is a series of zero
coupon bonds represented by the individual coupon and principal payments.
A dual currency bond is a straight fixed-rate bond which is issued in one currency and pays
coupon interest in that same currency. At maturity, the principal is repaid in a second
currency. Coupon interest is frequently at a higher rate than comparable straight fixed-rate
bonds. The amount of the dollar principal repayment at maturity is set at inception;
frequently, the amount allows for some appreciation in the exchange rate of the stronger
currency. From the investor’s perspective, a dual currency bond includes a long-term forward
contract.
Composite currency bonds are denominated in a currency basket, such as SDRs or ECUs,
instead of a single currency. They are frequently called currency cocktail bonds. They are
typically straight fixed-rate bonds. The currency composite is a portfolio of currencies: when
some currencies are depreciating others may be appreciating, thus yielding lower variability
overall.
31. Using modified duration find out the changed price due to drop of market
yield by 1% of a 4 year bond of face value of 1000, annually paid coupon of
5% today selling at par. (10)
(b) CALCULATE THE CONVEXITY OF BOND AT 3 (A) ABOVE AND
AGAING CALCULATE THE CHANGED PRICE BY USING CONVEXITY
IN ADDITION TO MODIFIED Duration. (10)
32. (a) A 91 days T Bill was issued on 29th Jane 2011. The Face value is Rs
100 and cut-off yield in the auction was 5.0%. How much amount would ha
paid by a successful bidder who had bid for T Bills of total nominal amount of
Rs 50 million?
(b) Find the price and the settlement amount of a 3 by 9 FRA of notional
sum of 100 million if the 3 months and 9 months spot rates at the initiation
were 3% and 5% respectively. Also the 6 months spot rate at the expiry of FRA
was 4% p.a. incidentally there is no mark up on the variable rte. which is fixed
asper pure respective spot rates prevailing at any point of time
33. (a)A financial Institution has to honor a liability of Rs 10 laks after 2
years. Presently the yield curve is flat at 10% p.a. There are 2 G- Secs- one of 1
year maturity of annually payable coupon of 7% and another of 3 years
maturity with annually payable coupon of 8%. Both have face and maturity
value of Rs 1000/- Tell how by investing in these 2 securities and how much
investment in these 2 securities the FI can ensure no default in repayment of Rs
10 lakhs after 2 years? (10)
(b) Find the value of the swap one year after start when the spot rates for 1 year and 2 years
were 3% and5% p.a. respectively. (10)
34. A company issues a floating rate bond with the following particulars:
Face Value 1000; Maturity 4 years; Coupon paid: Annually
Coupon Rate: Forward rates for each year as on the date of
Issue plus a mark-up of 2.5% subject to a cap of 9%. Total
Issue size 100 crore.
The price of Zeros of face value of 1000 as on the date of issue were as under:
1 year 943.40 2 years 898.42 3 years 847.50 4 years 713.03
How much provision the company should make at the time of issuing the bond so as to ensure
payment of coupon for the entire life of the bond?
35. the yield curve for default-free zero-coupon bonds from 1 to 4 years are currently
9%,10%,11% and 12% respectively.
a. If the unbiased expectations hypothesis of the term structure is
correct, what does the market expect the yield to maturity on 3-year zeros to be 1
year from today?
b. Again assume that the unbiased expectations hypothesis is correct. Suppose
an investor buys a 4-year zero today and sells it 1 year from today. What is this
strategy’s expected realized yield?
c. Suppose you believe that, 1 year from today, the yield on 1-year zeros will be
11%. You also believe that, 1 year from today, f1 will be 12% and f2 will be 15%.
 What do you expect the yield to maturity on 3-year zeros to be 1 year from today?
Based on your expectations, are 4-year zeros attractive investments today?
36. What are Spot and Forward Rates? How these can be derived from normal
(coupon) yield Curve- Explain with example.
(b) Assume the following:

• The six month spot rate is 4.3%

• The one year spot rate is 4.55%
• Find out the six month forward rate, after six months

(c) Consider three pure discount bonds with maturities of 1,2 and 3 years
and prices of Rs 930.23, Rs 923.79 and 919.54 respectively. Each bond has
Rs 1000/- as face value. Based on this information what are the one year, two
year and three year spot rates

37. Supposing that a swap dealer bank assesses and quotes the following rates to a
company for a loan of 100 million based on the annual spot yield curve for that
company’s risk class:
One-year 3.50% Two-year 4.60% Three-year 5.40%
The variable rate will have a mark of 50 basis points less than the rates based on
the above rates.
(a) Find the price of swap. (10)
Find the value of the swap one year after start when the spot rates for 1 year and 2 years
were 3% and5% p.a. respectively

38. A floating Rate bond was issued for 5 years on 1Jan 2015 for 5 years with face value
1000 and coupon of Libor + 2% p.a with half- yearly payment and reset. Find the value of
this bond on 1 April 2018. when spot Libor was4% for 3 months,6% for 9 months,8% for
15 months nd 21 months. The 6 months Libor on 1 Jan 2018 was 5% p.a.
39. Find the Par yield for 1 to 4 years when spot rates for 1 to 4 years were 5%, 5%, 6.5%
and 8% respectively.
40. Design the swap with cash flows to each party with the following information:
Rates offered in Cash Markets
Company Fixed Rate Floating Rate
A 7.5% p.a. Libor+0.5 % p.a.
B 9% p.a. Libor+3.5% p.a.
The dealer C will charge 0.25% from each party.