Investments

MSc in Finance and Banking

UPF Barcelona School of Management
AY 2016-2017
PROBLEM SET 1

Exercise 1:
a. Let b t be the price of a t-year zero-coupon bond with a 100-dollar face value, where t {1, 2}. Notice
that the payoff structure of bonds A and B can be mimicked by portfolios composed of the 1-year
and 2-year zero-coupon bonds. Using the Law of One Price, b 1 and b 2 satisfy the following system
of equations:

b 1 = 90
b 1 = 90
1
110

b 2 = 85
b1 +
b 2 = 102.5
10
100
b. First, we create the replicating portfolio of a 2-year zero-coupon bond whose no-arbitrage price is
$85. Let i , i { A, B}, be the weight of bond i in the replicating porfolio. This implies that A and
B satisfy the following system of equations:
100 A + 10B
110B

=0
= 100

A
B

= 0.0909
= 0.9091

Because the replicating portfolio is cheaper than the 2-year zero-coupon bond, an arbitrage strategy consists of buying the replicating portfolio and short-selling the 2-year zero-coupon bond. This
yields a payoff of $10 now with zero payoffs for sure in the future.
c. This time, the replicating porfolio is more expensive than the 2-year zero-coupon bond. An arbitrage strategy is to short-sell the replicating portfolio and to buy the 2-year zero-coupon bond.
This results in a payoff of $5 now, and zero payoffs for sure in 1 and 2 years.
Exercise 2:
a. As in Exercise 1, let b t be the price of a t-year zero-coupon bond with a 100-dollar face value,
where t {1, 2}. The prices b 1 and b 2 therefore satisfy:

3
103

b1 +
b 2 = 85.10

100
100
b 1 = 90

b 2 = 80

10
110

b1 +
b 2 = 97
100
100
b. Let r t be the t-year interest rates embedded into these prices. Using the bond prices obtained in
(a), the interest rates solve:
100
r 1 = 11.11%
1 + r1
100
b 2 = 80 =
r 2 = 11.80%
(1 + r 2 )2
b 1 = 90 =

c. The yield to maturity of a 2-year zero-coupon bond is the same as the 2-year interest rate, which
is equal to 11.80%.
d. Let yi be the yield to maturity of bond i. The yields yA and yB are obtained as follows:
103
3
+
yA = 11.79%
1 + yA (1 + yA )2
10
110
97 =
+
yB = 11.77%
1 + yb (1 + yB )2

85.10 =

Exercise 3:
a. The interest rates are computed from the bonds as follows:
100

r 1/2 = 4.12%
(1 + r 1/2 )1/2
100
r 1 = 5.26%
95 =
1 + r1
3.1
3.1
103.1
101 =
+
r 3/2 = 5.59%
+
1/2
1 + r 1 (1 + r 3/2 )3/2
(1 + r 1/2 )
4
104
4
4
+
+
104 =
+
r 2 = 5.98%
1/2
3/2
1 + r 1 (1 + r 3/2 )
(1 + r 2 )2
(1 + r 1/2 )

98 =

b. The forward rate at t = 0 from t to s is computed as

1
(1 + r s )s st
1 + f t,s =
.
(1 + r t ) t
Therefore, we have that f 1/2,1 = 6.42%, f 1,3/2 = 6.26% and f 3/2,2 = 7.15%.
c. The price P of the bond is
P=

3.5
(1 + r 1/2 )1/2

3.5
3.5
103.5
+
+
= $102.1290
1 + r 1 (1 + r 3/2 )3/2 (1 + r 2 )2

The yield to maturity y solves

3.5
(1 +

y)1/2

3.5
103.5
3.5
+
= $102.1290 y = 5.94%.
+
1 + y (1 + y)3/2 (1 + y)2

Exercise 4:
a. Denote the t-year spot yield as s t . First, because the half-year bond does not have any coupon
payments, the six-month spot yield (s 1/2 ) is equal to 0.80%, its par yield. Next, notice that par
yields are in APRs. We can translate these rates into EAYs (here, denoted as r t ), which can then
be used to properly discount coupon payments, using the following formula:

s t 2
1+
= 1 + r t.
2
For a bond to sell at par, its YTM, which is its par yield, should equal its periodic coupon payments.
This means that, in the absence of arbitrage, it must be the case that
1, 000 =

5.15
(1 + r 1/2

)1/2

1, 05.15
5.15
1, 005.15
=
+
s 1 = 1.0306%
1 + r1
1 + s 1/2 /2 (1 + s 1 /2)2

Using the same logic, we obtain that s 3/2 = 1.7672%, s 2 = 2.1936%, s 5/2 = 2.8840% ,and s 3 =
3.2888%.

b. We already have the formula for forward rates from Exercise 1, part b. We, however, still need to
convert the spot yields computed in (a) to effective annual rates so we can plug them in the forward
rate formula. Using the relationship between APRs and EARs, we obtain that r 1/2 = 0.80160%,
r 1 = 1.0332%, r 3/2 = 1.7750%, r 2 = 2.2057%, r 5/2 = 2.9048%, and r 3 = 3.31588%. Finally, we
have that the forward yield curve (in APRs) is now f 1/2 = 0.8000%, f 1 = 1.2615%, f 3/2 = 3.2484%,
f 2 = 3.4885%, f 5/2 = 5.6692%, and f 3 = 5.3251%.
c. Let yt , s t , and f t be the par, spot, and forward yields, respectively, at time t. We abstract from
convention, and suppose that all these rates are in EAYs. We illustrate the relationship among
the three yields by considering a two-year bond that pays coupons annually. The par, spot and
forward yields satisfy
F=

cF
cF
cF
F(1 + c)
F(1 + c)
F(1 + c)
+
+
+
,
=
=
1 + y2 (1 + y2 )2 1 + s 1 (1 + s 2 )2 1 + f 0,1 (1 + s 1 )(1 + f 1,2 )

where F is the face value, and c is the coupon rate. Notice that the par yield can be seen as a
weighted average of the one-year, and two-year spot yields. Hence, if the par yield curve is upward
sloping, the spot yield curve is above the par yield curve. This implies that the spot yield curve is
also upward sloping, and, thus, the forward yield curve is above the spot yield curve.
From the same relationship, a flat par curve generates flat spot and forward curves as well. Finally, if the par curve is downward-sloping, the spot curve is below the par curve, and, consequently, the forward curve is below the spot curve.