EMLyon Business School

Fixed Income Home Work Course of Fran

cois Le Grand
Third homework

Exercise I. Annuity. You invest money every eight months. Your first
payment of 1000e occurs in 2 months and you make 16 payments. Payments
increase by 1.0% each time (i.e. every 8 months) and the annual interest rate
is 6% (on a yearly basis).
1. What is the total value of your saving right after the last payment?
2. How much should you save today (not in 2 months) to obtain the same
amount?
You want to pay a constant amount every month and your first and last
payment dates are not modified.
3. How much should you pay every month (again, this monthly payment
is constant and does not increase), if you want to keep the same final amount?
You want to pay only every three months, but you want your payment to
increase by 0.5% each time. Additionaly, compared to both previous cases,
the last payment date is not modified, but your first payment date occurs in 5
months (and not 2). The interest rate remains equal to 6%.
4. How many payments do you make? What should be the value of your
first payment (in 5 months), if you want to keep the same final amount?
5. [More difficult]You want to pay only every four months, but you
want your payment to increase by 1% every year (once every payments: the
three first payments are constant, the fourth one increases, the next two ones
are constant again,. . . ). Additionaly, compared to the initial cases, the last
payment date is not modified, but your first payment date occurs in 6 months
(and not 2). The interest rate remains equal to 6%.
a. How many payments do you make? What should be the value of
your first payment (in 6 months), if you want to keep the same final amount?
b. The first payment is equal to 600 euros. What should be the value
of the interest rate to obtain the same final amount?
Correction.
1. You convert the interest rate r = (1 + 6%)8/12 1 = 3.961%. The F V (16)
after 16 payments is:
F V (16) = 1000

(1 + 3.961%)16 (1 + 1%)16
(1 + r)16 (1 + g)16
= 1000
= 23875.850
rg
3.961% 1%

2. The PV 16 periods ahead is the PV 1 period before the first payment,

i.e. 6 months ahead of the current date. We need to take it into account and
capitalize for 6 months (out of 8) to obtain the PV today, denoted P V (0):
P V (0) = (1 + r)6/8

F V (16)
= 12871.503
(1 + r)16

3. Let be Am this constant amount. On the whole, you make 8 (16

1) + 1 = 121 payments since both first and last dates are not modified. Noting
rm = (1 + 6%)1/12 1 = 0.487% the monthly interest rate:
F V (16) = Am

(1 + rm )121 1
rm
Am = F V (16)
= 141.698
rm
(1 + rm )121 1

4. We note rq = (1 + 6%)3/12 1 = 1.467% the 3m interest rate. The

last payment occurs in 8 (16 1) + 2 = 122 months. The number nq of 3m
payments staring in 2m verifies: 3 (nq 1)+ 5 = 122, which means that nq = 40.
Noting Aq this amount, we have:
F V (16) = Aq

(1 + 1.467%)27 (1 + 0.5%)27
(1 + rq )40 (1 + qq )40
= Aq
r qq
1.467% 0.5%

Aq = 394.993

5. a. Note that the last payment occurs in 2 + 15 8 = 122 months. The

number of 4m payment n4 verifies: 4 (n4 1) + 6 = 122 or n4 = 30 payments.
It implies that there are 10 blocks of 3 constant payments. Each block is a
standard annuity with 3 constant payments Ak (k = 1, . . . , 10), whose future
value at the last payment date is denoted F Vk with:
F Vk = Ak

(1 + r4 )3 1
,
r4

where r4 = (1 + 6%)4/12 1 = 1.961% the 4m interest rate.

The payments Ak grow at the constant rate of 1%, where A1 is the value
that we are looking for. The future value of the 30 payments is therefore equal
to the future value of a geometric annuity with 10 payments. The first payment
3
is F V1 = A1 (1+rr44) 1 and the rate of growth of paymens is 1%. Noting rY =
6% = (1 + r4 )3 1 the yearly interest rate, we obtain:
(1 + r4 )3 1 (1 + rY )1 0 (1 + 1%)1 0
r4
rY 1%
rY (1 + rY )1 0 (1 + 1%)1 0
= A1
r4
rY 1%

F V (12) = A1

or equivalently:
A1 = F V (12)

rY 1%
r4
rY (1 + rY )1 0 (1 + 1%)1 0

= 554.367
b. We need to solve the following equation in rY (remember that r4 =
(1 + rY )4/12 1):
F V (12) = A1

rY
(1 + rY )1 0 (1 + 1%)1 0
rY 1%
(1 + rY )4/12 1

This equation must be solved using a numerical solver (through XL for example).
The solution is rY = 4.391%.
2

Exercise II. Total Return. You are an investor with a 4 year horizon.
You purchase a 6 year standard nominal bond paying every 6 months a 6%
coupon, and at maturity a principal of 100 e. The bond is sold at par. You
make the following assumptions regarding the future:
(i) The first four coupons can be reinvested at a semiannual interest rate of
6% (expressed on a yearly basis) until the end of your investment horizon.
(ii) The next coupons can be reinvested at the rate semiannual interest rate
of 7% (expressed on a yearly basis).
(iii) The required YTM when selling the bond at the end of the 4 years will
be 7% (semiannual interest rate expressed on a yearly basis).
What is the total return of your investment?
Correction. We need to compute the initial investment, the final values of
coupons and the sale price of the bond.
The initial investment is Pp = 100 since the bond is purchased at par.
The future value of coupons is the sum of the future value of the first four
coupons reinvested with a (6m, 6m) interest rate of 3% and the 4 last ones
reinvested with a (6m, 6m) interest rate of 3.5%.
FV = 3

(1 + 3.5%)4 1
(1 + 3%)4 1
(1 + 3%)4 + 3
= 26.771
3%
3.5%

The sale value is the price of a bond with a maturity of 2 years, paying 4
coupons of 3% with a YTM of 3.5%: The sale bond price Ps is:
Ps = 3

1 (1 + 3.5%)4
100
+
= 98.163
3.5%
(1 + 3.5%)4

The semiannual total return (expressed on a yearly basis) over the 4 years
(i.e. 8 periods) is:


1+

8
Ps + F V
=
= 1.249 = 5.644%
2
Pp