Formula 1. Real versus nominal interest rates CPI te+!

CPI t 1+ i ir = 1 , where i = nominal interest rate and e = expected rate of inflation e = CPI t 1+ e Note: Inflation index bonds fix the real interest rate and nominal rate depends upon the rate of inflation.
_ _ Variance = p1 x1 x + p2 x2 x + ........ 2 2

S tan dard _ deviation = Variance

9. Option embedded bonds (i) zero coupon bond (guaranteed portion) (ii) call option with strike price, S0

2.

Bootstrapping, spot rates, YTM, forward rates a) To calculate spot rates:

Pb =
b)

C C C C+M (find zn) + + + ...... + (1 + z1 ) (1 + z1) 2 (1 + z1 )3 (1 + zn ) n

Pricing the call option, e.g. shown below Investment horizon = 5 years PV($1,000 repayment in 5 years) + PV(0.947calls) = PV(todays investment) Assuming annual rate of return of comparable CD is 6%, then solve for c as shown below:
1

To calculate forward rates of 1-period, 2-periods.up to n-periods:

1 period it ,t +1 =

(1 + i0,t +1 )t +1 (1 + i0,t )t

1
1/ 2

e.g. i23 =

(1 + i03 )3 (1 + i02 ) 2

1
1/ 2

(1 + i0,t + 2 )t + 2 2 period it ,t + 2 = (1 + i )t 0, t

(1 + i04 ) 4 e.g. i24 = (1 + i ) 2 02

1000 (1 + 0.06)5

+ 0.947c = 1,000

n period it ,t + n

(1 + i0,t + n )t + n = (1 + i )t 0, t

1/ n

e.g. i25

(1 + i05 )5 = (1 + i ) 2 02

1/ 3

Note: YTM = spot rate for zero-coupon bond. 3. Bond price a) Taking individual periods spot rates as discount rate

Pb =
b)

C C C C+M + + + ...... + (1 + z1 ) (1 + z1 ) 2 (1 + z1 )3 (1 + zn ) n
Taking YTM as each periods discount rate

1 1 C C C C+M (1 + YTM / 2) n Pb = + + + ...... + = C (1 + YTM / 2) (1 + YTM / 2) 2 (1 + YTM / 2)3 YTM / 2 (1 + YTM / 2) n For annual coupon/annual compounding, use YTM in place of YTM/2.
4. Total return of bond a) Coupon + interest on interest (at reinvestment rate, r1 for n1 period)

M + (semi annual coupon/compounding) (1 + YTM / 2) n

10. Futures

(1 + r1 ) n1 1 X = C r1
b) X above reinvested at rate of r2 for n2 period Y = X (1 + r2 )n2 c) Coupon + interest on interest (at reinvestment rate, r3 for n3 period)

Long position buy futures Short position sell futures Futures price - buyer will realize profits (long position) Futures price - seller will realize profits (short position) Eurodollar futures 3 month LIBOR is the underlying asset. 1 tick = 1 basis point = $25 e.g. index price = $94.52 3-month LIBOR = 100 94.52 = 5.48% If i , then price long position (buyer) benefits If i , then price short position (seller) benefits Futures notation Price is 90-16 means 90 + 16/32 = $90.50 Using futures to control interest rate risk of a portfolio Considering immunization concept,

d)

(1 + r3 ) n3 1 Z = C r3 Expected price of bond at end of investment horizon, t M + (1 + reqd _ rate / 2)( n t )

1 1 (1 + reqd _ rate / 2)( n t ) Pb = C reqd _ rate / 2

Therefore, total dollar return, TDR = X + Y + Z + Pb TDR Total return, TR = Pr ice

1/ t

e)

(in semi annual form) (in annual form) (in annual form)

Approximate number of future contracts ( DT DI ) PI n= DF PF Note: Assignment 2 on arbitrage pricing Simultaneous transactions in 110-day T-bills and 90-day T-bill futures contracts 1 F R0,T = ln to calculate yield/return N V F futures price of contract maturing in 20-days V T-bill price maturing at 110-days N = 20/365 Strategy: 1) Sell the 110 day T-bill for $97.90 2) Lend the proceeds for 20 days at the 2-day spot rate of 8.0% 3) Simultaneously go into a long position for a 90-day T-bill futures contact @ $98.30 per $100 face value.

Bond equivalent return = 2 x TR Effective rate of return = TR2 1

f)

Callable bonds YTC Using financial calculate to compute YTC (semi annual coupon bond) FV = call price PV = - current bond purchase price PMT = coupons N = periods I/Y = YTC/2

YTC = I/Y x 2
g) Breakeven reinvestment rate (i) zero coupon bond semi annual coupon bond (ii)

Total return of zero coupon bond = Total return of semi annual coupon bond = Par value + (coupon + interest on interest)

Therefore, (coupon + interest on interest) = (total return on zero coupon bond par value of coupon bond) X=y+z Using financial calculate to compute breakeven reinvestment rate (semi annual coupon bond) FV = (y + z) PV = 0 PMT = coupons N = periods I/Y = breakeven reinvestment rate (semi annual) multiply by 2 to get annual rate.
h) Portfolio total return (i) Weighted average method Portfolio total return (ii) i. Calculate the return of each bond in portfolio and sum them up ii. Calculate total dollar return and hence total return. Scenario analysis (i) d, discount rate to calculate expected price of bond at end of investment horizon as d varies r, reinvestment rate of coupon to calculate (coupon + interest on interest) (ii)

i)

TDR = (i) + (ii)

5. Duration of bond (express everything in years annualize all) 1 + i 1 ic D = H + n(1 H ) x ( years) i i 2 For zero-coupon bond, D = n /2 years; for par value bond (i=c), D = M P n (1 + i ) H = P D Modified _ Duration _ MD = (note D is in years and i is semi annual if bond is semi annual and annual if bond is annual) (1 + i )

1 + i 1 H x i 2

Given a % change in interest rate, I (annual),

6. Convexity PVCFt * t (t + 1) Convexity = 4 * (1 + i / 2) 2 * price

Approximate % in price = MD x i Approximate % in price = MD x i + 1/2 x convexity x (i)2

Given a % change in interest rate, I (annual),

CRITICAL ASSUMPTION IN 5 AND 6 IS THAT THE YIELD CURVE IS FLAT AND SHIFTS IN PARALLEL. 7. 8. Portfolio duration (or modified duration) Used weighted average method Application of duration for commercial banks asset liability management Short term income gap analysis: GAP = RSA RSL Long term duration gap analysis: Approximate % in price = MD x i Change in income, I = GAP x i (annual) Change in banks net worth = (%Passet x asset market value - %Pliability x liability market value)