1. Why is the zero coupon yield curve so important/useful in finance?

Why do you think we need to build zero coupon yield curves? (5 marks)

Spot yields can easily be derived from par yields and the computation behind this is shown below. Just like the yield to redemption yield curve the spot yield curve has a common presence in the market. The spot yield is viewed as the true term structure of interest rate, as there is no reinvestment risk involved-in essence; the stated yield is equivalent to the actual annual return, i.e., the yield on a zero-coupon bond of n years maturity is regarded as the true n-year interest rate. Assuming no arbitrage free condition, Since the 6-months bank bill makes only one payment (its a semiannual-pay bond) its spot rate is same as the YTM i.e., 2.550% * 2 = 5.100% The 1-year bond makes two payments, a $ coupon in one year and a $10 payment at maturity in two years. Since the spot rate to discount the 1-year bonds first cash flows must equal its (no-arbitrage) price of $ 1000, we can write: 57.5 + 1,057.5 = $ 1,000 1.02550 (1+1-year spot rate)

From here we can calculate the 1-year spot price as follows;

1,057.5 (1+1-year spot rate) = $ 1,000-56.070 = 943.93

(1+1-year spot rate) = 1.1203 1+1-year spot rate = 1.05845 Therefore, 1-year spot rate = 5.845%*2= Now that we have the 6-months and 1-year spot rate, we can calculate the 2-year spot rate as follows:
57.5 + 1.02550 57.5 (1.05845) + 1057.5 = $ 1,000 (1+2-year spot rate)

1057.5 = 1000-107.395=892.605 (1+2-year spot rate) (1+2-year spot rate) = 1.1847 (1+2-year spot rate) = 1.05813 2-year spot rate = 1.05813-1 = 5.813%

2. Estimate a zero coupon yield curve by using the bootstrapping technique (refer to the excel spreadsheet).

3. Test your model by analysing the relationship between the spot zero coupon yield curve, forward rate curve, and the coupon paying YTM curve. a. See excel chart B.See excel chart c. What do you notice about the relationship between the three yield curves when they are flat, upward or downward sloping? From the curves: When the YTM curve is flat, both the spot rate curve and the forward rate curve tend to be flat; When the YTM curve is downward sloping, both the spot rate curve and the forward rate curve tend to be downward; and When the YTM curve is upward, both the spot rate curve and the forward rate curve tend to be upward. Is this What you would expect? In theory, for an upward sloping yield curve: Fwd Rate > Zero Rate > Par Yield and For a downward sloping yield curve Par Yield > Zero Rate > Fwd Rate

4. What are the limitations of using the bootstrapping method to build a zero coupon yield curve? What other techniques are used to build zero coupon yield curves? The Problems with Bootstrapping include; two bonds with same maturity may have different yields; and the method is limited in application when we have more payment dates than bonds. What are the strengths and weaknesses of these techniques? Therefore, a good solution is to use regression techniques. The problem with regression techniques include: Normal distribution: of error terms for confidence intervals Nonlinearity: in relationships causes problems Heteroscedasticity: variance is not constant. Multicollinearity: Independent variables are correlated-this is where a group explains the dependent variable well, but the effect of each variable cant be estimated properly. Other methods used in valuing bonds include; Building Emerging, Market Yield Curves, and Iterative Methods.

5. Describe the interest rate movements that will hurt BFG Bank and those movements in interest rates that will benefit BFG Bank (5 marks) 6. What issues do you think the ALCO would have thought about when deciding whether to hedge BFG Banks interest rate risk? (10 marks) 7. Is this the appropriate interest rate swap to hedge BFG Banks interest rate risk? Explain your answer. Are there any other swap structures that would be suitable for BFG Bank? 8. Calculate the per annum fixed rate on the interest rate swap suggested by the treasurer of BFG Bank. 9. What issues should the treasurer think about when deciding to use the forward interest rate swap or a series of forward rate agreements?