ECON 251 PSet 4

Andrew Hu Financial Theory February 15, 2014

Problem 1. a. Employing backward induction, the respective prices have been found to be: p0 p1 p2 p3 p4 = 129.6565 = 125.8427 = 121.8764 = 117.7515 = 113.4615

where pt represents the price of the bond at year t. b. Just after the year 3 coupon payment, the owner of the bond will report the yield y as y such that: 1 1 9+ 109 p3 = 1+y (1 + y )2 which solves out to be y = 0.0011 or 0.11%. Marking to market, the investor would report p 4 p3 9 + = 0.04 p3 p3 or 4%. c. At 15%, we have p0 p1 p2 p3 p4 = 84.36166 = 88.01591 = 92.21830 = 97.05104 = 102.6087

Notice that with the shift in interest rate, the bond has gone from being a premium bond (with price greater than face) to being a discount bond (with price less than face).

ECON 251: PSet 4

Andrew Hu

Problem 2. a. The treasury yield curve for the two maturity dates are y1 and y2 such that: 1 105 1 + y1 1 1 100 = 10 + 110 1 + y2 (1 + y2 )2 100 = Solving gives y1 = 0.05 and y2 = 0.10 or yields of 5% and 10% respectively for the 1-yr and 2-yr bonds. b. We proceed by the method of duality. We write: 100 = 1 105 100 = 1 10 + 2 110 which solves and gives 1 = 0.9524 and 2 = 0.8225. Then, the $100 million in 2 years is worth 2 100 = $82.25 million today so we should not pursue the project. Instead, we can buy a combination of 1-yr and 2-yr bonds to generate the same cash-ow at a lower cost. Problem 3. a. The treasury yield curve for the two maturity dates are y1 and y2 such that: 1 105 1 + y1 1 1 105 91.32 = 5+ 1 + y2 (1 + y2 )2 100 = Solving gives y1 = 0.05 and y2 = 0.10 or yields of 5% and 10% respectively for the 1-yr and 2-yr bonds. b. We proceed by the method of duality. We write: 100 = 1 105 91.32 = 1 5 + 2 105 which solves and gives 1 = 0.9524 and 2 = 0.8244. Then, the $100 million in 2 years is worth 2 100 = $82.44 million today so we should pursure the project since we would need $82.44 > 82.35 million to invest at zero-rates to get $100 million in 2 years. c. Despite having the same treasury yield rates from (2) and (3), in one case, the project is worth undertaking and in the other, it is not. This demonstrates that simply knowing the treasury yield rates without knowing the coupon structure is eectively useless. Problem 4. a. To nd the zero prices, we solve simultaneously: 100.1 = 1 101 100.2 = 1 2 + 2 102 100.6 = 1 6 + 2 6 + 3 106 100.5 = 1 5 + 2 5 + 3 5 + 4 105 100.1 = 1 4 + 2 4 + 3 4 + 4 4 + 5 104 2

ECON 251: PSet 4

Andrew Hu

which gives 1 2 3 4 5 = 0.991089 = 0.962920 = 0.838452 = 0.824169 = 0.823399

t t+1

b. Applying the idea that the one year forward rates can be computed as iF t = write the forwards as: iF 0 = 0.008991 iF 1 = 0.029254 iF 2 = 0.148449 iF 3 = 0.017331 iF 4 = 0.000935 c. To determine the yield, we recognize that yt is the yield such that t = 100 . Using excel, we have solved for the yields as below: (1+yt )t y1 y2 y3 y4 y5 = 0.008992 = 0.018972 = 0.057765 = 0.048596 = 0.039776

1, we

t C (t) i=1 (1+yt )t

1 1/t ) 1, giving us: d. To calculate zero yields, we note that the zero yield zt satises zt = ( t

z1 z2 z3 z4 z5

= 0.008991 = 0.019072 = 0.060492 = 0.049533 = 0.039628

e. We recognize that 5 = 100 since right after the coupon payment, there is only the face 1 (C (t + 1) + Pt+1 ) gives: left to be paid. Then, applying backward induction with Pt = 1+ iF
t

p1 p2 p3 p4

= 96.88337 = 93.75445 = 92.49715 = 102.2283 p5 = 100 3

ECON 251: PSet 4

Andrew Hu

f. Just after the year 3 coupon payment, the owner of the bond will report the yield y as y such that: 1 1 4+ p3 = 104 1+y (1 + y )2 which solves out to be y = 0.0822 or 8.2%. Marking to market, the investor would report p4 p3 4 + = 0.148 p3 p3 or 14.8%. Problem 5. Yes, for sure. For example, the investor can opt to charge $1 quarterly. These will net him returns of (1.01)4 = 1.0406 > 1.04 on his dollar. Now suppose he has borrowed 90% of his apartment at 2%. Then, at the end of the year (after selling back), he will have to pay 90 0.02 = 1.80 on interest. As shown above, he can make 4.06 on charging the rent. Therefore, the investor wouldve made 2.26 on his $10 investment. This is a 22.6% return. Problem 6. Assuming the principal is $100, the monthly payment will be about $6.50. From excel, after year 20, there will be a remaining balance of $46.2374. After the coupon 42.004413 payment in year 21, the remaining balance is $42.04413. This means 46.2374 = 0.6507 6.505144 or 65% of the payment went to the principal and the other 35% went to the interest. Problem 7. With an ination rate of 2% and a corresponding mortgage rate of 7%, the annual payment is now $8.05, a signicant jump from the previous rate. This makes it more dicult to get mortgages because the annual rate is higher, making it more dicult for people to be able to pay and get mortgages.