Investments: Problem Set

Zero Coupon Bonds & Credit Risk

Problem 1 Part B
1. Calculate the price of a zero coupon with 10-year maturity, par value 100$
assuming that the 10-year zero coupon rate is 5% (per annum)
Solution: 100/(1 + 0.05)10 = 61.3913
2. A 10-year zero coupon with a par value of 1$ is sold for 0.90$. What is the
implied 10-year zero rate?
 1/10
1
Solution: r0,10 = (0.90) 1 = 0.0105917 = 1.05917%

3. Suppose all the interest rates are zero. Do you still need to know both the
maturity and the face value of a zero bond to compute its price?
Solution: No, (1 + 0)T = 1T but 1x = 1 for all values x, the only thing you need
to know is the Par value: the price is equal to the Par value.
4. Why the price of all bonds at maturity is equal to the Par value?
Solution: Because 1$ today is equal to 1$, and because y/(1 + x)0 = y for all
values x because k 0 is always 1 for all values of k
5. Calculate the price of a zero coupon with 10 years maturity, par value 100$
assuming that the 10-year zero coupon rate is 5%, the default and recover
probabilities are 50%, and recovery rate of 50%. Is the price lower or higher of
the same bond in the previous point? Why?
Solution: P = 100 (1 0.5 (1 0.5 0.5))/(1 + 0.05)10 = 38.36957. The
price is lower because the default probability is higher and investors require an
additional reward for risk (default premium)
6. Lets consider the same bond but with default probability of 0%, recover prob-
ability of 100% and recovery rate of 50%. Is the price the same? Why?
Solution: P = 100 (1 0 (1 1 0.5))/(1 + 0.05)10 = 61.39132. The price is
the same because the default probability is 0%
7. Suppose you have bought 2 Italian bonds with Face Value of 105$ for 100$
and one Greek bond for 50$. Assume that the probability of default for both
countries is 50%, compute the expected credit loss
Solution: you can not compute it because you also need the Recovery Rate.
Problem 3 2

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Problem 2 Part A
Suppose that a life insurance company has guaranteed a payment of $14 million to a
pension fund 5.5 years from now. If the life insurance company receives a premium of
$10.4 million from the pension fund and can invest the entire premium for 5.5 years
at an annual interest rate of 6.35%, will it have sufficient funds from this investment
to meet the $14 million obligation?
Solution: To determine the future value of any sum of money invested today, we
can use the future value equation, which is: Pn = P0 (1 + r)n where n = number of
periods, Pn = future value n periods from now (in dollars), P0 = original principal
(in dollars) and r = interest rate per period (in decimal form). Inserting in our
values, we have: P5.5 = $10,400,000(1.0635)5.5 = $14,591,151.19. Thus, it will have
sufficient funds to meet the $14 million obligation, and it would remain $14,591,151.19
? $14,000,000 = $591,151.19.

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Problem 3 Part A
Suppose that the 1-year interest rate today is 3% pa and that 6 months from now
you will observe the following interest rates

9-month interest rate is 2.5% pa

6-month interest rate is 2% pa

3-month interest rate is 1.5% pa

and that 3 months from now you will observe the following interest rates

9-month interest rate is 3.5% pa

6-month interest rate is 3% pa

3-month interest rate is 2.5% pa

1. What would be the price of a 1-year zero coupon bond with par-value of 100$
issued today on the primary market?
P v1 100
Solution: P0 = (1+r 01 )
= (1+0.03) = 97.0874

2. What would be the price of the bond six months from now?
Solution: 6 months from now the bond will have 6 months left to maturity and
we have to use the 6-month interest rate. Using the notation we adopted in
class P6/12 = (1+rP6v1)6/12 = (1+0.02)
100
6/12 = 99.0148
12 1

Investments Problem Set: Zero Coupon Bond and Credit Risk

Problem 5 3

3. Compute the yield-to-maturity of such bond today and 6 months from now
Solution: today is simply r01 = 0.03, six months from now r 6 1 = 0.02
12

4. Will the price of this bond be below par, at par or above par 3 months from
now?
Solution: 3 months from now the bond will have 9 months left to maturity and
we have to use the 9-month interest rate. Using the notation we adopted in
(1)
class P3/12 = (1+rP3v1)9/12 = (1+0.035)
100
9/12 = 97.4529 which is below par
12 1

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Problem 4 Part A
Credit quants infer default probabilities from prices. Suppose two bonds have been
just issued, they both have face value of $100 and a maturity of 5 years. But the
first is risk-free (and has a price of $70) while the second has recovery probability
and recovery rate equal to 50% (and is sold for $40). The spread between the interest
rates of the the risky bond and the default-free bond is 4%. Which is the implied
default probability of the risky bond?
 1
P vT T
Solution: First we compute the interest rate for the safe bond r0T = P0 1 =
  15
100
70
1 = 0.073940, we know the spread between the risky r0T and the safe bond

is r0T r0T = s = 0.04, To find d (default probability) we have to solve this equation

r0T r0T = s r0T = r0T + s

r0T =r0T + s
 P v [1 d(1 mR)]  T1
T
1 =r0T + s
P0
 P v [1 d(1 mR)] 
T
=(1 + r0T + s)T
P0
P0
d(1 mR) = 1 + (1 + r0T + s)T
P vT
1 PPv0T (1 + r0T + s)T
d=
(1 mR)
40
1 100 (1 + 0.073940924 + 0.04)5
d= = 0.5571
(1 0.5 0.5)
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Problem 5 Part A
We can price a coupon bond as a portfolio of zero coupon bonds, lets see how and
why. Suppose the following assets exist

Investments Problem Set: Zero Coupon Bond and Credit Risk

Problem 5 4

1-year zero coupon bond with par value of 1,000$ selling for 952.3810$
2-year zero coupon bond with par value of 1,000$ selling for 889.9964$
3-year zero coupon bond with par value of 1,000$ selling for 816.2979$
coupon bond with 3-year maturity, and 10% coupon rate
Find the price of the coupon bond by pricing each coupon as a zero-coupon bond.
Suppose the price of the coupon bond is 1, 000$, do you see any arbitrage ?
Solution:
First, find the three spot rates (r01 ,r02 and r03 ) needed to price each coupon:
 1/1
1,000$
r01 = 952.3810 1 = 0.05
 1/2
1,000$
r02 = 889.9964 1 = 0.06
 1/3
1,000$
r03 = 816.2979 1 = 0.07

Second, each coupon is equal to 100$ (C = P vT cr = 1000$ 0.1 = 100$ where

cr is the coupon rate). The price of the coupon bond is therefore
C C C + P vT
P0 = + 2
+
(1 + r01 ) (1 + r02 ) (1 + r03 )3
100 100 100 + 1000
= + 2
+
(1 + 0.05) (1 + 0.06) (1 + 0.07)3
=95.23809$ + 88.99964$ + 897.9277$
=1, 082.16540$
95.23809$ is the price of a 1-year zero coupon bond with face value of 100$ and
5% interest rate (per annum), 88.99964$ is the price of a 2-year zero coupon
bond with face value of 100$ and 6% interest rate (per annum), 897.9277$ is
the price of a 3-year zero coupon bond with face value of 1100$ and 7% interest
rate (per annum),
Third, if the price of the coupon bond was 1, 000$ < 1, 082.16540$. You could
Buy the coupon bond for 1,000$
Sell the three zero coupon bonds a) 1-year zero coupon bond with par value
of 100$ and interest rate 5% for 95.23809$, b) 2-year zero coupon bond
with par value of 100$ and interest rate 6% for 88.99964$ c) 3-year zero
coupon bond with par value of 1, 100$ and interest rate 7% for 897.9277$
Pocket the difference -1,000$ + (95.23809$+88.99964$+897.9277) =82.165$
It looks a tiny difference...but it is not if you trade millions of dollars.

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Investments Problem Set: Zero Coupon Bond and Credit Risk