Economics 172

Intermediate Finance

Spring 2013

Problem Set 2: Bond Markets

Question 1 The 5.75% coupon, 10-yr US Treasury bond is priced at 100.83. (i) What is its yield? (ii) Its DV01 (dollar duration) is 8.00. If its yield moves instantaneously to 5.69%, what will its price be (as estimated using DV01)? (iii) What is its real new price? (iv) What does this tell us about the accuracy of this 10yr bonds duration as a measure of price sensitivity to very small changes in yield?

Question 2 You have been asked to assist a pension plan which has the following liabilities (i.e., payouts) to fund, at the end of the following 3 years: Year 1 3 5 Liability $3,000,000 $5,000,000 $4,000,000

The pension plan wants to buy three semi-annual US Treasury bonds to fund these liabilities: Bond A: Bond B: Bond C: 1-year maturity, 6% coupon, currently yielding 2.2% 3-year maturity, 4.0% coupon, currently yielding 3% 5-year maturity, 4.25% coupon, currently yielding 3.6%

Assume that you can hold the coupon payments in a bank account which pays no interest. Find the lowest cost portfolio consisting of these 3 bonds that will deliver the required payments. The ps2_bonds.xls spreadsheet contains a template for you to complete that will help solve this optimization problem. All of the yellow highlighted cells need to be completed. Hint: You can solve the problem using Solver in Excel. If you dont have the Solver add-in on your computer, the public cluster computers should have it.

Economics 172

Intermediate Finance

Spring 2013

Problem Set 2: Bond Markets

Question 3 You have just purchased $5 million par amount of the 5yr and 30yr US Treasury bonds shown below, at the prices shown. (Assume all bonds are semi-annual compounding.)

Par Amt $millions 5.00 5.00

Coupon

Bond Maturity 5yr 10yr 30yr

Bond Yield 6.00% 6.00% 6.00%

Bond Price 100.00 99.00 100.50

$Duration (= DV01) 4.00 7.50 13.00

(i) Calculate the market values of the 5yr and 30yr bonds you purchased.

(ii) Calculate the DV01 risk for both of the bonds that you purchased. DV01 risk, for a given bond, is the dollar amount that you would make/lose if the bonds yield moved by 1% instantaneously.

(iii) What par amount do you need to buy or sell of the 10yr US Treasury bond, so that the DV01 risk of the entire portfolio is negligable? (Negligable in this context means less than $100 of DV01 risk over the entire portfolio.) You must calculate the par amount of the 10yr bond to the 3rd decimal place (i.e., to the nearest thousand dollars). (iv) What are the coupons on the three bonds?

(v) Here are the convexity values for the 3 bonds: 5yr convexity = 0.06; 10yr convexity = 0.50; 30yr convexity = 2.30. Using Duration and Convexity, estimate the change in market value of the portfolio to the nearest $1000 if all interest rates increase by 50bp.

(vi) What does the answer in part (v) tell you about using duration alone as a portfolio risk measure? When does convexity work in your favor, in terms of improving on a risk estimate from duration alone? When does convexity work against you?