MSF 501Math with Fin Apps

Exam 1, Fall 2008

Name: _________________________________
Use your notes and books, but absolutely do not look at other exams.

1. (10 points) The formula for a fixed-coupon bond with an infinite maturity (also called a perpetuity) is
y
C
y f V ) (
, where C is the annual coupon paid at the end of the year, and y is the yield to maturity.
Write the formula of the second-order Taylor Series expansion of the bond price around
0
y . That is, find
the formula that approximates ( ) y y f +
0
.
3
0
0
2
0
0
0
0
2
) (
) (
) (
y
C
y f
y
C
y f
y
C
y f

( ) ( )
( ) ( )
1
1
1
]
1

,
_

,
_

+
+ +

,
_

+ +
2
0 0
0
0
2
3
0
2
0
0
0
2
3
0
2
0
0
0
1 ) (
) (
2
2
1
) (
y
y
y
y
y
C
y y f
or
y
y
C
y
y
C
y
C
y y f
y
y
C
y
y
C
y
C
y y f
1
MSF 501Math with Fin Apps
Exam 1, Fall 2008
2. (10 points) Find the duration, modified duration and convexity of a perpetuity with the value of
y
C
y f V ) (
.
What is the duration of the this infinite maturity bond if the yield to maturity is 8%?
3
0
2
0
2
) (
) (
y
C
y f
y
C
y f


Modified Duration =
y C
y
y
C
V y
V 1 1
2

,
_

Duration = Modified Duration * (1 + y) =

5 . 13
08 . 0
08 . 1 1

+
y
y
Convexity =
2 3 2
2
2 2 1
y
C
y
y
C
V
y
V

2
MSF 501Math with Fin Apps
Exam 1, Fall 2008
3. (15 points) We want to find the optimal allocation of assets between a risk-free mutual fund and a risky
stock market fund. The expected return on this allocation is
[ ]
f s f C
R R E w R R E + ) ( ) (
and the volatility of the combined portfolio of risk-free and risky assets is
s C
w
where w is the fraction of wealth allocated to the risk stock portfolio.
An investor has a mean-variance utility function, ( )
2
2
1
) (
C C
A R E U , where A is given and
represents an investors aversion to risk.
a. Maximize the investors utility by finding the optimal weight w. Provide the formula for optimal w.
[ ]
[ ]
2
2
2 2
2
1
) (
*
0 ) (
) (
s
f s
s f s
s f s f
A
R R E
w
Aw R R E
dw
dU
Aw R R E w R U

+
b. How do you know your solution is indeed a maximum?
Check if the second derivative with respect to w is negative. If so, then its a maximum solution.
0
2
2
2
<
s
A
dw
U d
for A >0.
3
MSF 501Math with Fin Apps
Exam 1, Fall 2008
4. (10 points) Find the duration, modified duration and convexity of a bond with a face value of $100, a
maturity of 3 years, paying annual coupons of $10, with a yield to maturity of 5%.
Yea
r
Y(Y+1
)
CF PV(CF)
1 2 10 9.524
2 6 10 9.070
3 12 110 95.022
113.616
Duration =
( ) ( ) ( )
75 . 2
616 . 113
022 . 95 3 070 . 9 2 524 . 9 1

+ +
Modified duration = 62 . 2
05 . 1
75 . 2
05 . 1

D
CX =
( ) ( ) ( )
69 . 9
616 . 113
022 . 95 12 070 . 9 6 524 . 9 2
05 . 1
1
2

+ +
1
]
1

5. (5 points) A 20-year floating rate bond pays annual coupons at the end of each year based one the one-year
LIBOR rate at the beginning of the year (today), which is 5%. If the face value of the bond is $100,000, use
the duration approximation to estimate by how many dollars will this bond change if the LIBOR rate
increases to 5.5% tomorrow?
Duration of bond = 1 year
Modified duration = 9524 . 0
05 . 1
1

V= $100,000
19 . 476 $ 005 . 0 000 , 100 9524 . 0 * y V D V
4
MSF 501Math with Fin Apps
Exam 1, Fall 2008
6. (10 points) Find the determinant and inverse (if possible) of the following matrix.

,
_

0 1 1
4 3 0
4 2 1
( ) ( ) 0 4 1 0 4 1
0 1 1
4 3 0
4 2 1
+

Determinant = 0, so the inverse does not exist.

7. (5 points) Is the following matrix positive definite, negative definite, or neither?

,
_

8 0 0
3 2 0
5 5 1
0 16
8 0 0
3 2 0
5 5 1
0 2
2 0
5 1
0 1
2
2
1
>
>
>
H
H
H
The matrix is POSITVE DEFINITE.
5
MSF 501Math with Fin Apps
Exam 1, Fall 2008
8. (10 points) You are given the following information on a bond and an annuity.
Cash flows
Year 1 Year 2 Price
Bond $60 $1,060 $957.40
Annuity $500 $500 $895.00
a. What is the value of 2-year 30% coupon bond that is consistent with the discount factors implied by
the information provided above? Do NOT calculate the answer. Just provide a formula (involving
matrices) that will give the answer!
1
]
1

,
_

1
]
1

00 . 985
4 . 957
500 500
1060 60
1
2
1
d
d
( )
1
]
1

,
_

00 . 895
4 . 957
500 500
1060 60
1300 300
1
% 30
P
b. Write the matrix formula (using the information provided above) that finds the replicating portfolio of
the 6% coupon bond and $500 annuity that matches the cash flows of the 30% coupon bond. Do NOT
calculate the answer. Just provide a formula (involving matrices) that will give the answer!
( ) [ ]
1
2 1
500 500
1060 60
1300 300

,
_

n n
c. Show that the value of the portfolio constructed in part (b) equals the value you found in part (a).
( )
[ ]

,
_

,
_

,
_

895
40 . 957
500 500
1060 60
1300 300
895
40 . 957
1
2 1
n n V
port
Same as in part a.
6
MSF 501Math with Fin Apps
Exam 1, Fall 2008
9. (10 points) Using the following information to answer the questions below.
Bond Price Duration Convexity
$Dur $CX
2-year $100 1.8 3 171.43 300
5-year $102 4 10
388.57 1020
10-year $105 8 60
800.00 6300
A bonds have a yield-to-maturity of 5%.
a. What is the value, dollar-duration, and dollar-convexity of a butterfly trade that goes long 500 2-year
and 10-year bonds, and shorts 1,000 5-year bonds?
Bond Position Value $Duration $Convexity
2-year 500 $50,000 85,715 150,000
5-year -1000 ($102,000) (388,570) (1,020,000)
10-year 500 $52,500 400,000 3,150,000
Net $500 97,145 2,280,000
Net value = $500
Net dollar-duration = 97,145
Net dollar-CX = 2,280,000
b. By how much will the value of this portfolio change (in dollars) should the yield shift up 50 basis
points (that is, yield increases to 5.5%). You have durations and convexitiesyou can answer this!
( )
( ) ( )
23 . 457 $
72 . 26 73 . 485
005 . 0 000 , 280 , 2 005 . 0 145 , 97
$ $
2
2
1
2
2
1

+
+
+ y CX y D V
7
MSF 501Math with Fin Apps
Exam 1, Fall 2008
10. (10 points) Find the optimal x and y that solved the following equation:
y xy x y x f 5 20 5 ) , ( +
. Is
the answer a maximum or a minimum or neither?
Solve F.O.C.:

,
_

,
_

0
0
5 20
20 5
) , (
x
y
y x f
25 . 0
25 . 0

x
y
Solution
25 . 1 ) 25 . 0 , 25 . 0 ( f
Is it a max? Min?
Check Sufficient Conditions with Hessian:
0 400
0
0 20
20 0
2
1
<

,
_

H
H
H
The Hessian is neither positive definite nor negative definite, so the solution is neither a maximum nor a
minimum.
8