CHAPTER 3: BOND VALUE AND RETURN

PROBLEMS AND QUESTIONS WITH SOLUTIONS

Note on Problems: For problems requiring a number of calculations, the reader may want
to use their own Excel program, a financial calculator, or the Bond Excel Program
available on the text website.

1. Given a five-year, 8% coupon bond with a face value of $1,000 and coupon
payments made annually, determine its values given it is trading at the following
yields: 8%, 6%, and 10%. Comment on the price and yield relation you observe.
What are the percentage changes in value when the yield goes from 8% to 6% and
when it goes from 8% to 10%?

5
80 1,000 1 (1 / 1.08) 5 1,000
V0
t 1 (1.08)
t

(1.08) 5
80
. 08

(1.08) 5
$1,000

5
80 1,000 1 (1 / 1.06) 5 1,000
V0
t 1 (1.06)
t

(1.06) 5
80
.06

(1.06) 5
$1,084.25

5
80 1,000 1 (1 / 1.10) 5 1,000
V0 t
5
80 $924.18
t 1 (1.10) (1.10) .10 (1.10) 5

The problem shows the inverse relationship that exists between the price of a bond and its
rate of return. From 8% to 6%, the percentage change in value is 8.425%; from 8% to
10%, the percentage change in value is 7.582%.

2. Given a 10-year, 8% coupon bond with a face value of $1,000 and coupon
payments made annually, determine its value for the following yields: 8%, 6%, and
10%. What are the percentage changes in value when the yield goes from 8% to 6%
and when it goes from 8% to 10%? Comment on the price and interest rate
relation you observe for this 10-year bond and the price and interest rate relation
you observe for the five-year bond in question 1.

10
80 1,000 1 (1 / 1.08)10 1,000
V0
t 1 (1.08)
t

(1.08) 10
80
.08

(1.08)10
$1,000

10
80 1,000 1 (1 / 1.06)10 1,000
V0 t
10
80 $1,147.20
t 1 (1.06) (1.06) .06 (1.06)10
10
80 1,000 1 (1 / 1.10)10 1,000
V0
t 1 (1.10)
t

(1.10) 10
80
.10

(1.10)10
$877.11

From 8% to 6%, the percentage change in value is 14.72%; from 8% to 10%, the
percentage change in value is 12.289%.

1
Comment: The percentage changes in value for given changes in yields are greater for the
10-year bond than the 5-year bond. This illustrates the bond price relation that the greater
the maturity on a bond the greater its price sensitivity to interest rate changes.

3. Determine the value of a five-year, zero-coupon bond with a face value of $1,000
given it is trading at the following yields: 8%, 6%, and 10%. What are the
percentage changes in value when the yield goes from 8% to 6% and when it goes
from 8% to 10%? Comment on the price and interest rate relation you observe for
this zero-coupon bond and the price and interest rate relation you observe for the
five-year, 8% coupon bond you observe in question 1.

1,000
V0 $680.58
(1.08) 5
1,000
V0 $747.26
(1.06) 5
1,000
V0 $620.92
(1.10) 5

From 8% to 6%, the percentage change in value is 9.7975%; from 8% to 10%, the
percentage change in value is 8.766%.

Comment: The percentage changes in value for given changes in yields are greater for the
5-year, zero-coupon bond than the 5-year, 8% coupon bond than. This illustrates the
bond price relation that the lower the coupon rate on a bond, the greater its price
sensitivity to interest rate changes.

4. Given a five-year, 8% coupon bond with a face value of $1,000 and trading at a
simple annual rate of 9%, determine the values and effective annualized rates given
the bond has the following payment or compounding frequencies:
a. Semi-annual
b. Monthly
c. Weekly

Comment on the relation you observe.

2
 ( 5 )( 2 )
80 / 2 1,000
a. V0 t 1 (1 (.09 / 2)) t

(1 (.09 / 2) ( 2 )( 5)
1 (1 /(1 (.09 / 2)) ( 2)( 5) 1,000
(80 / 2) $960.44
(1 (.09 / 2))
( 2 )( 5 )
(.09 / 2)
( 5 )(12 )
80 / 12 1,000
b. V0
t 1 (1 (.09 / 12)) (1 (.09 / 12) (12)( 5)
t

1 (1 /(1 (.09 / 12)) (12)( 5) 1,000

(80 / 12) $959.86
(1 (.09 / 12))
(12)( 5 )
(.09 / 12)
( 5 )( 52)
80 / 52 1,000
c. V0
t 1 (1 (.09 / 52)) (1 (.09 / 52) ( 52)( 5)
t

1 (1 /(1 (.09 / 52)) ( 52)( 5) 1,000

(80 / 52) $959.76
(.09 / 52) (1 (.09 / 52)) ( 52 )( 5 )

Effective Rates: The effective rate earned for the year is (1+(R A/n))n 1. This rate
includes the reinvestment of interest (or compounding).

n
RA
Effective Rate 1 1
n
2
.09
a. Semiannual : Rate 1 1 9.2025%
2
12
.09
b. Monthy : Rate 1 1 9.3807%
12
52
.09
c. Weekly : Rate 1 1 9.4089%
52

Comment: The effective annual rate increases as the number of compoundings increases.

5. Given a 2-year, zero-coupon bond with a face value of $100 and trading at a simple
annual rate of 10%, determine the bond values given following compounding
frequencies:
a. Monthly
b. Weekly
c. Daily
d. Continuously

Comment on the relation you observe.

3
 100
a. V0 $81.941
(1 (.10 / 12)) ( 2 )(12 )
100
b. V0 $81.8889
(1 (.10 / 52)) ( 2 )(52)
100
c. V0 $81.875
(1 (.10 / 365)) ( 2 )(365)
d. V0 100 e ( 2 )(.10 ) $81.873

Comment: When the compounding becomes large, such as daily compounding, then we
are approaching continuous compounding.

6. Generate the price-yield curve for a zero-coupon bond with a face value of $100
and 260 actual days to maturity using the following annual yields: 4%, 4.25%,
4.5%, 4.75%, 5%, 5.25%, 5.5%, 5.75%, 6%, 6.25%, 6.5%, 6.75%, 7%, 7.25, 7.5%,
7.75%, and 8%. Use actual/actual day count convention.

7. Given a 10-year, 8% coupon bond with a face value of $100 and semiannual
coupon payments:
a. Generate the bonds price-yield curve using annual yields ranging from 5%
to 10% and differing by .5%.
b. What is the price change when the yield increases from 8% to 8.5%?
c. What is the price change when the yield decreases from 8% to 7.5%?
d. Comment on the capital gain and capital loss you observe in b and c.
e. Comment on the features of the price-yield curve.

4
a.

b. The price change when the yield increases from 8% to 8.5% is 3.32.
c. The price change when the yield decreases from 8% to 7.5% is +3.47.
d. The capital gain and capital loss in b and c are not equal in absolute value. This
suggests that gains and losses are not symmetrical.
e. The price-yield curve is convex from below, indicating that the slope gets smaller as
yields increase.

8. Suppose an investor bought a 10-year, 10% annual coupon bond at par (face value
of $1,000 and paying coupons annually) and then sold it 3.5 years later at a yield of
8%. Determine the full price, clean price, and accrued interest the investor would
receive when he sold the bond. Use a 30/360day count convention.
6
100 1000 1 (1 / 1.08) 6 1000
V4 (1 .08) t

(1 . 08) 6
100
.08

(1 .08) 6
$1,092.46
t 1
1,092.46 100
V3.5 1,147.45
(1.08) .5
Accrued Interest (.5)(100) 50
Clean Pr ice Full Pr ice Accrued Interest
Clean Pr ice 1,147.44 50 1,097.45

9. What would an investor pay for a four-year, 9% annual coupon bond (face value of
$1,000 and paying coupons annually) if the bond were trading to yield 10%? What
would the investor receive (full price) if she sold the bond 3.5 years later and bonds
with maturities of .5 years were trading at 8%? Use 30/360 day count convention.

Purchase Price = $968.30, Selling Price (full) = $1,048.85

5
 4
$90 $1,000 1 (1 / 1.10) 4 1,000
V0 (1.10) t

(1.10) 4
$90
.10

(1.10) 4
$968.30
t 1

$1,000 $90
V3.5 $1,048.85
(1.08) .5

10. Determine the actual prices a dealer would pay (bid) or sell (ask) on the following
bonds:
a. A Treasury bond with $1,000 face value quoted by a dealer at a bid price of
95-4 per $100 face value and fractions in 32nds.
b. A Treasury bond with $1,000 face value quoted by a dealer at an asked price
of 110-4+ per $100 face value with 4+ indicating fractions in 64th.
c. A corporate bond with $1,000 face value quoted by a dealer at a bid price of
97 per $100 face value with fractions in 100ths.
d. A zero-coupon bond with maturity of one year quoted at an asked price to
yield 550 basis points.
e. A T-bill maturing in 52 days and paying $10,000 face value and quoted by a
dealer at an asked annual discount yield of 4%.

a. The dealer would offer to buy the bonds from investors at $951.25: ((95 +
(4/32))/100) ($1,000) = (95.125/100)($1,000) = $951.25.
b. The dealer would be willing to sell the bond for $1,100.625: (110.0625/100)
($1,000) = $1,100.625.
c. The dealer would be willing to buy the bond for $975: (97.5/100)($1,000) = $975.
d. The dealer would sell the bond for $947.87: $1,000/(1.055) = $947.87.
e. The dealer is willing to sell the bond for $9,942: $10,000[1 .04(52/360)] =
$9,942.

11. Suppose you have an A-rated bond with an 8% annual coupon, face value of
$1,000, and due to mature in five years. Presently, the YTM on such bonds is 10%.
You expect the Federal Reserve will tighten credit and force yields up by 50 basis
points in the near future. Determine todays price and the expected price.

5
80 1,000 1 (1 / 1.10) 5 1,000
V0
t 1 (1.10)
t

(1.10) 5
80
.10

(1.10) 5
924.18

5
80 1,000 1 (1 / 1.105) 5 1,000
V0
t 1 (1.105)
t

(1.105) 5
80
.105

(1.105) 5
906.43

12. Suppose the AIF Company sold a bond with a 10-year maturity, $1,000 principal
and an annual 10% coupon paid semiannually. What would be the price of the
bond if two years after the bond were issued the promised YTM were 12%? What is
the effective YTM?

( 2)(8) 100 / 2 1000 1 (1 / 1.06)16 1000

V0 50 898.94
t 1 (1 (.12 / 2)) t (1 (.12 / 2))16 . 06 (1.06)16

6
Effective Yield (1.06) 2 1 .1236
 13. Define the following rates of return measures:
a. Discount Yield
b. Interest Rate
c. Coupon Rate
d. Current yield
e. Rate on Perpetuity
f. Yield to Maturity
g. Average Rate to Maturity (yield approximation formula)
h. Bond Equivalent Yield
i. Yield to Call
j. Yield to Put
k. Yield to Worst
l. Bond Portfolio Yield
m. Logarithmic Return
n. Spot Rate
o. Total Return
p. Geometric Mean

a. Discount yield is the bond's return expressed as a proportion of its face value.
b. Interest rate was the term used to refer to the price a borrower pays a lender for a
loan. Today, it often referred to the yield to maturity on a bond.
c. Coupon rate is the contractual rate the issuer agrees to pay each period; it is
expressed as the annual coupon per the bonds face value.
d. Current yield is the ratio of its annual coupon to its closing price.
e. Rate on perpetuity: A perpetuity, or consul, pays a fixed amount of coupons forever.
If the bond is priced in the market to equal Vb0, then the rate on the bond would be
equal to the current yield: R = C/ V b0. When a coupon bond has a long-term maturity
(e.g., 20 years), then it is similar to a consul and its current yield is a good
approximation of its rate of return.
f. Yield to maturity is the yield that equates the purchase price of the bond to the present
value of its future cash flows. It is the most widely used measure of a bond's rate of
return.
g. Average rate to maturity (yield approximation formula) is the average return per year
as a proportion of the average price of the bond. It is used to estimate the yield to
maturity.
h. Bond equivalent yield is the rate obtained by multiplying the simple semiannual
periodic rate by two. Bonds with different payment frequencies often have their rates
expressed in terms of their bond-equivalent yield so that their rates can be compared
to each other on a common basis.
i. Yield to call, YTC, is the yield obtained by assuming the bond is called on the first
call date.
j. Yield to put, YTP, is the yield obtained by assuming the bond is put on the first put
date.
k. Yield to worst is the minimum of the YTM, YTC, and YTP

7
l. Bond portfolio yield is the yield that will make the present value of bond portfolio's
cash flow equal to the market value of the portfolio.
m. Logarithmic return is the rate of return expressed as the natural log of the ratio of its
end of the period value to its current value.
n. Spot rate is the rate on a zero-coupon bond.
o. Total return is the rate earned on a bond for the period from when the bond is bought
to a specified horizon date (which could be either maturity or a date prior to
maturity), with the assumption that all coupons paid on the bond are reinvested to that
date.
p. Geometric mean is the geometric average of the current rate and the implied forward
rates.

14. Using the average rate to maturity (yield approximation formula) approach,
estimate the YTM on a 20-year, 7% annual coupon bond, with a face value of
$1,000, annual coupon payments, and currently priced at $901.82. What is the
value of the bond using the ARTM as the discount rate?

70 [(1,000 901.82) / 20]

ARTM .078776
(1,000 901.82) / 2

20 70 1,000
V0 = t +
t =1 (1.078776) (1.078776) 20
1 (1 / 1.078776) 20 1,000
= 70 +
.078776 (1.078776) 20
= $913.04

15. Suppose the 20-year, 7% annual coupon bond in Question 14 had a call option
giving the issuer the right to buy the bond back after five years at a call price of
1,000. Given the bond is priced at $901.82, estimate its yield to call using the yield
approximation formula (average rate to call, ARTC) approach.

70 [(1,000 901.82) / 5]
ARTC .0942634
(1,000 901.82) / 2

16. A zero-coupon Treasury bill maturing in 150 days is trading at $98 per $100 face
value. Determine the following rates for the T-bill:
a. Dealers Annual Discount Yield
b. YTM (use an actual/365 day count convention)
c. Logarithmic Return (use actual/365 day count convention)

Explain the differences in the rates.

8
 100 98 360
a. Discount Yield .048
100 150
365 / 150
100
b. YTM 1 .05039
98
ln(100 / 98)
c. Log Re turn .04916
150 / 365

The dealers discount yield is the bills return expressed as a proportion of its face value
instead of the investment; the yield measure also uses a 360 day-count convention. The
YTM is the bills return expressed as a proportion of the price paid. The logarithmic
return is based on the return as proportion of the price and assumes continuous
compounding.

17. ABC Trust has the following bond portfolio:

Bond Maturity Annual Coupon Face Price per $100 Face

(years) Value Value
A 1 0 100 92.59
B 2 8% 100 100.00
C 3 7% 100 97.42
D 4 10% 100 106.62
E 5 9% 100 104.00
500.63

The coupon bonds in the portfolio all pay coupons annually and all the bond prices are
quoted per $100 face value to yield 8%.
a. Explain how the bond portfolios YTM is calculated.
b. Determine the bond portfolios YTM using a financial calculator, Excel program,
or by trial and error (hint: try YTM = 8%).
c. Does the portfolios YTM equal the weighted average yield of the bonds? If so, is
this always the case?

a. The yield for a portfolio of bonds is found by solving for the yield that makes the present
value of the portfolio's cash flow equal to the market value of the portfolio.
P Port 92.59 100 97.42 106.62 104 500.63
134 134 126 119 109
500.63
(1 y) 1
(1 y) 2
(1 y) 3
(1 y) 4
(1 y) 5
y .08

b. Yield = 8%:

c. With all the bonds priced to yield 8%, the weighted average of the bond portfolio is 8%
in this problem. This is not always the case.

9
18. Bond A is a 10-year, 10% coupon bond with a face value of $1,000 and annual
coupon payments. The bond is currently priced at $1,064.18 to yield 9%.
a. Define the bond-equivalent yield.
b. Explain how Bond As bond equivalent yield is calculated.
c. Calculate Bond As bond equivalent yield using a financial calculator, excel
program, or by trial and error.
d. What is the importance of the bond equivalent yield?

a. The bond-equivalent yield is the rate obtained by multiplying the simple

semiannual periodic yield by two.
b. For Bond A, the yield is found by solving for the yield that equates the
$1,064.18 price of the bonds to the present value of its semiannual cash flows and
then annualizing that rate by multiplying the semiannual yield by 2.

c.
20
501,000
1,064.18 (1 y)
t 1 (1 y) 20
t
.045063

Bond Equivalent yield (2)(.045063) .09013

d. Treasury bonds and most U.S. corporate bonds pay coupon interest semiannually and
have their yields quoted on a simple annual basis. Determining a bonds equivalent
yield allows bonds to be compared on a common basis.

19. Suppose A-rated bonds were trading in the market at YTM of 10% on all
maturities, and you bought an A-rated, 10-year, 9% coupon bond with face value of
$1,000 and annual coupon payments. Suppose that immediately after you bought
the bond the yield on such bonds dropped to 8% on all maturities and remains
there until you sold the bond at your horizon date at the end of four years.
a. What price did you pay for 10-year, 9% coupon bond?
b. Show in a flow matrix (similar to Figure 2.4a) the coupons you received on
the bond and their values at your horizon date from reinvesting.
c. What is the price of the original 10-year bond at your horizon date?
d. What is your horizon date value and total return?

a.

10
90 1,000 1 (1 / 1.10)10 1000
Current Pr ice : V0
t 1 (1.10)
t

(1.10) 10
90
.10

(1.10)10
938.55

b.

0 1 2 3 4 HD
$90 $90(1.08)3 $113 .37
$90 $90(1.08) 2 $104.98
10
$90 $90(1.08) $97.20
$90 $90.00
$405.55
 c.
d. 6
90 1,000
P6 (1.08)
t 1
t

(1.08) 6
1,046.23
HD Value $1,046.23 $405.55 $1,451.78
1/ 4
1,451.78
TR 4 1 .1152
938.55

20. Given a 10year, 10% coupon bond with semiannual payments, $1,000 face value,
and currently trading at par, calculate the total return for an investor with a 5-year
horizon date, given the following interest rate scenarios:
a. Yields on such bonds stay at 10% on all maturities until the investor sells
the bond at her horizon date.
b. Immediately after the investor buys the bond, yields on such bonds drop to
8% on all maturities and remain there until the investor sells the bond at
her horizon date.
c. Immediately after the investor buys the bond, yields on such bonds increase
to 12% on all maturities and remain there until the investor sells the bond at
her horizon date.

HD1
(1 ( R A / 2)) HD 1
a. Coupon Values ( C A
/ 2)(1 ( R A
/ 2)) t
( C A
/ 2)
( R A / 2)

t 0
( 2 )( 5 ) 1
(1.05) ( 2 )( 5) 1
Coupon Values 50(1.05 ) t
50
.05
628.89
t 0
( 5 )( 2 )
100 / 2 1,000
P5b
t 1 (1 (.10 / 2)) (1 (.10 / 2))10
t

1 (1 / 1 (.10 / 2)) ( 2 )( 5) 1,000

(100 / 2) 1000
(1 (.10 / 2))
( 2 )( 5 )
(.10 / 2)
HD Value 1,000 628.89 1,628.89
1,628.89 1 / 10
TR 5 2 1 .10
1,000

Comment on the relation between ARR and interest rates.

11
 ( 2 )( 5 ) 1
(1.04) ( 2 )( 5 ) 1
b. Coupon Values 50(1 . 04 ) t
50
.04
600.31
t 0
( 5 )( 2 )
100 / 2 1,000
P5b
t 1 (1 (.08 / 2)) (1 (.08 / 2))10
t

1 (1 / 1 (.08 / 2)) ( 2 )( 5 ) 1,000

(100 / 2) 1081.11
(.08 / 2) (1 (.08 / 2)) ( 2 )( 5)
HD Value 600.31 1081.11 1681.41
1,681.41 1 / 10
TR 5 2 1 .1067
1,000

( 2 )( 5 ) 1
(1.06) ( 2 )( 5) 1
c. Coupon Values 50(1. 06 ) t
50
.06
659.04
t 0
( 5 )( 2 )
100 / 2 1,000
P5b
t 1 (1 (.12 / 2)) (1 (.12 / 2))10
t

1 (1 / 1 (.12 / 2)) ( 2 )( 5) 1,000

(100 / 2) 926.40
(. 12 / 2) (1 (.12 / 2)) ( 2)( 5)
HD Value 659.04 926.40 1,585.44
1,585.44 1 / 10
TR 5 2 1 .0943
1,000

Comment: Interest rate changes have a direct impact on the interest earned from
reinvesting coupons and an inverse impact on the bonds price. In this problem, the
inverse effect of rate changes on the bonds price dominates the direct effect rate changes
have on the interest earned from coupon reinvestment. As a result, the total return is
inversely related to interest rate changes. The uncertainty of interest rate changes on a
bonds return is known as market risk. This risk is examined in Chapter 5.

21. Given the following spot rates on 1-year to 4-year zero coupon bonds:

Year Spot Rate

1 8.0%
2 8.5%
3 9.0%
4 9.5%

a. What is the equilibrium price of a four-year, 9% coupon bond paying a

principal of $100 at maturity and coupons annually?

12
 b. If the market prices the four-year bond such that it yields 10%, what is the
bonds market price?
c. What would arbitrageurs do given the prices you determined in (a) and (b)?
What impact would their actions have on the market price?
d. What would arbitrageurs do if the market price exceeded the equilibrium price?
What impact would their actions have on the market price?

a.
9 9 9 109
P0* 2
3
98.75
1.08 (1.085) (1.09) (1.095) 4

b.
4 9 100 1 (1 / 1.10) 4 100
V0 t
4
9 96.83
t 1 (1.10) (1.10) . 10 (1.10) 4

c. An arbitrageur could (1) buy the four-year bond in the market for 96.83, (2) strip it
into four pure discount bonds, PDB: 1-year PDB paying F = 9 at maturity, 2-year
PDB paying F = 9 at maturity, 3-year PDB paying F = 9 at maturity, and 4-year PDB
paying F =109 at maturity, and (3) sell each of the strips. The arbitrageur would be
able to sell the stripped PDBs at prices reflecting the spot rates. The total proceeds
from the sale would be 98.75. Thus, the arbitrageur would realize a risk-free profit
equal to the difference between the equilibrium price and the market price: 98.75
96.83 = 1.92. In trying to buy the bond and strip it, arbitrageurs would be increasing
the demand for the four-year bond, pushing its price up until the arbitrage disappears;
thus the market price would be pushed toward the equilibrium price of 98.75.

d. If the market price of the four-year bond exceeded 98.75, at say 100, then
arbitrageurs could (1) go into the market and buy four PDBs (1-year PDB paying F =
9 at maturity, 2-year PDB paying F = 9 at maturity, 3-year PDB paying F = 9 at
maturity, and 4-year PDB paying F =109 at maturity), (2) bundle them to form a four-
year, 9% coupon bond, and (3) sell the bundled bond. By doing this, arbitrageurs
would earn a risk-free profit of 1.25. As arbitrageurs try to sell their bundled coupon
bond they would push the price of the four-year, 9% coupon bond down to 98.75
where the arbitrage disappears.

22. Given a one-year zero-coupon bond trading at 100 and promising to pay 106 at
maturity and a two-year 6% coupon bond with face value of 100, annual payments,
and trading at 96.54:
a. Determine the one-year and two-year spot rates.
b. What is the equilibrium price of a comparable two-year 8% annual coupon
bond (F = 100)?

a. Use bootstrapping techniques:

13
 106
S1 1 .06
100
6 106
96.54
1.06 (1 S 2 ) 2
1/ 2
106
S2 1 .08
90.8796

b.
8 108
P0* 100.14
1.06 (1.08) 2

23. Using the geometric mean show four expressions for the yield to maturity on a
four-year bond, YTM4.

4
YTM 4 (1 y1 )(1 f11 )(1 f12 )(1 f13 ) 1
4
YTM 4 (1 y 2 ) 2 (1 f12 )(1 f13 ) 1
4
YTM 4 (1 y1 )(1 f 21 ) 2 (1 f13 ) 1
4
YTM 4 (1 y1 )(1 f 31 ) 3 1

24. Bond X is a one-year zero with face value of 1,000 trading at $945 and Bond Y is a
two-year zero with a face value of 1,000 trading at $870:
a. Determine algebraically the implied forward rate f11.
b. Explain how the forward rate can be attained by a locking-in strategy.

a. The YTM on Bond X and Bond Y are:

1,000
YTM X 1 .058201
945
1/ 2
1,000
YTM Y 1 .0721125
870

The YTM on Y (the 2-year bond) is the geometric average of YTM on X (the 1-year
bond) and the implied forward rate on a one-year bond one from now:

YTM 2 [(1 YTM1 )(1 f11 )]1 / 2 1

Solving for f11 and then substituting in YTM values for X and Y into the resulting
equation yields an implied forward rate of 8.62%:

14
 (1 YTM 2 ) 2
f11 1
(1 YTM1 )
(1.0721125) 2
f11 1 .0862
(1.058201)

b. Locking-in Strategy:

(1) Sell X short at $945

(2) Buy $945/$870 = 1.0862 issues of Y
(3) After one year, cover short bond: cost = $1,000
(4) At the end of year 2 (one year after covering the short position) receive
(1.0862)$1,000 = $1,086.20 from original 2-year bond.

Rate on one-year investment made one year from the present period:

$1,086.20 $1,000
R 11 .0862
$1,000

25. Explain how you would lock in the following implied forward rates: f11, f21, and f23.

Use fmt rule: Short in t-bond and long in m + t bond.

f11: Short in 1-year bond (t) and long in 2-year (m + t) bond. After one year, you
would cover your short position using your funds and then one year later you would
collect on the original 2-year bond investment. Thus, the strategy results in a one-
year investment to be made one year from now.

f21: Short in 1-year bond (t) and long in 3-year (m + t) bond. After one year, you
would cover your short position using your funds and then two years later you would
collect on the original 3-year bond investment. Thus, the strategy results in a two-
year investment to be made one year from now.

f23: Short in 3-year bond (t) and long in 5-year (m + t) bond. After three years, you
would cover your short position using your funds and then two years later you would
collect on the original 5-year bond investment. Thus, the strategy results in a two-
year investment to be made three years from now.

26. Given that current 182-day T-bills are trading at a YTM of 4% and 91-day bills are
trading at YTM of 3.75%, what is the implied forward rate on a 91-day T-bill, 91
days from now? Explain how you would lock in the implied forward rate.

YTM 182 [(1 YTM 91 ) 91 / 365 (1 f 91,91 ) 91 / 365 ]365 / 182 1

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 Solving for f91,91:

365 / 91
(1 YTM182 )182 / 365
f 91,91 91 / 365
1
(1 YTM 91 )
365 / 91
(1.04)182 / 365
f 91,91 91 / 365
1 .0425
(1.0375)

Strategy: Price on the T-bills per $100 face value are P(91) = 100/(1.0375) 91/365 =
99.08637 and P(182) = 100/(1.04)182/365 = 98.0633. To lock in an implied forward rate on
a 91-day investment to be made 91 day from now, one could: (1) Short the 91-day bill:
borrow the bill and sell it for 99.08637 (or borrow 99.08637 at 3.75% interest). (2) Use
99.08637 proceeds from the short sale to buy 99.08637/98.0633 = 1.0104327 issues of
the 182-day bill. (3) At the end of 91 day, cover the short position: cost = 100 (equivalent
of a 100 investment made 91 days in the future. (4) At the end of 182 days (91 days after
covering the short position) collect on the 182-day investment: 1.0104327(100) =
101.04327.

Annualized rate on 91-day investment made 91 days from now would be 4.25%:

365 / 91
101.04327
R 91,91 1 .0425
100

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