Georgia Institute of Technology
Scheller College of Business
MGT 6769 - Fixed Income Securities
Midterm, February 20th 2013. Prof. Alex Hsu
DO NOT TURN THIS PAGE UNTILL INSTRUCTED TO DO SO
Last Name:
First Name:
GT ID #:
Section Points
A /30
B /40
C /30
Total /100
Instructions
1. I WILL NOT tolerate any forms of cheating during the test.
2. When you finish the test, DO NOT TALK with your classmates until you are outside
of the exam room.
3. Any suspicious activities will be investigated and dealt according to the rules of Georgia
Institute of Technology. Please refer to the GT Honor Code.
4. This exam is designed for exactly 80 minutes. Please use your time wisely.
5. Formulae sheet is provided, only standard non-wifi accessible calculator is allowed.
6. The points allocated to each question are not reflective of the amount of time you
should spend on each question.
7. Unless noted specifically in the question, all cash borrowing and lending rates are
quoted per annum with continuous compounding.
8. If the bond face value is not given, assume that it is $100.
9. All answers are to be written on this exam.
10. I WILL NOT answer any questions during the exam unless you are absolutely sure
that I have made a mistake in setting up the problem.
Signature:
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Part A: Choose the best answer (3 points each)
Choose the best answer from the following multiple choice questions. Please read each
question carefully. Precisely circle your answers.
Question 1
When the zero curve is decreasing, which of the followings is true?
a) The two-year zero rate, R(0, 2), is equal to the one-year zero rate, R(0, 1)
b) The forward rate between year one and year two, i.e. F0 (1, 2) , is lower than the one-year
zero rate, R (0, 1)
c) The forward rate between year one and year two, i.e. F0 (1, 2) , is between the one-year
zero rate, R (0, 1), and the two-year zero rate, R (0, 2) . That is R (0, 1) < F0 (1, 2) <
R (0, 2) .
d) The forward rate between year one and year two, i.e. F0 (1, 2) , is lower than the two-year
zero rate R (0, 2)
e) Two of the above answers are true
f ) None of the above
Question 2
Which of the following is NOT a step you would follow in order to take advantage of the
following arbitrage opportunity (if there is one)? Security A costs $100 and pays $120 in 3
years. Security B costs $100 and pays $110 in one year. Your friend tells you that he would
like you to lend him $110 in a year and that he would give $130 the following year. Finally
you know that in two years, with $130, you can invest in a security that will pay you either
$140 or $121 (with equal probability) after a year.
a) You long security A and short security B.
b) After a year you lend the money to your friend.
c) The next year when he pays back, you invest in the risky security.
d) After the third year, the risky security will give you either $140 or $121.
e) After the third year, you have to pay $120.
f ) Two of the above are wrong.
g) There is no arbitrage opportunity.
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Question 3
When the zero-yield curve is flat, the forward interest rate is
a) Negative
b) Equal to the difference between the ten-year zero rate and the two-year zero rate
c) Equal to the five-year zero rate
d) Equal to the inflation rate
e) Decreasing
f ) None of the above
Question 4
Compute the dirty bond price. Consider a bond with ten years to maturity that pays a
semi-annual coupon of $100 per year. The quoted price of this bond on the Bloomberg
terminal is currently $1000. The last time that this bond issued a coupon payment was 108
days ago. Assume that there are 360 days per year. What is the current dirty bond price?
a) $1020
b) $1030
c) $1050
d) $1060
e) $1080
f ) $1100
g) None of the above
Question 5
Consider two zero-coupon Treasury bonds with 7-year and 1-year to maturity. You can
assume that they both are riskfree and have the same face value. Which of the followings
best describe their relationship? Choose the best answer.
a) The yields (i.e. zero rates) of these two bonds are negatively correlated
b) The 1-year zero-coupon bond price is traded at par
c) The 7-year zero-coupon bond price is traded at a higher price than that of the 1-year
bond
d) The yield of the 7-year bond is higher than the yield of the 1-year zero bond
e) The price of 1-year zero coupon bond is more volatile than the price of 7-year zero coupon
bond
f ) None of the above
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Question 6
Recall our class discussion about the financial crisis based on the video titled “the Crisis
of Credit” and the conversation with regard to the Federal Reserve Bank. Which of the
following statement is false.
a) Subprime mortgages were in high demand by the investors because they paid higher
interests than Treasury bonds but have the same credit rating as the U.S. government.
b) CDS’ are assets backed by underlying loan payments that can be sliced up into different
tranches based on its likelihood of defaulting.
c) Mortgage brokers suffered from moral hazard because they were paid based on the amount
of loans they made.
d) Insurers like American International Group (AIG) sold credit protection to buyers who
did not own the reference entity.
e) The Fed pumped liquidity into the frozen credit market first by lowering the Fed funds
rate then through Quantitative Easing (QE).
Question 7
Assuming that the forward rate between year 1 and year 3, F0 (1, 3), is 5%,and the for-
ward rate between, year 3 and year 4, F0 (3, 4) , is 6%. The current four-year zero rate is,
R(0, 4), is 5%.What is the current one-year zero rate R(0, 1) ? (assume all rates are for
continuouscompounding)
a) 2 %
b) 3 %
c) 4 %
d) 5 %
e) 6 %
f ) None of the above
Question 8
The current government treasury yield curve is flat at 5%. What can you say about the par
bond yield of a 10-year coupon paying bond?
a) The bond par yield is 5%
b) The bond par yield is above 5%
c) The bond par yield is below 5%
d) The bond par yield undetermined
e) None of the above
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Question 9
The one-year zero-coupon bond with face value of $100 is priced at $96 and the two-year
zero-coupon bond with face value of $100 is priced at $90. What is the price of a two-year
bond with face value of $1000 that pays a $150 coupon annually?
a) $1179
b) $1170
c) $1169
d) $1185
e) $1181
f ) None of the above
Question 10
Which of the following is not true
a) A 10-year zero rate is less volatile than a 1-year zero rate.
b) The price of a 10-year zero coupon bond is more volatile than the price of a 1-year zero
coupon bond.
c) The price of a 10-year coupon paying bond is more volatile than the price of a 10-year
zero-coupon bond.
d) The bond’s ask price is higher than the bond’s bid price
e) Forward contracts are subject to counter party risk
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Part B: Short questions (20 points each)
Please write down your answers in the provided spaces. Be concise and label your answers
clearly.
Question 11
The one-year zero-coupon bond with face value of $100 is priced at $[Link] two-year zero-
coupon bond with face value of $100 is priced at $96. The three-year zero-coupon bond with
face value of $100 is priced at $94. The continuous compounding forward rate for three-year
loans starting in one year from now, i.e. F0 (1, 4), is 2.61%. What is the fair price of a
four-year zero-coupon bond with face value of $100?
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Question 12
Assume that the current spot rates for quarterly compounding are:
Spot-rates (quarterly compounding)
R(0,0.5) 5.5%
R(0,1.0) 6.0%
R(0,1.5) 6.5%
R(0,2.0) 7.0%
R(0,2.5) 7.5%
R(0,3.0) 8.0%
What is the price of a 2-year bond that pays 8% coupon semi-annually? The face value of
this bond is $100.
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Part C: Long question
The current time period is t = 0 and assume that the following spot rates are available to
you. All rates are for continuous compounding.
Spot-rates (continuous compounding)
R(0,1) 5%
R(0,2) 6%
R(0,3) 7%
R(0,4) 8%
R(0,5) 9%
R(0,6) 10%
Use the above information to answer questions 15 and 16.
Question 13 (30 points)
The current price of a two-year forward contract on a four-year riskfree bond with a face
value $1000 is $1080. Assume that this underlying bond pays coupons annually. What must
be the current coupon rate of this underlying bond such that there is no arbitrage in the
market? You must show all your work in order to receive the full mark.
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Interest Rates
Simple compounding
A (1 + R(0, T ))T
where R is annualized interest rate from 0 → T , and T is the number of years to compound
the principal A.
When the compounding frequency is something other than annually, use the augmented
formula:
nT
R(0, T )
A 1+
n
Continuous compounding
AeR(0,T )T
Bond price (discounted cash flow method)
T
X CFt
P V (Bond) =
t=1
(1 + Rs (0, t))t
XT
= CFt · exp (−Rc (0, t) · t)
t=1
XT
= B(0, t)CFt , where
t=1
CFt is the cash flow at time t
B(0, t) is the price of the discounted bond paying $1 at time t
Rs (0, t) is the simple compounding spot rates from time 0 to time t
Rc (0, t) is the continuously compounding spot rates from time 0 to time t
Bond price formula
If the bond pays a constant coupon rate c, and y is the discount rate that applies to all
maturities. Then the price of a coupon paying bond with maturity T and the face value of
F is
c×F 1 F
P0 = 1− T
+
y (1 + y) (1 + y)T
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Forward rates
Simple compounding
1
(1 + R (0, y))y
y−x
F (0, x, y) = −1
(1 + R (0, x))x
where F (0, x, y) is the forward rate agreement that is locked in at date t = 0, to be applied
from time x to time y
Continuous compounding
x
F (0, x, y) = R (0, y) + (R (0, y) − R (0, x)) ·
y−x
Yield to maturity
Yield to maturity for a n−maturity coupon paying bond with the cash flow CFi on each
year i = 1..n is
CF1 CF2 CFn
P = + 2 + ...... + ,
1 + y (1 + y) (1 + y)n
where I have assumed simple (annual) compound above.
However, if we use continuous-compounding and assume that the cash flow CFi on each time
ti is
P = CF1 e−y·t1 + CF2 e−y·t2 + ...... + CFn e−y·tn .
Bond par yield
A par bond is a bond with a coupon identical to its yield to maturity. The bond par yield
c (n) is the coupon rate such that a n−year maturity fixed bond that pays such coupon rate
annually is a par bond. Let’s say if $100 is the bond face value, then
100 × c (n) 100 × c (n) 100 + 100 × c (n)
+ 2 + ...... + = 100.
1 + R(0, 1) (1 + R(0, 2)) (1 + R(0, n))n
The bond par yield is thus
1
1− (1+R(0,n))n 1 − B (0, n)
c(n) = Pn 1 = Pn .
i=1 (1+R(0,i))i i=1 B (0, i)
Forward and Futures price
For an underlying security with the present value B0 ,the fair price for a forward contract to
buy/deliver this asset at the future date T is
Continuous compounding
F0 = B0 eR(0,T )T
Simple compounding
F0 = B0 (1 + R(0, T ))T
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Hedging with duration
First-order Taylor approximation of the change in bond price with respect to its yield to
maturity (YTM) is
∆P ' P 0 (y)dy
' ∆$ dy
Dollar duration
For simple compounding with annualized interest rates
T
X ti · Ki
$Dur = ∆$ = − .
i=1
(1 + y)ti +1
For continuous compounding
T
X
$Dur = ∆$ = − ti · Ki e−yti .
i=1
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