Scribd
Upload
63 views

End of Chapter Exercises - Answers

Uploaded by

Yvonne
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
63 views

End of Chapter Exercises - Answers

Uploaded by

Yvonne
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 3

1

END OF CHAPTER EXERCISES - ANSWERS

Chapter 20 : Bond Markets

Q1 What is a Treasury ‘strip’?

A1
A conventional long dated coupon paying bond has a large number of coupon payments,
usually payable every 6 months. For example Merrill Lynch or Solomon’s purchase these
bonds and then sell the entitlement to say, the coupon payment in the 20th year to a Pension
Fund. The latter is a “strip”. In the City, in “the old days” of Top Hats and Gentlemen, the
coupon was literally torn off (stripped) from the (paper) bond certificate.

Q2 What are the key features of a bond that determine the yield to maturity?

A2
If a coupon paying bond is held to maturity then the investor receives periodic coupon
payments and the maturity value. In calculating the yield to maturity, all the coupon payments
are assumed to be reinvested at rate equal to the current yield to maturity, until the maturity
date of the bond. In practice of course, these coupons will be reinvested at whatever spot
rates happen to prevail when the coupon payments are actually received and “today” we do
not know what these rates will be. Hence the yield to maturity is really the best approximation
we can make “today” of the average annual “return” from all the cash flows from the bond. If
reinvestment rates in the future for the coupons, turn out to be higher (lower) than the current
yield to maturity then the actual (ex-post) annual return on the bond will be higher (lower) than
the yield to maturity, calculated ‘today’.

Q3 The quoted (clean) price for a UK gilt-edged stock is “£105.21875 xd” (xd = “ex-
dividend”, that is excluding the next ‘dividend’/coupon payment). Will this be the
invoice price paid by the purchaser?

A3
Clean price quoted = £ 105.21875

The gilt has ‘gone’ ex-dividend (xd) so the purchaser will not receive the next coupon
payment. However, the clean price, being the PV of future coupons, does “include” the next
coupon payment. Hence the purchaser needs some compensation. So, the dirty price (i.e.
invoice price paid by the purchaser) will be lower than the (screen quoted) ‘clean price’ to
reflect this ‘loss’ of the next coupon payment. This adjustment is known as rebate interest.

Invoice Price = Clean Price - Rebate Interest

Q4 Assume that you require a 10% (compound) return on a zero coupon bond with a par
(face value) of £1,000 and five years to maturity. What price would you pay for the
bond ?

A4
P = M/(1 + r)n = £ 1000 / (1.10)5 = £ 620.92.

Q5 Consider a 7%-coupon US government bond that has a par value of $1000 and
matures five years from now. The coupon payments are made annually. The current

© K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition


2

yield to maturity (YTM; redemption yield) for such bonds is 8%. Calculate the market
price of the bond and state whether you expect this bond to sell at par, at a premium
(over par), or at a discount.

A5
P = Annuity(n=5, y=8%)*70 + $1000/(1.08)5 = 3.9927 * 70 + 680.5832 = $ 960.07

Because the coupon rate (of 7%) is lower than the YTM, you would expect the bond to sell at
a discount to its par value. This implies that you obtain a capital appreciation over the
remaining life of the bond and this is what leads to the current quoted YTM being higher than
the coupon rate.

Q6 Consider the following German government, coupon bond (i.e. “Bund”) :

Price = € 769.42
Coupon = 7% p.a. (paid every 6 months)
Par value = € 1000
Maturity = 15 years

Show that the semi-annual yield on the bond is y = 5%, so that the yield to maturity
on a "bond equivalent basis" (i.e. simple annual yield) is 10%.

A6
Coupon payments = 0.07 x €1000 = € 70 (i.e. € 35 every six months)
n = 15yrs x 2 = 30 (6-monthly payments)

Assume a semi-annual yield = 5% (every six months) and use this to see if it results in a price
of € 769.42

Price = € 769.42 = annuity(30, 5%) * € 35 + € 1000/(1.05)30

or

€ 769.42 = € 35/(1.05)1 + € 35/(1.05)2 + ... + € 1035/(1.05)30.

If coupon payments are made every six months “the Street” just doubles this to give a quoted
simple (annual) yield of 10% (i.e. “the Street” doesn’t compound the 5%).

Q7 Why are coupon bonds priced using spot yields? What then is the significance of the
yield to maturity (YTM)?

A7
If coupon bonds are not priced using spot rates then there is a potential profit in ‘coupon
stripping’ the bond. This is because each coupon can be sold separately today for PVi = Ci
/(1+ri )i where Ci is the coupon paid at time t = i. Therefore the “fair” or no-arbitrage price of
the coupon bond V is simply the sum of the present values of all the coupon payments plus
the present value of the maturity value M:

n
V = ∑C
i =1
i /(1 + ri ) i + M /(1 + r ) n .

For example, if the quoted price of the coupon bond is P where P < V, then you could buy the
coupon bond for $P and immediately sell off all the coupons (and the payment at maturity, M)
for a total of $V. Hence, today you are guaranteed a riskless arbitrage profit of $(V-P).
Arbitrage by many traders then ensures that the quoted price P will quickly equal V.

© K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition


3

Having calculated the fair price (which will also be the quoted price) then the yield to maturity
is simply the internal rate of return of the bond. That is, it is a rather artificial (but
nevertheless useful) construct, which loosely speaking is a single figure which approximately
represents the expected annual percentage return, if the bond is held to maturity. Hence the
market price of a coupon bond is determined by the current term structure of spot rates and
the YTM is then derived by “arithmetically inverting” the price-yield relationship. The YTM is
therefore consistent with the current market price but the YTM does not determine (in an
economic sense) the price of the bond. It is also the case that the TYM is a complex
weighted average of the set of individual spot rates.

© K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition

You might also like