EMLyon Business School

Fixed Income Home Work Course of Fran

cois Le Grand
Sixth homework

Exercise I. Price and duration. We suppose that the current yield curve is
the following one:
Maturity (Y)
1
2
3
4
5

Yield
1.20%
1.80%
2.25%
2.60%
2.85%

Maturity (Y)
6
7
8
9
10

Yield
3.05%
3.20%
3.30%
3.35%
3.40%

We consider a bond, paying every year a coupon c (expressed as a percentage

of the principal), and at the last payment date a principal M . The first coupon
is paid in 1 year and there are T payments.
The three following bonds are traded on the market:
Bond
A
B
C

Coupon
9.00%
0.00%
4.60%

Maturity (in years)

2
5
10

1. Compute the price of bonds A, B and C.

2. Compute the modified durations of bonds A, B and C.
3. You want to invest 100 k e in a portfolio with a modified duration of 4.861
years (check that this is the modified duration of bond B).
a. What are the two possible portfolios (explicit the amount you have to
invest for each portfolio)?
b. How could you select one of the portfolios? (do not simply give intuitions, but make additional computations if necessary)
c. Which portfolio do you prefer if you expect that all yields increase by
100bp? (this is a parallel shift of the curve) Same question for a decrease of
100bp. Same question if you expect the first three yields to increase respectively
by 50, 40 and 30bp (and other yields remain constant)? Conclude about the
selection of portfolios.
Correction.
1. 2. We use the formulas seen in class and find:
Bond
A
B
C

Price
114.073%
86.892%
110.807%

Mod. Duration (in y.)

1.889
4.861
8.034

I detail the computations for bond A:

9%
109%
+
1 + 1.2% (1 + 1.8%)2
114.073%

PA =

and for the modified duration:



1
109%
9%
M oDA =
+2
1
PA
(1 + 1.2%)2
(1 + 1.8%)3
1.889 years.
3. a. Since the target duration is equal to the modified duration of bond
B, we have two possible portfolios: the bullet (everything invested in B) and
the barbell (investment in both A and C). More precisely (I assume that the
principal of bond is equal to 1e):
the bullet: quantity xB such that xB PB = 100ke and xB 115086 bonds;
the barbell: the quantities xA and xC of bonds A and C are such that
A +xC PC DC
xA PA + xC PC = 100ke and xA PxAAD
= 4.861 years. We find:
PA +xC PC
xA 45255 bonds A and xC 43659 bonds C.
b. We pick up the portfolio with the largest convexity, in that case the
barbell (convexity of 41.49 years2 , while the bullet has a convexity of 28.36
years2 ). The portfolio with the largest convexity provides a better hedge
only in case of parallel shifts of the curve (i.e., changes in the level of the
curve).
c. In case of parallel shift of the curve (both + or 100 bp), you prefer
the portfolio wuth the largest convexity, i.e., the barbell.
In case of an increase in short rates, you can check that the price of the
bullet in not affected, while the price of the barbell decreases (shifts from
100ke to 99.567ke if the explicit computation is made). The reason is
that bullet contains only a zero-coupon bond with a maturity that is not
affected by the increase in short rates. On the contrary, the barbell embeds
a bond with a short maturity (bond A), which is affected with the rise in
the short end of the curve.
The selection of portfolios when several movements of the yield curve are
possible is ambiguous and depends on the type of risks the investor desires
to hedge: in case of hedging a change in the level, one prefers a portfolio
with a large convexity, but the opposite may hold in case of hedging a
change in the slope.

Exercise II. Bootstrap. We suppose that the following bonds, paying annual
coupons, are traded at par on the market.
Bond
A
B
C
D

Coupon
4.50%
5.20%
6.70%
7.40%

Maturity (in Years)

1
2
3
4
2

Use the bootstrap method to compute the zero-coupon yield curve.

Correction.
We use the bootstrap method presented in class. We express bond prices using
the zero-coupon curve information and the YTM information. This last part
is simplified since bonds are traded at par: their price is equal to the principal
(i.e., 100%) and their coupon to the YTM. We start with bond A, which has
the smallest maturity and then compute prices of bonds B to D in that order.
We obtain the following yield curve:
Maturity (in Years)
1
2
3
4

Zero-coupon rate R(0, k)

4.500%
5.218%
6.821%
7.586%