ACST202/ACST851 : Mathematics of Finance

Tutorial Solutions 10 : Bonds

Question 1
(a) Price at 15/9/2013
= $4a23 + $100v 23 at 4.6%
= $91.592 749
= $91.593
We’ll use the unrounded result in the next 2 parts.
(b) Price at 15/2/2014

= ( $4a23 + $100v 23 ) (1 + i ) 6 at 4.6%

5

= $91.592 749 × (1 + i ) 6 at 4.6%

5

= $95.091
(c) Do any 2 of the following 3 day counts.
15 / 9 / 2013 → 15 / 2 / 2014 = ( 46 + 365 ) − 258 = 153
15 / 2 / 2014 → 15 / 3 / 2014 = 74 − 46 = 28
15 / 9 / 2013 → 15 / 3 / 2014 = ( 74 + 365 ) − 258 = 181
Price at 15/2/2014

= ( $4a23 + $100v 23 ) (1 + i ) 181 at 4.6%

153

= $91.592 749 × (1 + i ) 181 at 4.6%

153

= $95.142
(d) The price is $P where
P = 4 × (1 − .3) a23 + {100 − 0.3 × (100 − P )} v 23 at 3.9%
= 2.80a23 + {70 + 0.3P} v 23 at 3.9%
= 81.149
(e) The effective half-yearly gross yield is i where
$101.201 = $4a23 + $100v 23

4 + 231 (100 − 101.201)

The approximate formula gives i ≈ = 3.92%
1
2 (100 + 101.201)
Price at 3.9% = $101.501
Price at 4.0% = $100
Linear Interpolation gives
i − 3.9% 101.201 − 101.501
=
4% − 3.9% 100 − 101.501
i = 3.9198%
The yield to maturity is 7.840% p.a. compounded half-yearly.
Copyright  2016 Macquarie University.
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(f) The effective half-yearly net yield is i where
$98.45 = $4 × (1 − .3) a14 + {$99.45 − 0.3 × ( $99.45 − $98.45 )} v14
= $2.80a14 + $99.15v14

The approximate formula is usually stated as dealing with a gross yield for a bond held to
maturity. Our equation describes a net yield where the bond was sold prior to maturity. But we
can simply pretend our equation refers to a bond with 14 half-years to run, paying gross
coupons of $2.80, bought at $98.45 and maturing at $99.15. Then the approximate equation
gives
2.8 + 141 ( 99.15 − 98.45 )
i≈ = 2.88%
1
2 ( 99.15 + 98.45 )

Question 2
(a) Current indexed capital
= $1, 000 × 1.0142 × 1.0145 ×1.0176 × 0.9965
= $1, 043.35
The bond runs a further 36 quarters. The coupon rate is 1% per quarter, so coupons are 1% of
the indexed capital. Due to inflation, the indexed capital is expected to grow at 1.2% per
quarter. The required yield is 1.706% per quarter. The effective quarterly real yield is
1.01706
− 1 = 0.5%
1.012
Required price
 36 1.012t  1.01236
=  ∑ 1% × $1, 043.35 ×  + $1, 043.35 ×
 t =1 1.01706t  1.0170636
 36 1  1
=  ∑ 1% × $1, 043.35 × t 
+ $1, 043.35 ×
 t =1 1.005  1.00536
= 1% × $1, 043.35a36 + $1, 043.35v 36 at 0.5%
= $1, 214.830
The terms still collapse nicely. It would still be sufficient to know the required real yield,
rather than needing both the required money yield and estimated future inflation rate.
(b) Clearly all that will change is the indexed capital.
Current indexed capital
267.1
= $1, 000 ×
256.7
= $1, 040.51
Required price
= 1% × $1, 040.51a36 + $1, 040.51v 36 at 0.5%
= $1, 211.523

Copyright  2016 Macquarie University.

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Question 3
Since she buys ex interest she buys the bond excluding the 1/3/2012 coupon.
The labels ex/cum interest are from the buyer’s perspective. The person Ann sells the bond to is
buying cum (with) interest, so that person receives the 1/3/2013 coupon.
Hence Ann does not receive any coupons.
Question 4
(a) The bond pays only positive cash flows to the owner, so the present value of all the cash flows
must be positive, giving 0 < P .
Only positive yields to maturity make sense. If the yield to maturity is negative (or zero), there
is no incentive for you to buy the bond, since you do better (or just as well) by simply keeping
your cash. Given a positive interest rate, the value of the bond must be less than the total face
amount of the coupons and maturity proceeds, giving P < 100cn + 100 = 100 (1 + cn )

Alternatively, i > 0 implies v n < 1 and an < n , so P = 100c an + 100v n < 100cn + 100

(b) When i = c we have

P = 100c an + 100v n at c
1 − (1 + c )
−n

+ 100 (1 + c )
−n
= 100c
c
= 100
If
• a bond matures at par;
• the yield to maturity equals the coupon rate; and
• the valuation date is either at issue or at a coupon date immediately after payment of the
coupon,
then the value of the bond equals the face value.
(c) If i < c then 100 < P < 100 (1 + cn )

If i = c then P = 100
If i > c then 0 < P < 100

Copyright  2016 Macquarie University.

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 Additional Exercise Solutions 10 : Bonds
Question 1
The required price is $P where:
$ P = 0.73 × $8a33 + {$110 − .27 ( $110 − $ P )} v33 at 7%
= $85.571

Question 2

Issue Purchase

0 9 40
1/1/71 1/7/75 1/1/91

(The upper time scale in the above diagram is measuring time in half years from 1/1/71.)
6% pa = 2.9563% per half.

Price on 1/7/75
= $1.5a31 + $100v31 at 2.9563%
= $70.704
Frank’s net of tax half-yearly yield is i where:
$70.704 = (1 − .4 ) × $1.5a31 + {$100 − .2 ( $100 − $70.704 )} v31
70.704 = 0.9a31 + 94.1408v31

A rough guess for the yield is

0.9 + 311 ( 94.1408 − 70.704 )
i≈ ≈ 2.0%
1
2 ( 94.1408 + 70.704 )
Using linear interpolation
RHS at 2.0% = 71.597 260  i − .02 70.704 − 71.597 260
 ≈
RHS at 2.1% = 69.783 710  .021 − .02 69.783 710 − 71.597 260
i ≈ 2.049 255%
which converts to an annual rate of 4.141% pa effective.
(Using a spreadsheet gives a half-yearly yield of 2.048 886%, or 4.140% pa effective.)

Copyright  2016 Macquarie University.

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Question 3
The effective half-yearly yield is i where
90.132 = (1 − 20% ) × 5.50a12 + {100 − 15% (100 − 90.132 )} v12
= 4.4a12 + 98.5198v12

Solving by spreadsheet gives i = 5.45129%.

Hence the required net yield is 10.903% pa compounded half-yearly.
To use linear interpolation we need an approximate guess. The half-yearly net yield is about
4.4 + 121 ( 98.5198 − 90.132 )
≈ 5.41%
1
2 ( 98.5198 + 90.132 )
So we can start by evaluating the price at 5.4%, and use that price to determine whether we need to
consider a lower or higher yield next.
Price at 5.4% = 90.5459
Price at i = 90.132
Price at 5.5% = 89.7411
Linear interpolation gives
i − 0.054 90.132 − 90.5459
=
0.055 − 0.054 89.7411 − 90.5459
i = 5.4514%
This gives a yield of 10.903% p.a. compounded half-yearly.
Question 4
(a) Price

1.0075v + 1.0075 v + 1.0075 v 

2 2 3 3

= 1.25% × $1000 ×   + $1000 × 1.0075 v at 1.25%

40 40

+... + 1.0075 v
40 40

= $12.50 {v′ + v′2 + v′3 + ... + v′40 } + $1000v′40 , where 1.0075
1+ i = 1+1i′

′ + $1000v′40 at i′ = 0.496 278%

= $12.50a40
= $1272.838
(Rough check on real yield: 1
4 ( 5% − 3% ) = 0.5% )
(b) Price
= $12.50a40 + $1000v 40 at 1.25%
= $1000
This makes sense. If we pay $1,000 for the bond, then each quarter we expect the indexed
capital (or loan outstanding) to grow at 0.75%, compensating us for inflation, and at the end of
each quarter we receive a coupon (or interest) of 1.25% of the indexed capital (loan
outstanding) giving the required real return.

Copyright  2016 Macquarie University.

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Question 5
If the nominal yield is i per quarter, the estimated inflation is c per quarter and the real yield is 1%
per quarter then
1+ i
= 1.01
1+ c
Required Price
 1+ c 1+ c 1+ c 1+ c 
2 3 52

= % × $110.125 
+ $110.125  
 + $110.125  +...+$110.125 
 1 + i  
3
4
 1+ i  1+ i   1+ i 

1+ c
52

+$110.125 
 1+ i 
= 43 % × $110.125{v + v 2 + v 3 +...+ v 52 } + $110.125v 52 at 1%
= $0.8259375a52 + $110.125v 52 at 1%
= $99.004

Copyright  2016 Macquarie University.

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Question 6

2.5 2.5 2.5 2.5 82.5

1/8/15 1/12/15 1/2/16 1/8/16 1/2/22 1/7/22 1/8/22 1/2/35

BUY SELL

We will round bond prices to tenths of a cent.

Sheila buys at 1/12/15 cum interest, meaning she receives the 1/2/16 coupon.
Buy Price (including the 1/2/16 coupon)

( )
= 2 12 a39 + 80v 39 (1 + i ) 6 at 6%
4

= 47.424
Sheila sells at 1/7/22 ex interest to Bazza, meaning Bazza does not receive the 1/8/22, so Sheila will
get that coupon. The sell price is the present value of the payments Bazza will receive, being the
maturity proceeds and the coupons after the 1/8/22 coupon.
Sell Price (excluding the 1/8/22 coupon)

( )
= 2 12 a25 + 80v 25 v 6 at 4%
1

= 68.615
Sheila receives the 1/2/16 to 1/8/22 coupons inclusive.
Sheila’s half yearly yield is i where:

47.424 = (1 − 10% ) 2 12 a14 (1 + i ) 6 + {68.615 − 10% ( 68.615 − 47.424 )} v

4
13 16

= 2.25a14 (1 + i ) 6 + 66.4959v
4
13 16

RHS at 7% = 47.869
RHS at 7½% = 45.704
Linear interpolation produces
i − .07 47.424 − 47.869
≈
.075 − .07 45.704 − 47.869
i ≈ 7.1028%
giving a yield of 14.206% p.a. compounded half-yearly.

Copyright  2016 Macquarie University.

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