April 2, 2014 Chapter 9, Section 1 1. (S09T3) John must pay Kristen 10,000 at the end of 1 year. He also must pay Ahmad 30,000 at the end of year 2. John wants to exactly match his liabilities by purchasing the following two bonds: a. Bond A is a one year zero coupon bond maturing for 1000. b. Bond B is a two year bond with annual coupons of 200 and a maturity value of 1000. Calculate the amount of each bond that John should buy. Solution: John needs to make the cash flows going out equal to the cash flows coming in. To do this, we can set up two equations where a is the amount of bond A and b is the amount of bond B. We know that at the end of year 1 John will pay 10,000 and he will receive 1000 from every bond A and 200 from every bond B. Then at the end of year two when he needs to pay 30000, he will be receiving 1200 for every bond B. 10000 1000 200 30000 1200 a b b Simply solve this system algebraically. 30000 1200 25 10000 1000 200(25) 5 b b a a
18
Embed
Chapter 9, Section 1 - Purdue Universityjbeckley/q/WD/MA373... · Chapter 9, Section 1 1. (S09T3) John must pay Kristen 10,000 at the end of 1 year. He also must pay Ahmad 30,000
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
April 2, 2014
Chapter 9, Section 1
1. (S09T3) John must pay Kristen 10,000 at the end of 1 year. He also must pay Ahmad 30,000 at
the end of year 2.
John wants to exactly match his liabilities by purchasing the following two bonds:
a. Bond A is a one year zero coupon bond maturing for 1000.
b. Bond B is a two year bond with annual coupons of 200 and a maturity value of 1000.
Calculate the amount of each bond that John should buy.
Solution:
John needs to make the cash flows going out equal to the cash flows coming in. To do this, we
can set up two equations where a is the amount of bond A and b is the amount of bond B. We
know that at the end of year 1 John will pay 10,000 and he will receive 1000 from every bond A
and 200 from every bond B. Then at the end of year two when he needs to pay 30000, he will be
receiving 1200 for every bond B.
10000 1000 200
30000 1200
a b
b
Simply solve this system algebraically.
30000 1200 25
10000 1000 200(25) 5
b b
a a
April 2, 2014
2. (S08T3) Yvonne must make a payment of 80,000 at the end of one year. Additionally, she must
make a payment of 40,000 at the end of two years. Finally, she must make a payment of 60,000
at the end of 3 years.
She wants to purchase bonds to exactly match her payments.
She can purchase the following three bonds:
Bond
Number
Term of
Bond
Annual
Coupon
Maturity
Value
1 1 Year 0 1000
2 2 Years 60 1000
3 3 Years 70 1200
Calculate the amount of Bond 2 which Yvonne should purchase.
Solution:
Once again, we just need to set up equations that will match the cash flows.
80000 1000 60 70
40000 1060 70
60000 1270
a b c
b c
c
Now we need to solve, starting with c.
60000
1270
6000040000 1060 70
1270
34.616
c
b
b
April 2, 2014
3. (F11HW) Rivera Insurance Company has committed to paying 10,000 at the end of one year and
40,000 at the end of two years. It’s Chief Financial Officer, Miguel, wants to exactly match this
obligation using the following two bonds:
Bond A is a one year bond which matures at par of 1000 and pays an annual dividend at a
rate of 6%. This bond can be bought to yield 6% annually.
Bond B is a two year bond which matures at par of 1000 and pays an annual dividend at a
rate of 10%. This bond can be bought to yield 7% annually.
Calculate the amount of each bond that Rivera should purchase.
Calculate the cost of Rivera to exactly match this obligation.
Solution:
10000 1060 100
40000 1100
a b
b
Solving, 36.363636
6.0034305
b
a
Now, let’s find the price of each bond in order to find the total cost to match.
Price of Bond 1: 1 / 6% 60 1000 1000N I Y PMT FV CPT PV
Note: We could also know this intuitively because the coupon rate is the same as the yield.
Price of Bond 2: 2 / 7 100 1000 1054.240545N I Y PMT FV CPT PV
Now we can find the total price 6.0034305(1000) 36.363636(1054.240545) 44339.45
April 2, 2014
4. (F11HW) Wang Life Insurance Company issues a three year annuity that pays 40,000 at the end
of each year. Wang uses the following three bonds to absolutely match the cash flows under this
annuity:
a. A zero coupon bond which matures in one year for 1000.
b. A two year bond which matures for 1200 and pays an annual coupon of 100. This bond is
priced using an annual yield of 7%.
c. A three year bond which matures for 2000 and pays annual coupons of 75. This bond has a
price of 1,750.
It cost Wang 104,000 to purchase all three bonds to absolutely match this annuity.
Calculate the one year spot interest rate.
Solution:
Absolute matching means that the cash flow from the bonds at any given time should be exactly the
same as the cash flow from the annuity. In this case, we need the bonds to produce a cash flow of
$40,000 at times 1,2, and 3. In order to do this we will need to buy a certain amount of each bond.
These values will be “x, y, and z”.
Sometimes it is easiest to set up a table that summarizes cash flows:
Bond Amount Price CF at t=1 CF at t=2 CF at t=3
A X 1000/(1+r1) 1000 0 0
B Y 1228.928291 100 1300 0
C Z 1750 75 75 2075
In the table above, the Price for bon B was found using the calculator.
2 100 / 7 1200 1228.928291N PMT I Y FV CPT PV
Now we can set up a few equations in order to solve for the unknown variables.
First, since there is only one bond with a cash flow at time 3 we can find z very easily:
2075 40000
19.277
Z
Z
Then we can find Y:
1300 75 40000
40000 75(19.277)29.657
1300
Y Z
Y
Finally we can find X.
April 2, 2014
1000 100 75 40000
40000 75(19.277) 100(29.657)35.5885
1000
X Y Z
X
Now that we know the amount of each bond we are purchasing and we are given our total cost, we just
need to find the price of the one year bond which will in turn give us the one year spot rate.
1
1000104000 1228.928291 1750
1X Y Z
r
Note that the price of the first bond = 1
1000
1 r.
Now just plug in the values we found above to get 1 0.05233r
Chapter 9, Section 2
5. (S12HW) Ace is receiving an annuity immediate with level annual payments of 500 for 18 years.
Calculate the Macaulay duration and the Modified duration at an annual effective interest rate of
6%.
Solution:
Use for formula for Macaulay Duration first:
2 18
18
2 18
18
18
18
18
18 18
500500 500(2) ... 500(18)( , )
500 500 ... 500 500
18 11.47725969 6.30618824
0.067.9597
10.82760
t
t
t
t
IaC tv v v vD i
C v v v v a
a v
iIa
a a
Now that we have the Macaulay Duration, it is easy to find the modified/
7.9597( , ) 7.5092
1.06Modified D i v
April 2, 2014
6. (S12HW) Hopkins Life Insurance Company is paying Keith an annuity due of 234 per year for
the next 10 years.
Calculate the Modified duration of Keith’s annuity at an annual effective interest rate of 10%.
Solution:
0 1 9
9
0 1 9
10
9
9
9
10 10
234234 234(2) ... 234(9)( , )
234 234 ... 234 234
9 6.334926198 3.816878565
0.103.725460513
6.759023816
t
t
t
t
IaC tv v v vD i
C v v v v a
a v
iIa
a a
Now that we have the Macaulay Duration, it is easy to find the modified/
3.725460513( , ) 3.3868
1.1Modified D i v
7. (S08T3) Kyle purchases a 10 year bond. The bond matures for 1300 and has annual coupons of
80.
Calculate the Macaulay duration of Kyle’s bond at an interest rate of 8%.
Solution:
Use your calculator to find the price of the bond.
80 1300 10 / 8 1138.958046PMT FV N I Y CPT PV
Macaulay Duration=
2 10 10
10
1010
10
10
80(1) 80(2) ... 80(10) 1300(10)
1138.958046
1080 1300
0.0880 13007.58
1138.958046 1138.958046
t
t
t
t
C tv v v v v
C v
a vv
Ia v
April 2, 2014
8. (S12HW) Wenda owns an 8 year bond with a par value of 1000. The bond matures for par and
pays semi-annual coupons at a rate of 6% convertible semi-annually.
Calculate the Modified duration of this bond at an annual effective interest rate of 8.16%.
Solution:
Use your calculator to find the price of the bond.