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(FINA361)[2010](f)midterm~2047^_10341.pdf
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FIXED INCOME SECURITIES (FINA361) Mid-term Exam
Question 1 (points 15)
Bond A provides a yield of 6%, pays coupon of 5% annually, matures in 4 years and has a par value of 100$.
a. What is the bond price at time zero?
P=96.535
b. What would the internal rate of return on this bond would be at the end of the 2nd year? P=98.167 The accumulated coupons =5+5*1.06=10.3 Total FV at second year=98.167+10.3 Initial buying cost=96.535
Hence the .........1 = 6%
......
c. Assume that instantaneously, after you have bought the bond, the yield drops by 50bps and stay there until maturity. What is the internal rate of return if you were to sell the bond at the end of the 2nd year? P=99.077 The accumulated coupons =5+5*1.055=10.275 Total FV at second year=109.352 Initial buying cost=96.535
Hence the .........1 = 6.432%
......

Question 2 (points 8)
Based on the local expectations form of the pure expectation theory, what would be the difference in the 6month total return if an investor purchased a 5yr zero coupon bond or a 2year zero coupon bond?
According to the local expectation theory the 6mnths return should be the same for both bonds. This is because this theory states that the forward rates represent exactly the future interest rates and it is just a multiplication of short term interest rates. Hence the forward rates are an unbiased predictor of future rates. Therefore there is no price or reinvestment risk. All rates are known with certainty already now. By arbitrage no matter the maturity of yr bond they should all yield same return in short time horizon

Question 3(points 8)
Explain why you agree or disagree with the following statement:
If two bonds have the same duration, then the percentage change in price of the bonds will
be the same for a given change in interest rate.
The statement is not true. It might be closely to true only for very small yield changes. It is nevertheless generally not true for any change in yield due to the convexity of each bond. The more convex the bond the more the duration measure only will underestimate the price change.

Question 4(points 7)
How would you interpret the concepts of positive convexity and pay up the convexity? Under which of the following scenarios would you be more willing to pay up the convexity:
a. Highly volatile interest rates
b. Stable interest rates environment The positive convexity implies that the for higher interest rates the bond price fall at a rate slower than the rate at which it increases when interest rate falls. In other words for the same interest rate change one benefits more from price increases and suffers less from price drops due to the positive convex. Therefore as positive convexity is desirable the investor is willing to pay more, hence accept a lower yield on the bond in return for convexity. Positive convexity is good to have in highly volatile interest rate environment.

Question 5(points 15)
We observe the follow