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(FINA361)[2011](s)midterm~fn_csxag^_46306.pdf
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FIXED INCOME SECURITIES (FINA361) Mid-term Exam----Solution
Question 1 (points 5)
Two sales people of analytical systems are making a presentation to you about the merits of their respective systems. One sales person states that in valuing bonds the system first constructs the theoretical spot rates and then discounts cash flows using these rates. The other sales person believes that using forward rates rather than spot rates to value the cash flows is a better approach to valuing bonds. Which approach do you think is better?
Spot rates are nothing but a package of short term forward rates. So discounting at spot rates is the same as discounting at forward rates.

Question 2 (points 5)
Bond B has greater convexity than Bond A. Which of the following is true;
1.
Bond B offers a higher yield than Bond A

2.
Bond B offers a lower yield than Bond A


3. Bond B offers a same yield as Bond A Please explain why? Answer. Bond B, due to positive convexity the investor is willing to pay more, hence accept a lower yield on the bond.

Question 3 (points 5)
Consider the following two bonds A and B.
Bond Price Modified Duration PVBP
A 100 5.2 0.052
B 90 6 0.054

1.
Which bond has the highest price volatility in terms of percentage change in price?

2.
Which bond has the greater dollar price volatility, PVBP, for 1bps change in yield?


Answer:
1) Bond B has the highest price volatility in terms of % change in price, because it has the highest
modified duration for the same change in yield.
2) Bond B has the greater dollar price volatility for 1bps change in yield.


Question 4 (points 5)
Which of the term structure theories cannot explain an inverted term structure of interest rate? Explain why.
The liquidity theory, the terms increases with maturity and it is big enough to compensate even for declining spot rates. The end result is always an upward sloping curve.

Question 5 (points 7)
You are holding a bond with time to maturity 5years, coupon 4%, face value of 100 and current yield to maturity level of 5.4%. Assume the modified duration of this bond 4.1. The coupons are paid semi-annually. What would the bond price be if you expect the yield to drop by 150bps? Is that price similar to the price you get from the calculator? Why?
P0=93.94 dp=-D* P0*dy dp=-4.1*93.94*(-0.015)=5.777 P=99.717 P_calculator =100.45

Question 6 (points 15)
Bond A pays 6% coupon interest quarterly. The yield to maturity is 8%, face value of 100 and it matures in 4years. Calculate:
a.
The approximate duration using the shortcut formula by changing yields by 20bps.

b.
The approximate convexity measure using the shortcut formula by changing yields by 20bps.

c.
Using duration and convexity, estimate the price of the bonds for a 100 basis point increase.


Answer I would normally only use two digits pric, but since most of you used 4 digits the answer looks like as following:
P0=93.