Problem set 1

Q1 Consider a zerocoupon bond with a face value of $100, a timetomaturity of one year
and a price of $90.09. What is its yieldtomaturity?

Q2 Consider a coupon bond with a face value of $100, a coupon rate of 25%, a timeto
maturity of two years and a price of $121.97. What is its yieldtomaturity?
Hint: Solve numerically using a scientific calculator or Excel

Q3 (Essential to cover) Consider a coupon bond with a face value of $100, a coupon rate of
10%, a timetomaturity of three years and a price of $119.80. What is its yieldtomaturity?
Hint: Solve numerically using a scientific calculator or Excel

Q4 (Essential to cover, a, b, and c only) Consider a coupon bond with a face value of $100, a
coupon rate of 20%, a timetomaturity of three years and a yieldtomaturity of 4%
(implying a price of $144.40).

a. What would be the holding period return on buying the bond today and selling it in one
years time if interest rates in one years time are such that the bonds yieldtomaturity is
still 4%?

b. What would be the holding period return on buying the bond today and selling it in one
years time if interest rates in one years time are such that the bonds yieldtomaturity is
5%?

c. What would be the holding period return on buying the bond today and selling it in one
years time if interest rates in one years time are such that the bonds yieldtomaturity is
3%?

d. Can you think of any reason why the change in holding period return is not symmetric
even though the change in yieldtomaturity is, i.e. it is changing by one percent in both
question b and c compared to question a (although in different directions)?

Q5 (Essential to cover) Suppose that there is a bank that is offering to lend and/or borrow
money at an interest rate of 8% (risk free and regardless of the timetomaturity of the
loan). Further suppose that there is a twoyear riskfree coupon bond trading with a face
value of $100 and a coupon rate of 5% trading in the market. Price the bond using an
explicit noarbitrage argument.

Q6 (Essential to cover) Suppose that the bond in the previous question is actually trading
for $92.
Show how you could exploit the mispricing to make an arbitrage profit.

Q7 Suppose that the bank from the previous question is still around. Consider a gold mine
that will produce annual cash flows of $100 (with certainty) for five years starting in two
years, i.e. from t = 2 to t = 6. What is the arbitragefree price of the gold mine?

Q8 (Essential to cover) A 2year bond with par value of $1000 making annual coupon
payments of $100 is priced at $1000. What is the yield to maturity of the bond (without
any calculation, are you able to answer this question?)? What will be the realized
compound yield to maturity if the 1year interest rate next year turns out to be: a) 8%, b)
10%, c) 12%?

Selected endofchapter questions (Optional):
BKM 14: 3, 4, 8, 9, 13, 31a
Note:

To obtain the full credit, you would need to attempt all essential to cover questions (Q3;
Q4-a, b, c; Q5; Q6; Q8).

To obtain the half credit, you would need to attempt at least 3 out of 5 essential to cover
questions.