MGT 6769 - Fixed Income Securities

Assignment 2 Prof. Hsu

This assignment must be submitted by the end of class on Wednesday, March 8th , 2017.
The assignment questions are to be completed in groups of up to three people. You must show
the details of your work in Excel spreadsheets. Please HIGHLIGHT your final answers. The
assignment will be marked based on (1) how you arrive at the solution, (2) is the solution
correct or does it make sense? (3) the presentation of your results. Remember, you must
present your work in a clear and concise manner. Make sure your spreadsheets are tidy, and
clearly labeled. Your group members can be different from assignment 1. This assignment
consists of two parts: A and B.

Hedging and Risk Management

1. Risk Measurement, Dollar Duration, Convexity, and Macaulay Duration - 15 points
The following discount factors are given:
B(0, 1) = 0.95506 B(0, 2) = 0.88145 B(0, 3) = 0.81476 B(0, 4) = 0.75821

As a reminder, $ Duration, for a bond with continuously compounded yields is:

T
tKt e−yt .
X
∆$ =
t=1

(a) Using continuous compounding, calculate the duration D(y), modified duration
M D(y),the dollar duration ∆$ , and the dollar convexity Γ$ of a 4-year 6% annual
coupon bond with face value $1,000.
(b) If there is a 150 basis point downward shift in the continuously compounded zero-
yield curve (assume all shifts in the continuously compounded zero yield curve
are uniform) calculate the following:
i. The actual price of this 4-year, 5% coupon bond;
ii. The price of the 4-year bond as estimated by ∆$ alone;
iii. The price of the 4-year bond as estimated by both ∆$ and Γ$ .

2. Risk Measurement, Risk Management, Duration - 15 points

Dollar duration and convexity are used to characterize and to control the riskiness of
fixed income securities. However, several examples were presented in the lectures to
exhibit the limitations of these measures. One way we might attempt to improve these
measures is by making them more robust to non-uniform shifts in the term structure.

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 For a fixed income security that makes annual payments over four years,
4
Kt e−t·Rt ,
X
P (R1 , R2 , R3 , R4 ) =
t=1

where Rt is short for the spot rate R(0, t), we can perform a Taylor expansion to arrive
at an expression relating the change in price of the bond to changes in the zero coupon
term structure by
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X ∂P
∆P ≈ ∆Rt . (1)
t=1 ∂Rt

Consider an 8% coupon bond maturing in four years with a face value of $1000. You are
given the following information about the current state of the continuously compounded
zero yield curve, and four possible scenarios that might occur instantaneously.

Yield Yr. 1 Yield Yr. 2 Yield Yr. 3 Yield Yr. 4

Current 6.25% 7.00% 7.50% 8.00%
Scenario 1 7.00% 7.75% 8.25% 8.75%
Scenario 2 6.25% 7.50% 8.00% 8.50%
Scenario 3 5.00% 6.00% 7.50% 7.00%
Scenario 4 7.00% 6.50% 6.25% 6.00%
Scenario 5 7.25% 7.25% 7.25% 8.20%

For each scenario, compute the following:

(a) The actual price change of this bond.

(b) The price change of this bond as approximated by the duration method ∆$ . This
is by assuming that the bond price depends on a single risk factor, the yield-to-
maturity. Comment on your findings.
(c) The price change of this bond as approximated by the first-order changes in the
underlying five spot rates.
(d) Compare the price changes as approximated by the duration method to those
approximated by the first-order method. Comment on your findings.

3. Risk Management, Duration, and Convexity - 15 points

Consider the following three securities:

• Security A is a 2-year zero which matures two years from today, and pays $1 at
maturity;
• Security B is a 3-year zero which matures three years from today, and pays $1 at
maturity;
• Security C is a 1-year forward contract which matures one year from today, and
delivers a 1-year zero (with face value $1) at maturity.

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 My portfolio currently consists of a long position of 5,000 units of security B and a
short position (liability) of 3,000 units of security A. Suppose the only securities I can
currently trade (buy/sell) are Security A and Security C. The current term structure
based on zero coupon bonds (with 1-, 2-, 3-, and 4-year maturity from today) in
annualized rates with continuous compounding is:
R(0, 1) = 4% R(0, 2) = 6% R(0, 3) = 7% R(0, 4) = 9%

(a) What are the current value, the dollar duration and the convexity of my portfolio?
Interpret the dollar duration and the convexity numbers (i.e. for a 100 basis
point parallel increase in the term structure, what do the duration and convexity
numbers say?).
(b) Without changing the value of my portfolio (found in part (a)), what do I have
to do now (i.e., if anything, long/short what? how much?) to achieve a dollar
duration of zero for my portfolio? (Suppose I don’t care about convexity.)
(c) How long is the hedge in part (b) (i.e., the zero dollar duration position) good
for? Why? Explain.

4. Risk Management, relaxing the parallel shift assumption - 20 points

Currently, t = 0, a portfolio of 5 annually coupon-paying bonds, each with a face value
of $100. Their characteristics are given by
Bond A Bond B Bond C Bond D Bond E
Current Price $98 $98 $98 $95 $85
Maturity 2 3 4 5 6
Annual Coupon payment 5.50% 6.75% 7.00% 8.25% 6.00%
In addition to the above bond prices, you also know that the current one-year con-
tinuously compounded spot rate is R(0, 1) = 4%. Your objective here is construct a
portfolio that hedges the changes in the 1-year, 2-year, and 3-year spot rates. You
decide to leave your portfolio exposed to changes in the interest rates at the longer
horizon (i.e., 4-, 5- and 6-year spot rates). This is because you are betting on the
changes in the zero rates at the longer end of the maturity. However, you want to limit
your risk of the short-term rate changes.

(a) Construct a zero initial cost portfolio using Bond A to Bond E such that you
are hedged against the changes in the 1-year, 2-year, and 3-year spot rates. This
portfolio must have zero initial investment cost. Note, you only have to hedge
against the first-order changes in these rates, see for example, equation (1). Hint:
there are more than one way to construct your portfolio. Show me the possible
solutions that are sensible (at least three). Use your common sense. Then finally
choose the portfolio that is most appropriate for your objective. Use this optimal
portfolio in your Part B and C.
(b) Assume that exactly a year has gone by, t = 1, and you want to close out the
portfolio that you constructed in (a). Notes, all these bonds are now a year closer

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 to their maturities. The zero rates at time t = 1 is flat at 5% across all the
maturities. How much profit or loss has this trading strategy been for you?
(c) You decide not close out your positions at year 1, but hold the portfolio until two
years have gone by, hence we are now at t = 2. The zero rates at time t = 2 is
flat at 10% across all the maturities. How much profit or loss has this trading
strategy been for you?