Problem Set 1 Sol

FINA 3103: Intermediate Investments
Problem Set 1 Solution

Prof. Don Noh
February 19, 2024
Problem 1
This question tests your understanding of pricing coupon bonds by no arbitrage condition. We
can replicate the payoff of a T-year coupon bond of coupon rate c with a portfolio of zero-coupon
bonds: c units of each maturity from 1 to T − 1 years and 1 + c units of maturity T.
Pc (T) = cPa (T) + Pb (T) (1)

T T
c 1
= c ∑ Pb (t) + Pb (T) = ∑ t
+ T
(2)
t=1 t=1 [1 + Y b (t)] [1 + Yb (T)]
T−1 T−1
c 1+c
= c ∑ Pb (t) + (1 + c)Pb (T) = ∑ + (3)
t=1 t=1 [1 + Yb (t)] [1 + Yb (T)]T
t
Therefore
1. PE = 0.02PA + 1.02PB ⇒ PA = 98.770
2. PD = 0.01PA + 1.01PB ⇒ PD = 100.705
3. PC = xPA + (1 + x)PB ⇒ x = 1.149%
Problem 2
1. By definition, yield is the single constant rate that equates the following equation given
price and future streams of cash flow
T
c 1
Pc (T) = ∑ t
+ (4)
t=1 [1 + Yc (T)] [1 + Yc (T)]T
1
Plug in numbers and denote the coupon rate by c we have
10
100c 100
Pc (10) = ∑ t
+ (5)
t=1 1.0253 1.025310
2. Using either Equation (2) or (3) draws the connection of bond price to zero-coupon yield
curve. I will use Equation (2) here, and plug in numbers
10
100c 100
Pc (10) = ∑ t
+ (6)
t=1 [1 + Yb (t)] [1 + Yb (10)]10
3. Equate the RHS of Equation (5) and (6), and simplify the computation using the annuity
factor
N
1 1 1
AF(r, N) = ∑ n
= [1 − ] (7)
n=1 (1 + r) r (1 + r) N
We have
10
1 1 1
c × AF(0.0253, 10) + 10
= c × ∑ t
+
1.0253 t=1 [1 + Yb (t)] [1 + Yb (10)]10
The only unknown in the above equation is c. Extract the series of zero-coupon yield and
we can find c = 2.417%.
2
Problem 3
1. The curve is shown in Figure 1 with the data provided in Table I. The relationship between
the columns
1
Pb (T) =
[1 + Yb (T)]T
T
Pc (T) = c ∑ Pb (t) + Pb (T)
t=1
T
c 1
Yc (T) = x∗ that solves Pc (T) = ∑ t
+
t=1 [1 + x] [1 + x]T
1 − Pb (T)
c(T) = T
∑t=1 Pb (t)
where c = 0.023. You can solve Yc (T) using the Rate(T,PMT,-PV,FV) function in Excel or
using a scalar minimizer.
2. See the last column in Table (I), the difference changes from negative to positive between
year 7 and year 8, i.e., the constant-coupon yield curve cross the par yield curve.
Figure 1. Constant coupon yield curve.
3
Table I
Constant coupon yield curve
T
Maturity Yb (t) Pb (T) ∑t=1 Pb (t) Pc (T) Yc (T) c(T) Yc (T) − c(T)
1 0.009017 0.991063 0.991063 1.013858 0.009017 0.009017 -0.000000

2 0.012091 0.976251 1.967314 1.021499 0.012057 0.012072 -0.000015
3 0.015127 0.955957 2.923271 1.023193 0.015035 0.015066 -0.000031
4 0.017787 0.931905 3.855176 1.020574 0.017627 0.017663 -0.000036
5 0.019983 0.905806 4.760983 1.015309 0.019754 0.019785 -0.000030
6 0.021740 0.878937 5.639920 1.008655 0.021447 0.021465 -0.000018
7 0.023127 0.852103 6.492022 1.001419 0.022778 0.022781 -0.000003
8 0.024221 0.825756 7.317778 0.994065 0.023823 0.023811 0.000012
9 0.025090 0.800099 8.117877 0.986810 0.024652 0.024625 0.000027
10 0.025793 0.775180 8.893057 0.979720 0.025321 0.025280 0.000040
11 0.026378 0.750965 9.644022 0.972778 0.025875 0.025823 0.000052
12 0.026878 0.727402 10.371424 0.965945 0.026346 0.026284 0.000063
13 0.027322 0.704396 11.075820 0.959140 0.026762 0.026689 0.000073
14 0.027728 0.681872 11.757692 0.952298 0.027140 0.027057 0.000083
15 0.028112 0.659773 12.417464 0.945374 0.027493 0.027399 0.000094
16 0.028482 0.638047 13.055511 0.938323 0.027828 0.027724 0.000103
17 0.028846 0.616655 13.672166 0.931115 0.028154 0.028038 0.000115
18 0.029209 0.595569 14.267735 0.923727 0.028475 0.028346 0.000129
19 0.029575 0.574777 14.842511 0.916154 0.028792 0.028649 0.000143
20 0.029944 0.554283 15.396794 0.908409 0.029106 0.028949 0.000157
21 0.030317 0.534081 15.930876 0.900492 0.029419 0.029246 0.000172
22 0.030696 0.514197 16.445073 0.892434 0.029731 0.029541 0.000191
23 0.031079 0.494634 16.939707 0.884247 0.030042 0.029833 0.000209
24 0.031466 0.475426 17.415133 0.875974 0.030351 0.030122 0.000230
25 0.031858 0.456565 17.871697 0.867614 0.030659 0.030408 0.000251
26 0.032252 0.438096 18.309793 0.859221 0.030963 0.030689 0.000274
27 0.032649 0.420030 18.729823 0.850816 0.031264 0.030965 0.000299
28 0.033046 0.402389 19.132212 0.842430 0.031559 0.031236 0.000324
29 0.033445 0.385181 19.517393 0.834081 0.031849 0.031501 0.000348
30 0.033844 0.368424 19.885817 0.825798 0.032134 0.031760 0.000374
4
Problem 4
1. Unknown. There are 17 bonds traded in the market (coupon rates 0% to 2% with incre-
ments of 0.125%). There could exist two combinations of bonds that have identical cash
flow over the 10 year. However, because we only know the prices of 2 out of 17 bonds, we
cannot determine whether there is an arbitrage opportunity.
2. No arbitrage. CF A = [0, 0, 100], CFB = [0, 1, 101], CFC = [0, 100, 100]. We can replicate the
payoff of Bond B using 1 unit of Bond A and 0.01 unit of Bond C, so the replication cost is
PA + 0.01PC = $99.97, which equals PB .
3. Arbitrage. We can replicate the payoff of asset A using 10 units of asset B and 5 units
of asset C, i.e., we can get $1 for sure in each state of the world. The replication cost is
10PB + 5PC = $1, which is greater than PA . “Buy low, sell high”. So an arbitrage opportunity
is to buy 1 unit of asset A, and short sell 10 units of asset B and 5 units of asset C. This
strategy produces a riskless profit of $0.01.

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FINA 3103: Intermediate Investments

Problem Set 1 Solution

February 19, 2024

Pc (T) = cPa (T) + Pb (T) (1)

Figure 1. Constant coupon yield curve.

1 0.009017 0.991063 0.991063 1.013858 0.009017 0.009017 -0.000000

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