Topic 5 Exercises

1. Calculate the one-year implicit rate for the next year (0f1.2) knowing that the one-year
and two-year spot interest rates are respectively 4% and 5.5%.

a) 8.02%
b) 7.52%
c) 7.42%
d) 7.02%

2. Calculate the 3-year spot interest rate knowing that 0f2,3 = 5%, 0r1 = 3%, 0r2 = 4%.

a) 3.37%
b) 4.33%
c) 5.45%
d) 6.67%

3. Suppose spot rates are 0r1 = 0.2%, 0r2 = 0.3%, 0r3 = 0.4%. You want to calculate 0f1,3, i.e.
the term rate or implied rate for a two-year loan that starts at the time t = 1.

a) The implicit rate cannot be estimated with these data.

b) 0.63%
c) 0.57%
d) 0.50%

4. Can you fill in the missing data in the following table of spot interest rates and implicit
term rates?

t (years) 0rt 0f1,t

1 1.50% -

2 ? 2.71%

3 1.30% 1.20%

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 a) 2.50%
b) 2.35%
c) 2.10%
d) 1.95%

5. The one-year term interest rate for loans starting within 5 years is 6.5% and the 6-year
spot rate (0r6) is 7%. According to the Theory of Pure Expectations, it is expected that:

a) E0 [5r1] = 6.5%
b) E0[5r1] = 7.1%
c) E0[5r1] > 7.1%
d) We cannot calculate it without knowing the liquidity premium.

6. A fixed income analyst looks at the following yield curve in the Eurozone. Under the
theory of pure expectations, determine what will be the one-year interest rate that will
exist in 2 years.

Term Annual rate

1 year 0.04%

2 years 0.06%

3 years 0.11%

5 years 0.43%

10 years 1.37%

15 years 1.86%

a) 0.11%
b) 0.21%
c) 0.35%
d) None of the above.

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7. Knowing that the liquidity premium is 1% and 0f1.2 = 3%, calculate the expected one-
year spot rate for next year.

a) 2%
b) 3%
c) 4%
d) 5%

8. Determine under the theory of liquidity preference the expected interest rate for one
year that will exist at t = 3 if we know that the 1, 2, 3 and 4 year spot interest rates are
4%, 5%, 6%, and 7% respectively. In addition, there is a liquidity premium that is
estimated at 1.5%.

a) 10%
b) 11.53%
c) 8.55%
d) None of the above

9. Calculate the duration of a three-year bond with a face value of €1,000 with an annual
coupon of 3% assuming that the yield to maturity is 4% per annum.

a) Between 2.87 and 2.89 years.

b) Between 2.90 and 2.92 years.
c) Between 2.93 and 2.95 years.
d) None of the above.

10. Point out the correct answer:

a) Spot interest rates are also known as implicit rates.

b) A fixed-income security issued at par will always be amortized at par.
c) If the 2-year spot interest rate (0r2) is higher than the 1-year spot interest rate
(0r1), the implied rate from year 1 to 2 must necessarily be higher than the 1-year
spot rate.
d) The duration of a bond with coupons is always longer than that of a zero-coupon
bond that is amortized at the same time.

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11. Which of the following statements about the ratings of debt securities is false?

a) Credit rating agencies assess the credit quality of debt securities issued by
countries, local governments and companies.
b) Investors discount expected future payments on bonds from issuers with a better
credit rating (corresponding to a lower risk of default) at higher discount rates.
c) The rating that corresponds to the securities of the highest credit quality is AAA.
d) If there is a worsening of the credit quality of a company or a country
(downgrade), the price of its bonds in the secondary market falls.

12. What will be the percentage change in the price of a 3-year bond with a duration of
2.8 years and an IRR of 3.5% if the interest rate curve shifts upwards by 25 basis points
(i.e. 0.0025%)?

a) It will grow by 0.36%

b) It will grow by 0.47%
c) It will decrease by 0.56%
d) It will decrease by 0.67%

13. A bond has a market price of €2,000. There is a change in the term structure of
interest rates that produces a decrease in the internal rate of return (IRR) of the bond of
15 basis points (0.15%). The modified duration of the bond is equal to 4.3. This means
that the price of the bond increases by approximately:

a) €12.9.
b) €27.0.
c) €1.4.
d) €3.4.

14. Suppose the interest rate curve is flat at 3%. You want to calculate the modified
duration of a standard 2-year bond of the highest credit quality with a face value of
€5,000 that pays an annual coupon of 10% and whose repayment is at par.

a) Between €1.94 and €1.96

b) Between €1.91 and €1.93
c) Between €1.88 and €1.90
d) Between €1.84 and €1.86

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15. An investor has an investment horizon of 4.3 years and wishes to invest in fixed-
income securities, but protecting themselves from interest rate risk. Knowing that your
financial institution offers you to invest in 3-year and 5-year zero-coupon bonds at the
same cost, what proportion should you invest in each of the two bonds?

a) 40% on 3-year bonds and 60% on 5-year bonds.

b) 35% in 3-year bonds and 65% in 5-year bonds.
c) 30% on 3-year bonds and 70% on 5-year bonds.
d) 25% on 3-year bonds and 75% on 5-year bonds.

16. A manager manages a fixed income investment fund whose duration is equal to 3
years. The yield curve is currently flat at 2% and the manager believes that interest rates
will rise in the future. Which of the following bonds should you add to the fund if your
goal is to minimize exposure to interest rate risk by reducing portfolio duration?

a) 3-year zero-coupon bonds with 100% redemption and a nominal value of €1,000.
b) Standard 5-year bonds with 5% annual coupon, 100% redemption and a nominal
value of €1,000.
c) Standard 2-year bonds with 5% annual coupon, 100% redemption and a nominal
value of €1,000.
d) 2-year zero-coupon bonds with 100% redemption and a nominal value of €1,000.

17. Consider two bonds issued by the same company and with a face value of €10,000.
One is a 3-year zero-coupon bond and the other is a standard 3-year bond with a 4%
coupon and 115% over-par amortization. Let's assume that the interest rate curve is flat
at the moment. How will the price of these two bonds change if the yield curve moves
upwards? (Suppose the interest rate curve remains flat after the move.)

a) Both prices will rise.

b) Both prices will fall, but the fall in the price of the zero-coupon bond will be
greater in percentage terms.
c) Both prices will fall, but the fall in the price of the zero-coupon bond will be
smaller in percentage terms.
d) It is not possible to say anything without information about the current level of
the interest rate curve.

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18. An investor wishes to acquire a portfolio of bonds with the lowest possible level of
interest rate risk. Determine which asset you should acquire:

Coupon
Active Coupon Expiration Payment
Frequency

Bond 1 8% 5 years Semiannual

Bond 2 8% 5 years Annual

Bond 3 4% 5 years Annual

Bond 4 2% 5 years Annual

a) Bond 1
b) Bond 2
c) Bond 3
d) A portfolio made up of bonds 1 and 2.

19. Determine which of the following assets has the highest interest rate risk.

Title Coupon Expiration

A1 Bond 3% per year 10 years

4% semi-
A2 Bond annually 10 years

AAA Treasury Bill 0% 18 months

Promissory note 0% 6 months

A3 Bond 0% 10 years

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 a) A1 Bond
b) A2 Bond
c) A1, A2 and A3 bonds have the same maturity and therefore the same duration.
d) None of the above.

20. Suppose an investment fund manager wants to immunize his fixed income portfolio
for the next 5 years, select the strategy to be carried out:

a) Create a portfolio with 1-year zero-coupon bonds and repurchase 1-year bonds
after that time, until completing the 5 years.
b) Buy a portfolio of bonds with periodic payment of coupons, with a maturity of 5
years.
c) Purchase a portfolio of bonds with periodic payment of coupons whose duration
is equal to 5 years.
d) Purchase of 1-year AAA Treasury Bills.

21. Indicate which answer is correct:

a) The duration of a bond with coupons with a maturity of K years should be equal to or
greater than K years.
b) The duration of a bond increases with the increase in the amount of the bonds.
c) To immunize a portfolio to a time horizon of H years, it is necessary to create a portfolio
with a duration of less than H.
(d) To immunize a portfolio over a time horizon of H years, it is necessary to create a
portfolio with a duration equal to H.

22. Consider the following two bonds. If there is a parallel downward shift in the
economy's interest rate curve, it would be expected that:

Bond 1 Bond 2

Duration 5.21 5

IRR 5.71% 1.45%

Price 1.245€ 975€

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a) The prices of both bonds fall, with the prices of Bond 1 falling by a greater
percentage.
b) The prices of both bonds rose, with the prices of Bond 2 rising by a greater
amount.
c) The price of both bonds rose, with the price of Bond 2 rising by a greater
percentage.
d) The price of both bonds rises by the same percentage.