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Group Assignment 5_Group 9

The document discusses the relationship between long-term and short-term interest rates, explaining that long-term rates are typically higher due to liquidity preference theory. It also covers bond pricing, duration, and the sensitivity of bond portfolios to interest rate changes, providing calculations for bond price and duration. Additionally, it estimates the effect of yield changes on bond prices using duration and convexity, highlighting the accuracy of these approximations for small yield changes.

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maes94868
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3 views

Group Assignment 5_Group 9

The document discusses the relationship between long-term and short-term interest rates, explaining that long-term rates are typically higher due to liquidity preference theory. It also covers bond pricing, duration, and the sensitivity of bond portfolios to interest rate changes, providing calculations for bond price and duration. Additionally, it estimates the effect of yield changes on bond prices using duration and convexity, highlighting the accuracy of these approximations for small yield changes.

Uploaded by

maes94868
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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GROUP ASSIGNMENT 5

Group Member 09
Lo Viễn Quyên BAFNIU20404
Phạm Thị Thanh Thư BAFNIU20433
Bùi Anh Quân BAFNIU20232
Đỗ Nhật Tân BAFNIU20414

9.2 Explain why long-term rates are higher than short-term rates most of the time. Under what
circumstances would you expect long-term rates to be lower than short-term rates?

If long-term rates were simply a reflection of expected future short-term rates, we would expect long rates
to be less than short rates as often as they are greater than short rates. Liquidity preference theory argues
that long-term rates are high relative to expected future short-term rates. This means that long rates are
greater than short rates most of the time. When long rates are less than short rates, the market is expecting
a relatively steep decline in rates.

9.6 :What does duration tell you about the sensitivity of a bond portfolio to interest

rates? What are the limitations of the duration measure?

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a

change in interest rates. In general, the higher the duration, the more a bond's price will drop

as interest rates rise. This also indicates a higher level of interest rate risk.

Bond Pricing and Duration


Given:

• 5-year bond

• Yield = 11% (continuously compounded)

• Coupon rate = 8% (annual)

(a) Bond Price

P = C * e^(-yt) + F * e^(-yt)

where:

• P = bond price

• C = coupon payment

• y = yield to maturity

• t = time to maturity

• F = face value (assumed to be 1000)

Calculating the price:

• C = 8% of 1000 = 80

• y = 0.11

• t = 1, 2, 3, 4, 5 (for each year)

• F = 1000
P = 80 * (e^ (-0.11*1) + e^ (-0.11*2) + ... + e^ (-0.11*5)) + 1000 * e^ (-0.11*5)
=> P ≈ 892.74

(b) Bond Duration

D = (C/y + t) * (1 - e^(-yt)) / (1 + e^(-yt))

=> D = (80/0.11 + 1) * (1 - e^(-0.11*5)) / (1 + e^(-0.11*5))

=> D ≈ 4.02 years


(c) Effect of a 0.2% decrease in yield

%ΔP ≈ -D * Δy

Δy = -0.2% = -0.002
=> %ΔP ≈ -4.02 * (-0.002) ≈ 0.00804
So, the bond price is expected to increase by about 0.804%.

(d) Recalculating price with a 10.8% yield

Using the same formula for bond price as in part (a), but with y = 0.108, we find:

• P ≈ 901.15

Verification: The percentage change in price due to the yield decrease is:

➢ (901.15 - 892.74) / 892.74 ≈ 0.00946

This is close to the estimated change of 0.804% from part (c), confirming the accuracy of the duration
approximation for small changes in yield.

9.9 A six-year bond with a continuously compounded yield of 4% provides a 5% coupon at the end
of each year. Use duration and convexity to estimate the effect of a 1% increase in the yield on the
price of the bond. How accurate is the estimate?

For a bond with annual coupon payments, the price \(P\) is given by the sum of the present value of future
cash flows:

𝐶 𝐹
P = ∑6𝑡=1 + 𝑒 6𝑦 where:
𝑒 𝑦𝑡

• C = 5 (annual coupon, 5% of par value F = 100)

• F = 100 (face value of the bond)

• y = 4% (continuously compounded yield)

We now compute the bond price:

𝐶 𝐹
P = ∑6𝑡=1 + 𝑒 6𝑦
𝑒 𝑦𝑡
Evaluating these terms:

𝑒 0.04 ≈ 1.0408, 𝑒 0.08 ≈ 1.0833, 𝑒 0.12 ≈ 1.1275, 𝑒 0.24 ≈ 1.2712

Discounting each cash flow:

5
Year 1: ≈ 4.80
1.0408

5
Year 2: ≈ 4.61
1.0833

100
Year 6:
1.2712
≈ 78.63

Summing all these terms, the bond price P ≈ 109.53

The Macaulay duration 𝐷𝑀 is a weighted average of the time until cash flows are received, weighted by

the present value of those cash flows.

Evaluating this step (using the earlier discounted cash flows):

- Year 1: 1 × 4.80 ≈ 4.80

- Year 2: 2 × 4.61 ≈ 9.22

- Year 6:6 × 78.63 ≈ 471.78


The convexity C measures the curvature of the price-yield relationship:

Evaluating this term similarly:

𝐶 ≈ 26.1 𝑦𝑒𝑎𝑟 2

The formula to estimate the percentage price change using duration and convexity is:

where ∆𝑦 = 0.01 (1% increase in yield).

So, the estimated percentage change in price is:

∆𝑃 ≈ −4.64%

The estimated new price is:


Step 6: Accuracy of the Estimate

The duration and convexity approximation is accurate for small changes in yield. For larger changes,
higher-order effects become significant, and the approximation might deviate from the true value. In this
case, since the change in yield is 1%, the approximation should be reasonably accurate, but there might still
be a small error.

The exact new price could be computed using the bond pricing formula with the new yield y = 5% to assess
the accuracy. However, the duration-convexity approach gives a good approximation.

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