Yield measures, spot rates and forward rates (Reading 58)

Exercise Problems:
1. Consider a $1,000 par value Ans: B;
bond, with an annual paid
coupon of 7%, maturing in 10 Use the calculator to calculate YTM:
years. If the bond is currently
selling for $980.74, the YTM
isclosest to:

N=10, PMT=70, FV=1000, PV=-980.74 CPT ->

1/Y=7.28

A. 8.28%
B. 7.28%
C. 6.28%

2. Consider the three bonds in Ans: C;

the following table. Which of
the three bonds is most likely The yield to maturity assumes the coupon payments
are reinvested at the yield to maturity and the bond
to have the greatest
reinvestment risk?
Bond

YTM

Time to Maturity The bond selling at a premium has the highest

8%

15

8%

15

8%

15

A. Bond A

will be held until maturity.

coupon rate and thus is expected to earn the most

reinvestment income.
If the reinvestment rate falls, this bond will suffer the
greatest loss.
Therefore Bond C, which is currently selling at
premium, is most likely to have the greatest
reinvestment risk.

B. Bond B
C. Bond C

3. Using the U.S. Treasury

forward provided in the

Ans: A;

following table, the value of a According to the definition of the forward rate, the
2 year, 100 par value Treasury value of the bond=
bond with a 4% coupon rate
is closes to:
+
Period

Years

0.5

1.0

1.5

2.0

+
+

=$104.20

A. $104.20
B. $100
C. $98.74

4. Using the BEY (bond-

Ans: A;

equivalent yield) spot rates for

U.S. Treasury yields provided Assume:
in the following table, the 6month forward rate one year

f represents x-period forward rate y-period from

x y

from now on a bondequivalent yield basis

now;

is closest to:

x+y

represents (x+y)-period spot rate;

Period

Years

0.5

We have (1+Z

1.0

6-month forward rate one year from now in this case

is 1 period forward rate 2-period from now.

1.5

2.0

represents y-period spot rate.

)x+y=(1+Zy)y (1+xfy)x

x+y

All spot rates are given on a BEY basis and must be

divided by 2 in the calculation:

A. 4.41%

(1+1f 2)1 (1+0.023/2)2=(1+0.03/2)3

B. 2.20%

C. 2.30%

f 2=0.022038

On a BEY basis, the forward rate is

0.022038*2=4.41%

5. Elaine Wong has purchased Ans: C;

an 8%
coupon bond for $1,034.88
with 3 years to maturity. At
what rate must the coupon
payments be reinvested to
produce a 5% yield-to-

C is correct. Yield-to-maturity measure assumes that

the coupon payments can be reinvested at the yieldto-maturity.
In this case, its 5%. C is the correct answer.

maturity rate?
A. 8%
B. 6.5%
C. 5%

6. The yield of a 3-year bond Ans: B;

issue quoted on an annual-pay
basis is 7.84%. The yield-to- (1+bond-equivalent yield/2) 2 =1+annual-pay yield
maturity on a bond-equivalent
basis is closest to:

In this case,

A. 3.85%

(1+bond-equivalent yield/2) 2 =1+0.0784

B. 7.69%

Therefore, bond-equivalent yield=7.69%

C. 7.84%

B is the correct answer.

7. The U.S. Treasury spot rates Ans: A;

are provided in the following
The current price should be calculated using cash

table:

flows discounted at appropriate spot rate plus

corporate spread:

Period

Years

0.5

1.0

1.5

2.0

Current Price

Given a consistent corporate

spread of 0.50%, what will be
the most likely price of a 4%
coupon corporate bond with 2
years to maturity?

=$100.61

A. $100.61
B. $102.96
C. $98.92

8. Tina Mo, a fixed income

analyst, is asked to value a

Ans: C;

single, default-free cash flow

of $60,000. She is given the

The theoretical spot rate for Treasury securities

information in the following

table:

represent the appropriate set of interest rates that

should be used to value single, default-free cash
flows.

Period

Years

Annual Par Theoretical

Therefore:
Spot
$60,000/(1+0.0323/2)4=$56,276
Yield to
Rate BEY
Maturity
BEY

0.5

2.00%

2.00%

1.0

2.40 %

2.40%

1.5

2.70%

2.71%

2.0

3.20%

3.23%

The value of this single cash

flow at the end of Period 4
is closest to:
A. $56,427
B. $56,309
C. $56,276

9. The zero-volatility spread is Ans: C;

a measure of the spread off:
A. one point on the Treasury

Instead of measuring the spread to YTM, the zerovolatility spread measures the spread to Treasury

yield curve.

spot rates necessary to produce a spot rate curve

that correctly prices a risky bond. Therefore B is

B. all points on the Treasury

incorrect.

yield curve.
The zero-volatility spread is the equal amount that
C. all points on the Treasury
spot curve.

we must add to each rate on the Treasury spot yield

curve in order to make the present value of the risky
bonds cash flow equal to its market price. Therefore
A is incorrect.

10. The U.S. Treasury spot

rates are provided in the

Ans: B;

following table:

The Z- spread is the equal amount that we must add

Period

Years

to each rate on the Treasury spot yield curve in order

to make the present value of the risky bonds cash

flow equal to its market price.

To compute the Z-spread, set the present value of
2

the bonds cash flows equal to todays market price.

Discount each cash flow at the appropriate zerocoupon bond spot rate plus a fixed spread named ZS.
3

3
89.464 =

Consider a 3-year, 9% annual

coupon corporate bond
currently trading at $89.464.
Given the YTM of a 3-year

Treasury is 12%, the Z- spread

of the corporate bond
+
is closest to:
A. 1.50%.
B. 1.67%.
C. 1.76%.

11. Which of the following

Solve for ZS. Note that ZS can be found by replacing

Choice A, B and C into the equation to see which is
the correct answer.
ZS=1.67%

Ans: A;

statement is correct about the

The option-adjusted spread takes the option yield
option adjusted spread
component out of the Z-spread measure. The option( OAS ):
adjusted spread is the spread to the Treasury spot
A. OAS is Z-Spread minus the rate curve that the bond would have if it were optionoption cost.

free.

B. OAS is the value of the

Therefore Z-spread OAS = option cost in percent. A

embedded option.

is the correct answer.

C. OAS is Z-spread plus the

option cost.
12. The difference between Z- Ans: C;
spread and nominal spread will
The difference between the Z-spread and the nominal
most likely be
spread is greater for issues in which the principal is
the most significant for a:
repaid over time rather than only at maturity.
A. Treasury security with short Therefore B is incorrect.
maturity in a flat yield curve
environment
B. zero coupon Treasury

In addition, the difference between the Z-spread and

the nominal spread is greater in a steep yield curve
environment. Therefore, B is incorrect and C is the

security.

correct answer.

C. mortgage-backed security
in a steep upward-sloping yield
curve environment
13. All else being the same,
Ans: A;
the difference between the Zspread and the nominal spread A is correct because for short-term securities, the
for a non-Treasury security will difference between the nominal spread (which does
not account for the shape of the yield curve) and the
be greater when:
A. maturity of the security is
longer.

Z-spread (the spread over the entire theoretical spot

rate curve) is small. This difference grows with the
maturity of the security and as the slope of the yield
curve increases.

B. yield curve is flatter.

C. security has a bullet
maturity rather than an
amortizing structure.

14. A semiannual-pay bond is Ans: C;

callable in five years at $106.
The bond has an 8% coupon Use the calculator to calculate yield to call:
and 15 years to maturity. If
the bond is currently trading at Time to call is 5 years and semi-annual pay=> N=10,
$98 today, the yield to call
8% coupon and semi-annual pay=> PMT=4,
is closest to:
A. 8.22%

The call price is $106 => FV=106,

B. 8.49%.

PV=-98

C. 9.48%.

CPT -> 1/Y=4.7386

4.7386*2=9.48
Therefore the yield to call is 9.48%. C is the correct
answer.

15. A 10% annual coupon

Ans: A;
bond with 3 years to maturity
is currently trading at $1,010. The yield to worst for a callable bond is the lowest of
The bond is callable in one
year at a call price of $1,008
and in two years at a call price

the yields to call for each possible call date and the
yield to maturity.

of $1,005. The bonds yield to The yield to call if the bond is called in one year is
worst most likely occurs when 10.45%, because 1,005=(100+1,010)/1.1045
the bond is:
A. held until maturity in 3

The yield to call if the bond is called in two years is

10.09% , because

years.

1,005=100/1.1009+(100+1,008)/1.10092

B. called in year 1.

The yield to maturity of the bond is 9.80%, because

C. called in year 2.

1,005=100/1.0980+100/1.0980 2+(100+1,000)/1.09
80 2
The yield to worst is the lowest of these and occurs
when the bond is held until maturity. Therefore A is
the correct an