investment science solution Chapter4.pdfVIP

Investment Science Chapter 4 Solutions to Suggested Problems Dr. James A. Tzitzouris jimt2@ams.jhu.edu 4.1 (One forward rate) f1,2 = (1 + s2)2 (1 + s1) ? 1 = 1.069 2 1.063 ? 1 = 7.5% 4.2 (Spot Update) Use f1,k = [ (1 + sk)k 1 + s1 ]1/(k?1) ? 1 . Hence, for example, f1,k = [ (1.061)6 1.05 ]1/5 ? 1 = 6.32% . All values are f1,2 f1,3 f1,4 f1,5 f1,6 5.60 5.90 6.07 6.25 6.32 1 4.3 (Construction of a zero) Use a combination of the two bonds: let x be the number of 9% bonds, and y teh number of 7% bonds. Select x and y to satisfy 9x+ 7y = 0, x+ y = 1. The first equation makes the net coupon zero. The second makes the face value equal to 100. These equations give x = ?3.5, and y = 4.5, respectively. The price is P = ?3.5× 101.00+ 4.5× 93.20 = 65.90. 4.5 (Instantaneous rates) (a) es(t2)t2 = es(t1)t1eft1,t2 (t2?t1) =? ft1,t2 = s(t2)t2?s(t1)t1t2?t1 (b) r(t) = limt→t1 s(t)t?s(t1)t1 t?t1 = d[s(t)t] dt = s(t) + s ′(t) (c) We have d(lnx(t)) = r(t)dt, = s(t)dt+ s′(t)dt, = d[s(t)t]. Hence, lnx(t) = lnx(0) + s(t)t, and finally that x(t) = x(0)es(t)t. This is in agreement with the invariance property of expectation dynamics. Investing continuously give the same result as investing in a bond that matures at time t. 4.6 (Discount conversion) 2 The discount factors are found by successive multiplication. For example, d0,2 = d0,1d1,2 = 0.950× 0.940 = 0.893. The complete set is 0.950, 0.893, 0.770, 0.707, 0.646. 4.7 (Bond taxes) Let t be the tax rate, xi be the number of bond i purchased, ci be the coupon of bond i, pi be the price of bond i. To create a zero coupon bond, we require, first, that the after tax coupons match. Hence x1(1? t)c1 + x2(1? t)c2 = 0, which reduces to x1c1 + x2c2 = 0. Next, we require that the after tax final cash flows match. Hence p0 = x1p1 + x2p2. Using this last relation in the equationfor final cash flow, we find x1 + x2 = 1. Combining these equations, we find that p0 = c2p1? c1p2 c2 ? c1 . After plugging in the given values, we find that p0 = 37.64. 4.8 (Real