I am confused as to how this question will be solved. Kindly list out all the st
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I am confused as to how this question will be solved. Kindly list out all the steps so that I can practice questions like this.
Question 4: This problem is intended to utilize your knowledge about the term structure of interest rates. You are given the following information about three bonds that have recently been traded. Cash flows Bond Price r 1 100 120 100 r 3 1100 0 100 r 0 100 1120 100 Suppose there are also three strips in the market: i. A one year strip with par value S 1000 (Strip D), its price is $909.05; ii. A two year strip with par value S 1000 (Strip E), its price is $819; iii.A three-year strip with par value S 1000 (Strip E), its price is $731.25. (a) What are the prices of these three bonds, A, B and C? (b) What are the interest rates for one-year, two-year and three-year loans (r, r2 and ra) in the market? structure? in year 1, S340 in year 2, and S 290 in year 3. Should you take the project? (c) Plot the term structure of the interest rates. Can you say something about the term (d) Using the rates in (b), calculate the PV of a project that costs S1217 and pays out $ 840Explanation / Answer
Answer:
A. Price of the Bonds.
Bonds Price Yr 1 Cash Yr2 Cash Yr3 Cash
A $ 977.18 100 100 1100
B $ 1026.37 120 1120 0
C $ 245.93 100 100 100
Calculation of Price is below
Bond A : = 0.1 Strip D + 0.1 + Strip E + 1.1 Strip F
Bond B : = 0.12 Strip D + 1.12 Strip E + 0 Strip F
Bond C := 0.1 Strip D + 0.1 Strip E + 0.1 Strip F
So,
Price of A = 0.1 * Price of Strip D + 0.1 * Price of Strip3 + 1.1 * Price of Strip F = 977.18
Price of B = 0.12* Price of Strip D + 1.12 * Price of StripE + 0 * Price of Strip F = 1026.37
Price of C = 0.1 * Price of Strip D + 0.1 * Price of Strip + 0.1 * Price of Strip F = 245.93
B. P 1,0 = 1 / (1 + r1 ) = r1 = 1 / P1,0 - 1 = .10
P 2,0 = ( 1 / 1 + r2 )2 = r2 = (1 / P2,0 )1/2 - 1 =.105
P3,0 = ( 1 / 1 + r3 )3 = r3 = (1 / P3,0 )1/3 - 1 = .11
D. Period :
0 / -1217 1 / +840 2 / +340 3 / +290
NPV = -1217 + 840 / 1 + r1 + 340 / (1 + r2 )2 + 290 / ( 1 + r3 )3
= -1217 + 840+ 340 + 290 = $ 37.12
NPV0 > 0, So we can take the project.
C. The term structure of Interest rates is the relationship among the interest rates on bonds with different maturities. we can say term structure of interest rates is to plot the data for given day for interest rates on debt securities with different times to maturity.
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