Q1. The annual coupon rate for a TIPS is 6%. Suppose that an investor purchases $1,000 of par value (initial principal) of this issue today and that the annual inflation rate is 3%. (10 points) 1. What is the dollar coupon interest that will be paid in cash at the end of the first six months? 2. What is the inflation-adjusted principal at the end of the year? 3. Suppose that an investor buys a five-year TIP and there is deflation for the entire period. What is the principal that will be paid by the Department of the Treasury at the maturity date? Q2. Suppose that the price of a Treasury bill with 60 days to maturity and a $1 million face value is $990,000. What is the yield on a bank discount basis? (10 points) Q3. Investors largely anticipated that the FOMC would announce tapering off its bond-buying (QE3) program at the end of the FOMC meeting on September 18, 2013. The FOMC surprised the financial market by indicating no taper for at least another month. How did stock and bond markets react to the FOMC announcement and why? What are the rationales for the FOMC policy action? (Hint: read the FOMC statement at the link http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm) (10 points) Q4. The chart below plots the yield to maturity for the 10-year nominal Treasury bond (solid line) and 10-year TIPS (dashed line) over the January 2003 to August 2013 period. Explain why the nominal bond always has a higher yield than the TIPS. Does the yield spread between the nominal bond and the TIPS tell us anything about future inflation rate? Discuss. (10 points) 6.00 5.00 4.00 3.00 2.00 1.00 0.00 ‐1.00 ‐2.00 2003‐01‐01 2006‐01‐01 2009‐01‐01 2012‐01‐01 Q5. “If the term structure is flat, it must mean that the market expects the future interest rate stay the same.” Use the three hypotheses that we discussed in the class to assess this statement. (10 points) Q6. A and B are two Treasury bonds with a maturity of 3 years and a par value of $1000. The annual coupon rate is 2% for A and is 10% for B. Suppose there are two coupon payments a year. The annualized spot rates are as follows (20 points): Years from Now Annualized spot rates 0.5 5% 1 6% 1.5 7% 2 8% 2.5 9% 3 2% Calculate the prices for both bonds A and B. Calculate the annualized YTM for both bonds A and B. Do bonds A and B have the same YTM, and why? C and D are zero coupon bonds with a maturity of 2 years and a par value of $1000. Do bonds C and D have the same YTM, and why? Q7. We observe the following annualized yields for Treasury securities: Maturity (years) 0.5 1 1.5 2 Yield-to-maturity (%) 4.00 4.50 5.00 5.50 The par is $1000 for all the securities. The security with 0.5-year to mature is a zero coupon bond. All other securities are coupon-bearing bonds selling at par. Note that the coupon rate is equal to YTM for par bonds. (30 points) 1. Calculate the spot rates for all maturities 2. What should the price of a 2-year bond with 8% annual coupon rate be (suppose $1000 par)? 3. Suppose a 1-year zero-coupon bond with a par value of $1000 is selling at $900. Is there any arbitrage opportunity? If there is, construct an arbitrage portfolio and show the profit. 4. Calculate the one-period-ahead forward rates for all maturities when possible. 5. One year from now, what is the expected price of a one-year bond with 8% coupon? Assume the expectation hypothesis holds.