6. Consider the treasury rate term structure below.

1-year 2-year 5-year 7-year 10-year 20-year Interest rate 1.05% 1.63% 2.21% 2.60% 2.95% 3.11%

a. Under the expectations hypothesis, what is the 1-year interest rate expected one year from today and how does it compare to the current one-year rate?

b. What is the 2-year rate expected in five years (called the two-year, five-year forward rate) and how does this rate compare to the current 2-year rate?

c. What are the key assumptions you are making in order to arrive at your answers? d. What are some of the possible explanations for the expected changes in interest rates you computed?

7. Consider a three-year security with a $1 million face value, a 5% coupon, and a current yield of 4%.

a. what is the current market value of this security?

b. what if interest rates rise to 6%? What happens to its market value?

c. what is the duration of this security?

d. use duration analysis to estimate the impact of a 2% rise in interest rates on the security value.

e. is the answer in part d. different than b.? If so, why? If not, why not?

8. Consider a two-security portfolio. You own a $25 million bond that yields 4.5% with a standard deviation of 3.1%, and a $30 million bond that yields 5.5% with a standard deviation of 4.6%.

a. What is the expected return on this portfolio?

b. If the assumptions for modern portfolio theory exist, and the correlation of the returns for the two securities is -0.55, what is the expected variance (risk) of your portfolio?

c. The quant that gave you that correlation of returns made a mistake (quants sometimes do that.) You learn that the correlation of returns between the two securities is +0.55, not -0.55. What is the actual risk of this portfolio?

a. What is the expected return on this portfolio?

b. If the assumptions for modern portfolio theory exist, and the correlation of the returns for the two securities is -0.55, what is the expected variance (risk) of your portfolio?

c. The quant that gave you that correlation of returns made a mistake (quants sometimes do that.) You learn that the correlation of returns between the two securities is +0.55, not -0.55. What is the actual risk of this portfolio?