(a) Given below is the zero-coupon yield curve in percent per annum. Calculate the 2-year key rate duration of a 2-year 5% coupon bond if the yield is changed by 20 basis points. How to interpret the calculated duration? (20 MARKS) 0.5 1 1.5 2 year period 1 2 4 3 8.05 8.33 zero-coupon yield 7.35 7.76 (b) In the bond indexing strategies where a portfolio manager's benchmark is a bond index, risk is measured by the tracking error. (i) Calculate the tracking error given the following monthly returns. How to interpret the calculated tracking error? (15 MARKS) Return (%) Month Portfolio Index 1 0.02 0.05 2 1.58 1.55 3 0.04 0.01 4 0.61 0.55 5 0.71 0.78 6 0.27 0.34 (ii) Suppose that the credit risk factor has an annual volatility of 10%, and the factor loading of the portfolio and the index is 1.03 and 1, respectively. What is the forward-looking tracking error of the portfolio relative to the index with respect to the factor? Is this portfolio strategy passive or active? (15 MARKS) 0.61 0.55 0.71 0.78 0.27 0.34 Suppose that the credit risk factor has an annual volatility of 10%, and the factor loading of the portfolio and the index is 1.03 and 1, respectively. What is the forward-looking tracking error of the portfolio relative to the index with respect to the factor? Is this portfolio strategy passive or active? (15 MARKS) (c) The predictive regression is of the form (N) (N) rx} = a + Z + (4}, (N) where rx is the excess return of holding an N-year bond from time t to t + 1; Zt is a vector of K predetermined variables at time t; & is a forecast error. (i) What are the two categories of Z that are used in the literature? List two predictors for each category. (10 MARKS) What is the prediction of the expectations hypothesis about ? If z measures economic uncertainty, what is the sign of as predicted by asset pricing models that characterise risk premiums? And why? (10 MARKS) How to assess the predictive power of Z? (30 MARKS) 456 (iii)