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Fixed Income

This document contains problems related to fixed income securities including swaps, bonds, and interest rate derivatives. 1) It provides calculations to determine the 1-year par swap rate that makes the value of a 1-year interest rate swap equal to zero. It also calculates zero rates and forward rates implied by the prices of interest rate derivatives. 2) It prices interest rate derivatives like inverse floaters and calculates hedge ratios needed for immunization of a fixed income portfolio using interest rate swaps. 3) It prices zero-coupon bonds and interest rate derivatives using binomial trees under the risk-neutral measure and calculates implied forward rates. It also prices and analyzes an embedded call option on a coupon bond.

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180 views6 pages

Fixed Income

This document contains problems related to fixed income securities including swaps, bonds, and interest rate derivatives. 1) It provides calculations to determine the 1-year par swap rate that makes the value of a 1-year interest rate swap equal to zero. It also calculates zero rates and forward rates implied by the prices of interest rate derivatives. 2) It prices interest rate derivatives like inverse floaters and calculates hedge ratios needed for immunization of a fixed income portfolio using interest rate swaps. 3) It prices zero-coupon bonds and interest rate derivatives using binomial trees under the risk-neutral measure and calculates implied forward rates. It also prices and analyzes an embedded call option on a coupon bond.

Uploaded by

k_Dashy8465
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Problem Set 1

1
a)swap (k,T) = fixed (k,T) - floater
hence 1 year par-rate = 8%, since newly issued swaps have a par value of zero

1 year par rate is the rate that makes value of the 1 year swap equal to zero
swap value is equal to fixed bond floater (floater has a value of 100 at every
coupon date)
to make the swap value zero, the value 1 year maturity bond must also be made
100
1 year par-rate=(1-Pn)/(summation of all discount factors), Pn is discount
factor/price of a $1 par bond 1-year zero. Its unknown currently
0=(1-Pn)/(Pn+0.06)

b) k=8% (swap rate = fixed rate)


at time 0.5, the fixed payer (one who pays floating rate), receives money, i.e fixed
rate must be greater than floating rate
At time 0.5, 100* (8% - 0 r 0.5 )/2 = 1
8% - 0 r 0.5 = 0.02, 0 r 0.5 = 0.06 (this is annualized 0.5 year zero rate)

C) price = 1/(1+0.08/2)^2 = 0.9246

d) find forward rate between time 0.5 and time 1


(1+0.06/2)^1 * (1+f/2) = (1+0.08/2)^2 , f=10%
at time 0.5 it pays: 100*[(16% - 0.06)/2] = $5
at time 1 it pays: 100*[(16%-10%)/2] = $3 + $100 (par value)

discounted value of inverse floater = 5/(1+0.06/2)^1 + 103/(1+0.08/2)^2 =


100.084
2.
a) Value of fixed bond of 1 year maturity and coupon rate 8% =4/(1+0.06/2)^1 +
104/(1+0.08/2)^2 = 100.037
Value of swap = value of fixed bond value of floater
to make the swap value zero, the value 1 year maturity bond must also be made
100, since floater has a value of 100 on each coupon date
P1=1/(1+0.08/2)^2 = 0.924556
P0.5=1/(1+0.06/2)^1 = 0.970874
par rate=2*(1-0.924556)/(0.924556+0.970874) = 7.96%
100=4/(1+x) + 104/(1+x)^2 solve by trial and error
swap rate that will make value of swap equal to zero is 8.01%

B) duration of swap = duration of fixed bond duration of floater


Dollar duration of $1 par value floater = dollar duration of a 6-month T-bill = 0.5/
(1+0.06/2)^(2*0.5+1) = 0.4713
Dollar duration of $1 par value bond = 1/(1+0.08/2)^(2*1+1) = 0.889
Dollar duration of swap = 100*0.889 100*0.4713 = 41.77
Value of swap = 100.037-100 = 0.037
Hence duration of swap = 41.77/0.037 = 1128.92

c) for immunization, dollar duration of assets = dollar duration of liabilities


100,000*3 + N*1128.92 = 100,000*5
N=177.16, these are the number of units of swap that should be sold (liability side)
to immunize the portfolio

Problem Set 2
1.
a) N0.5*1 +N1*0.96 = 1
N0.5*1 + N1*0.98 = 0
N1*0.02=-1, N1 = -50 , and N0.5 + (-50*0.98) = 0, i.e. N0.5 = 49
50 units of N1 must be sold and 49 units of N2 must be bought

b) value of claim = 0.97*0.5*(1+0) = value of portfolio replicating the claim =


49(0.97) - 50(0.94) = 0.53

D1=0.94, d0.5=0.97, 0.5d1u=0.96, 0.5d1d=0.98, hence p=0.5464 (probability of


up state)
1-p=0.4536 (probability of down state)

2.
a) price of zero maturing at time 1= 0.97(0.5*(0.96+0.98) = 0.9409
b) answer 3. Because the same discount factor (0.97, discount rate of 0.97=1/
(1+r/2), r=6.19%), is applicable to both zeroes between time 0 and time 0.5

3.
a) we need to find discount factor between 0 and 0.5, let it be r, p is probability of
up state and 1-p is probability of down state
asset a: 0.49=r*(p*1+(1-p)*0) , 0.49=pr, p=0.49/r
asset b: 0.49=r*(p*0 + (1-p)*1), 0.49=r-rp

0.49=r-r(0.49/r), 0.49=r-0.49, hence, r=0.98, p=0.5 and 1-p=0.5


Now discount back the two possible values of the 1-year zero at 0.5, at r
Price of 1-year zero=0.98*0.5*(0.97+0.99) = 0.9604

b) price of the zero maturing at time 0.5 is simply the discount factor we found
earlier i.e. 0.98

4.
a) working back the 1-year zeros price at time 0.5 in the up state, i.e. 0.96
This 0.96 implies a certain forward rate between time 0.5 and time 1, since the ayear zero will pay $1 at maturity and in the up state this is being discounted to 0.96
at time 0.5
0.96=1/(1+r/2)^1, r=8.33%
So, the FRN will have the floating rate of 0.833% applicable as 0.5 r 1
Payoff = par i.e. 100,000 + 100,000*(0.0833/2)= 104,166.5

b) working back the 1-year zeros price at time 0.5 in the down state, i.e. 0.98
0.98=1/(1+r/2), r=4.082%
Payoff= 100,000 + 100,000*(0.04082/2) = 102,041

c) value of note at time 0 = 0.5*104,166.5 + 0.5*102,041 = 103,103.75

d) N0.5*1 + N1*0.96 = 104,166.5 and N0.5*1 + N1*0.98 = 102,041

Problem set 3
1.
a)
(i) since its ex-coupon price, we are no including coupon in the calculation
100
100*0.9565=95.65
0.5032(95.65) + .4968(96.55)=96.10
100
100*0.9655=96.55
100

Find probabilities:

for (0.5 d 1 u) and (0.5 d 1 d) use the 0.5 year zero


rates at time 1 because we are considering it standing at time 0
P=[(0.9258/0.9634)-0.9655]/(0.9565-0.9655) = 0.5032, 1-p =0.4968

(ii) interest rate delta= - (Pu Pd)/(ru rd) = - (95.65-96.55)/(0.0910-0.0716) =


46.39

B) the option has a value of zero at time 0 and time 0.5 (in both states) because the
value of the bond (underling asset) is less than strike price (100),
value of option = min of [Value of asset (Vt) Strike price (k), 0] , hence the min i.e.
0 will be chosen and option will not be exercised at either time 0 or time 0.5

c) now making the tree with coupon included:

Risk neutral probabilities for the up state from time 0.5 to time 1:
p=((0.9156/0.9565)-0.9621)/(0.9523-0.9621) = 0.4959 and 1-p=0.5041
since its are three outcomes at time 1, it means probabilities for the down state
from time 0.5 to time 1 must be the same as calculated above
Risk neutral probabilities for the states from time 0 to time 0.5:
P=((0.9258/0.9634)-0.9655)/(0.9565-0.9655)=0.5032, and 1-p=0.4968
These are the same calculated in part a
(it wasnn really necessary to caulctae these, could have just approximated 0.5, but I
was checking)
Coupon is lagged one time period before.
100
0.9565(4+(0.4959*104+0.5041*104))=99.476
0.9634(4+0.5032(99.476) + 0.4968(100(called))=99.9396
100
0.9655(4+0.4959(100)+0.5041(100))=100.412 (called)
100
since value of option at time 0 is 99.9396, i.e. less than par (100), the firm should
not call the bond at time 0 (since option has value of 0 and liabilities and not
minimized at time 0 liabilities are minimized when value of option is maximized)

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