Test bank

to accompany the textbook

Fixed Income Securities: Valuation, Risk, and Risk

Management by Pietro Veronesi

Preliminary Version

Author: Javier Francisco Madrid

1
Chapter 1
1. Is the following an arbitrage opportunity? A gift that makes me feel good
just by having it.
Ans. This is an arbitrage opportunity because it doesn’t cost anything at initi-
ation and it generates a positive profit by a certain date in the future (i.e.
’you feel good’).
2. Is the following an arbitrage opportunity? A bond that cost nothing but
will payoff zero with certainty in the future.
Ans. This is not an arbitrage opportunity, since it doesn’t give a positive payoff
in the future.
3. Is the following an arbitrage opportunity? A free car that if I repair well, I
won’t have to spend money on gasoline or maintenance costs (i.e. repairs)
ever.
Ans. This is not an arbitrage opportunity, since I have to pay money (to repair
the car) in order to be free of future costs.
4. Is the following an arbitrage opportunity? Suppose you are in the desert
and are given a bag of ice with a penny inside. Assume that the ice will
melt instantly and the cost of disposing of the bag is zero.
Ans. This is an arbitrage opportunity because even though I can’t take advan-
tage of the ice, I gain the penny for free.
5. Is the following an arbitrage opportunity? A security that cost zero and
might pay a dollar in the future, but pays zero otherwise.
Ans. This is an arbitrage opportunity because I get for free the chance of getting
a dollar in the future.
6. What steps would you follow in order to take advantage of the following
arbitrage opportunity (if there is one)? Security A costs $3 and pays $5
in 2 years, while security B costs $3 and pays $4 in 2 years.
Ans. You borrow security B and sell it, which means you receive $3, with these
proceeds you buy security A. In 2 years you receive $5 and have to pay
$4. You make a $1 profit.
7. What steps would you follow in order to take advantage of the following
arbitrage opportunity (if there is one)? Security A costs $100 and pays
$120 in 3 years. Security B costs $100 and pays $110 in one year. Your
friend tells you that he would like you to lend him $110 in a year and that
he would give $130 the following year. Finally you know that in two years,
with $130, you can invest in a security that will pay you either $140 or
$121 (with equal probability) after a year.

2
Ans. You borrow security A and sell it, with the proceeds you buy security B.
After a year you lend the money to your friend. The next year when he
pays back, you invest in the risky security. After the third year, this will
give you either $140 or $121, while you have to pay $120. So you either
have a profit of $20 or $1.
8. What steps would you follow in order to take advantage of the following
arbitrage opportunity (if there is one)? Security A costs $100 and pays
$110 in 2 years. Security B costs $100 and pays $109 in one year. You
know that in a year with $109 you can invest in a security that pays $120
or $109 (with equal probability) the following year.
Ans. This is not an arbitrage opportunity.
9. Intuitively, is the Federal Funds rate generally higher, lower or the same
as LIBOR? Why?
Ans. The LIBOR rate should be higher than the Federal Funds rate, since it
should include a higher probability of default by the banks trading LIBOR.
10. Intuitively, is LIBOR generally higher, lower or the same as the repo rate?
Why?
Ans. LIBOR should be higher than the repo rate since it is not collateralized
with another security, as it occurs with the repo rate.
11. What are the steps to take a long position on a given U.S. security via the
repo market?
Ans. The trader must take the following steps (repo):

At time t:
i. Buy bond at Pt and deliver the bond to the repo dealer.
ii. The repo dealer will pay Pt − haircut to the trader, which is made
whole (minus the haircut) for the cost of the bond.
At time T :
iii. The trader gets the bond from the repo dealer and sells it for PT .
iv. With the proceeds PT the trader pays back (Pt −haircut)×(1+Repo)
to the repo dealer.
12. What are the steps to take a short position on a given U.S. security via
the repo market?
Ans. The trader must take the following steps (reverse repo):

At time t:

3
 i. Borrows the bond from the repo dealer and sells it at Pt .
ii. Receives Pt which he posts as collateral with the repo dealer.
At time T :
iii. The trader buys the bond for PT and gives it back to the repo dealer.
iv. The repo dealer pays Pt × (1+Repo). The dealer makes a profit if
this is larger than PT .
13. What’s the return on capital for a trader who entered into a one-month
repo where Pt = 98.5, PT = 99.01, Repo= 5% and haircut= 0.8?
Ans. The return on capital is 0.13.
14. What’s the profit for a trader who entered into a one-week reverse repo
where Pt = 99.40, PT = 99.48 and Repo= 6%?
Ans. The profit is 0.0347.
15. You find a bond that has a repo rate substantially lower than the GCR.
Is this, for certain, an arbitrage opportunity?
Ans. No, it might be that the bond is short on supply (hard to find), which
means that the trader might be thinking that the bond is overpriced and
is speculating that the price will fall. By entering in a reverse repo, the
trader might make a substantial profit, even willing to forgo part of the
rate to be in the transaction.
16. You are told that there is an ample supply for the bond mentioned in
question 13. Does this affect your previous answer?
Ans. Yes, since it shows that the lower rate is not due to scarcity of a specific
type of bond.
17. What are the gains from trade of entering into a swap for these two firms?

Firm A Firm B
Fixed Rate 13% 16%
Floating Rate LIBOR + 3% LIBOR + 6%

Ans. Gains from trade are zero.

18. What are the gains from trade of entering into a swap for these two firms?

Firm A Firm B
Fixed Rate 10% 15.5%
Floating Rate LIBOR + 2% LIBOR + 4%

Ans. Gains from trade are 3.5%.

4
 19. What are the gains from trade of entering into a swap for these two firms?

Firm A Firm B
Fixed Rate 9% 5%
Floating Rate LIBOR + 7% LIBOR + 4%

Ans. Gains from trade are 1%.

5
Chapter 2
1. Do discount factors depend on compounding frequency? Why?
Ans. No, discount factors do not depend on compounding frequency, since they
are terms of exchange (prices) between having money at time t versus
having at a later date T . If they changed with compounding frequency,
there would be an arbitrage opportunity.
2. What effect does inflation have on discount factors?
Ans. Higher inflation makes less appealing money in the future, so discount
factors will go down.
3. Can a bond be quoted in more than one interest rate?
Ans. Yes. It can be quoted in various compounding frequencies.
4. From the following data obtain the discount curve:
a. A zero coupon bond Pz (0, 0.5) = 99.20.
b. A coupon bond paying 3% quarterly P (0, 0.25) = 100.5485.
c. A coupon bond paying 6% quarterly P (0, 0.75) = 100.1655.
d. A coupon bond paying 5% semiannually P (0, 1) = 103.0325.
Ans. The discount factors are the following:

t Z(0, t)
0.25 0.9980
0.50 0.9920
0.75 0.9870
1.00 0.9810

5. Using the previous discount curve price the following: A zero coupon bond
expiring at t = 0.75.
Ans. The price of the bond is 98.70.
6. Using the previous discount curve price the following: A 1-year coupon
bond paying 4% quarterly.
Ans. The price of the bond is 102.0580.
7. Using the previous discount curve price the following: A 6-month coupon
bond paying 7% semiannually.
Ans. The price of the bond is 102.6720.
8. Using the previous discount curve price the following: A 9-month coupon
bond paying 5% semiannually.

6
Ans. The price of the bond is 103.6625.
9. For the following scenario, check if there is a mispriced security:
a. A zero coupon bond Pz (0, 0.5) = 99.00.
b. A coupon bond paying 6% quarterly P (0, 0.25) = 101.1955.
c. A coupon bond paying 4% quarterly P (0, 0.50) = 102.0830.
d. A coupon bond paying 7% semiannually P (0, 0.75) = 105.8440.
Ans. The mispriced bond is [a.] the zero coupon bond.
10. For the following scenario, check if there is a mispriced security:
a. A zero coupon bond Pz (0, 0.25) = 99.40.
b. A zero coupon bond Pz (0, 0.50) = 98.00.
c. A coupon bond paying 3% quarterly P (0, 0.50) = 100.4880.
Ans. The mispriced security is [b.].
11. For the following scenario, check if there is a mispriced security:
a. A coupon bond paying 1% quarterly P (0, 0.25) = 100.6498.
b. A coupon bond paying 4% semiannually P (0, 0.25) = 101.8980.
c. A coupon bond paying 3% quarterly P (0, 0.50) = 101.2978.
d. A coupon bond paying 5% quarterly P (0, 0.75) = 103.4425.
e. A coupon bond paying 4% semiannually P (0, 1.00) = 103.5880.
Ans. The mispriced bond is [a.].
12. For the following scenario, check if there is a mispriced security:

a. A zero coupon bond Pz (0, 0.5) = 99.50.

b. A coupon bond paying 3% quarterly P (0, 0.50) = 100.9948.
c. A coupon bond paying 5% quarterly P (0, 0.75) = 102.7288.
d. A coupon bond paying 2% semiannually P (0, 1.25) = 102.8720.
e. A zero coupon bond Pz (0, 1.25) = 98.4.
Ans. The mispriced bond is [d.].
13. For the following scenario, check if there is a mispriced security:
a. A zero coupon bond Pz (0, 0.25) = 99.30.
b. A zero coupon bond Pz (0, 0.50) = 98.70.
c. A coupon bond paying 3% semiannually P (0, 0.50) = 100.1850.
d. A coupon bond paying 2% semiannually P (0, 0.75) = 101.4880.

7
Ans. The mispriced bond is [d.], since it requires the discount factor Z(0, 0.75)
to be larger than the previous ones.
14. What is the price on a 4.5-year floating rate bond that pays a semiannual
coupon (no spread)?
Ans. The price of the coupon is 100.
15. What is the price on a 5.75-year floating rate bond that pays a semiannual
coupon (no spread)? We know the following:
a. There is a coupon bond paying 3% quarterly P (0, 0.25) = 100.0448.
b. Last quarter the semiannually compounded rate was 3%.
Ans. The price of the floating rate bond is 100.7895.

16. What is the price of a 0.5-year floating rate bond that pays a quarterly
coupon equal to floating rate plus a 1% spread? We know the following:
a. There is a zero coupon bond Pz (0, 0.25) = 99.80.
b. There is a coupon bond paying 2% quarterly P (0, 0.5) = 100.3960.
Ans. The price of the floating rate bond is 100.4980.
17. What is the price of a 0.75-year floating rate bond that pays a semiannual
coupon equal to floating rate plus 2% spread? We know the following:
a. There is a zero coupon bond Pz (0, 0.25) = 99.70.
b. There is a zero coupon bond Pz (0, 0.50) = 99.20.
c. There is a coupon bond paying 3% quarterly P (0, 0.75) = 101.7380.
Ans. The price is 102.3145.

18. You have two coupon bonds with same maturity, one pays 5% semiannu-
ally and the other 5% quarterly. Which one has a higher yield?
Ans. The second bond has a higher yield because it compounds more frequently
than the first one, increasing the expected return.
19. A Treasury dealer quotes the following 182-day bill at a 3.956% discount.
What is the price of the security?
Ans. The price of the Treasury is 98.00.
20. A Treasury dealer quotes the following 91-day bill at a 3.956% discount.
What is the price of the security?
Ans. The price of the Treasury is 99.00.

8
Chapter 3
Use the following discount factors when needed.
t Z(0, t)
0.25 0.9840
0.50 0.9680
0.75 0.9520
1.00 0.9360
1.25 0.9190
1.50 0.9040
1.75 0.8880
2.00 0.8730
2.25 0.8587
2.50 0.8445
2.75 0.8308
3.00 0.8175
3.25 0.8047
3.50 0.7924
3.75 0.7806
4.00 0.7691

1. Calculate the duration of the following security: 5-year zero coupon bond.
Ans. The duration of the security is 5.00.
2. Calculate the duration of the following security: 2-year fixed coupon pay-
ing 5% quarterly.
Ans. The duration of the security is 1.9138.
3. Calculate the duration of the following security: 1.25-year floating coupon
paying float + 50 bps semiannually. You know that last quarter the semi-
annual rate was 6.4%.
Ans. The duration of the security is 0.2534.
4. Calculate the duration of the following portfolio:
i. 5 units of a 2-year fixed rate bond paying 6% quarterly.
ii. 2 units of a 1.75-year floating rate bond paying float + 80 bps semi-
annually. You know that the reference rate was 6.5% three months
ago.
iii. 6 units of a 1-year zero coupon bond.
iv. 5 units of a 1.5-year floating rate bond with no spread paid semian-
nually.
Ans. The duration of the portfolio is 0.8805.
5. Calculate the duration of the following portfolio:

9
 i. 3 units of a 0.75-year fixed rate bond paying 6% quarterly.
ii. 4 units of a 2-year fixed rate bond paying 3% semiannually.
iii. 7 units of a 1.75-year zero coupon bond.
iv. 1 unit of a 2-year floating rate bond with no spread paid semiannually.
Ans. The duration of the portfolio is 1.4617.
6. You have two bond coupon with the same maturity, one has a 9% coupon
paid semiannually and the other a 8% coupon paid semiannually. Which
one has a higher duration?
Ans. The one with the lower coupon has a higher duration. Higher coupons
mean that a higher proportion of the total cash flows from the bond will
be paid more quickly. These cash flows will also be less sensitive to interest
rates as cash flows paid later are more exposed to interest rate variation.
7. Calculate the MacCaulay Duration for the following security: 1-year fixed
rate coupon bond paying 6% semiannually. You know that the yield of
the bond is 6.72%.
Ans. The MacCaulay Duration for the bond is 0.9854.
8. Calculate the Modified Duration for the same security.
Ans. The Modified Duration for the bond is 0.9533.
9. What is the duration of the following portfolio?
i. Long a 1.5-year zero coupon bond.
ii. Short a 2-year fixed coupon bond paying 1% quarterly.
Ans. Trying to compute duration from this long-short portfolio brings many
problems since we can’t adequately weigh the securities within the port-
folio.
10. What is the dollar duration of the following portfolio?
i. Long a 1.5-year zero coupon bond.
ii. Short a 2-year fixed coupon bond paying 1% quarterly.
Ans. Dollar duration for the portfolio is -41.0462.
11. What is the dollar duration of the following portfolio:
i. Long a 1-year fixed coupon bond paying 4% quarterly.
ii. Long a 1.75-year floating rate bond paying float plus 80 bps semian-
nually. You know that the reference rate was set at 6% six months
ago.
iii. Short a 2-year zero coupon bond.

10
Ans. The dollar duration of the portfolio is -51.8169.
12. What is the dollar duration of the following portfolio:
i. Long a 2-year fixed coupon bond paying 7% quarterly.
ii. Short three 1.25-year floating rate bonds paying float plus 80 bps
semiannually. You know that the reference rate was set at 7% six
months ago.
iii. Short two 0.5-year zero coupon bonds.
Ans. The dollar duration is 13.2098.
13. What is the PV01 of the following portfolio?
i. Long a 1-year fixed coupon bond paying 4% quarterly.
ii. Long a 1.75-year floating rate bond paying float plus 80 bps semian-
nually. You know that the reference rate was set at 6% six months
ago.
iii. Short a 2-year zero coupon bond.
Ans. The PV01 is -0.0052.
14. What is the PV01 of the following portfolio?
i. Long a 2-year fixed coupon bond paying 7% quarterly.
ii. Short three 1.25-year floating rate bonds paying float plus 80 bps
semiannually. You know that the reference rate was set at 7% six
months ago.
iii. Short two 0.5-year zero coupon bonds.
Ans. The PV01 is 0.0013.
15. Compute the 95% VaR for the following portfolio:
i. A 1.5-year fixed rate bond paying 2% quarterly.
ii. A 0.75-year floating rate bond paying float plus 80 basis points semi-
annually. You know that the reference rate was set to 6% six months
ago.
iii. A 0.25 zero coupon bond.
Additionally you know that μdr = 0 and σdr = 0.4233.
Ans. The 95%V aR = 1.3116.
16. Suppose that you calculate VaR from Duration. In your many results you
find that:
i. using historical data (of whatever length) or a normal distribution
does not affect the result;

11
 ii. you find that kurtosis between historical data and the normal distri-
bution is almost identical;
iii. You find the expected change in the portfolio μP = 0, with very small
standard errors.
Given the above, can you say that this Duration based VaR is an appro-
priate approach to measure risk?
Ans. No, it is not. It is still internally inconsistent: Duration measures small
changes, but VaR uses extreme values (large changes).
17. Mr. Brown wants to invest $100,000 for the next five years. He purchases
an annuity from a financial institution. Currently the term structure is
flat at 10% (yearly compounded).
i. If the payments are made yearly, what is the amount that the finan-
cial institution will agree to pay Mr. Brown?
ii. Assume that there is a 5-year fixed coupon bond that pays 12%
coupon every year. What is the price and duration of the bond?
iii. How much must the financial institution invest in the long-term bond
in order to hedge the position? What should it do with the remainder
of the money?
Ans. The results for the immunization exercise are:
i. The financial institution would pay a yearly amount of $26,379.75.
ii. The price of the security is $107.58 with 4.074 duration.
iii. The financial institution should invest 93.05% of the proceeds from
the investment in the long-term bond and the rest in the money
market account.

12
Chapter 4
Use the following discount factors when needed.
T Z(0, T )
0.25 0.9840
0.50 0.9680
0.75 0.9520
1.00 0.9360
1.25 0.9190
1.50 0.9040
1.75 0.8880
2.00 0.8730
2.25 0.8587
2.50 0.8445
2.75 0.8308
3.00 0.8175
3.25 0.8047
3.50 0.7924
3.75 0.7806
4.00 0.7691
1. Calculate the convexity of the following security: a 5-year zero coupon
bond.
Ans. The convexity of the security is 25.
2. Calculate the convexity of the following security: a 3-year fixed rate bond
paying 4% coupon on a semiannual basis.
Ans. The convexity of the security is 8.3780.
3. Calculate the convexity of the following security: a 3-year floating rate
bond with no spread paid quarterly.
Ans. The convexity of the security is 0.
4. Calculate the convexity of the following portfolio:
i. 1 unit of a 2-year fixed coupon bond paying 10% coupon quarterly.
ii. 1 unit of a 2-year fixed coupon bond paying 1% coupon semiannually.
iii. 1 unit of a 2-year zero coupon bond.
Ans. The convexity of the portfolio is 3.8230.
5. Calculate the convexity of the following portfolio:
i. 2 units of a 1.5-year fixed rate bond paying 6% quarterly.
ii. 4 units of a 1.75-year floating rate bond paying float + 80 bps semi-
annually. You know that the reference rate was 7% three months
ago.

13
 iii. 6 units of a 2-year zero coupon bond.
iv. 1 units of a 1.5-year floating rate bond with no spread paid semian-
nually.
Ans. The convexity of the portfolio is 2.0655.
6. Calculate the convexity of the following portfolio:
i. 4 units of a 1.5-year fixed rate bond paying 4% quarterly.
ii. 5 units of a 1.5-year fixed rate bond paying 5% semiannually.
iii. 10 units of a 1.5-year zero coupon bond.
iv. 3 units of a 1.5-year floating rate bond with no spread paid semian-
nually.
Ans. The convexity of the portfolio is 1.8916.
7. Calculate annualized expected returns (including convexity) for a 5-year
zero coupon bond, when E[dr] = 0 and E[dr 2 ] = 6 × 10−07 (on a daily
basis).
Ans. Annualized expected return on the bond is: 0.189%.
8. Calculate annualized expected returns (including convexity) for a 30-year
zero coupon bond, when E[dr] = 0 and E[dr 2 ] = 7 × 10−07 (on a daily
basis).
Ans. Annualized expected return on the bond is: 7.938%.
9. Calculate annualized expected returns (including convexity) for a 3-year
fixed rate bond paying 2% coupon semiannually, when E[dr] = 0 and
E[dr 2 ] = 7.5 × 10− 07 (on a daily basis).
Ans. Annualized expected return on the bond is 0.0815%.
10. Suppose you hold a bond and interest rates suddenly fall. Duration says
that bond prices will raise a given amount. If Convexity is included in
this estimate, will bond prices go above or below what Duration predicts?
Ans. Prices will go up even more than what Duration predicts.
11. Suppose you hold a bond and interest rates suddenly rise. Duration says
that bond prices will fall a given amount. If Convexity is included in this
estimate, will bond prices go above or below what Duration predicts?
Ans. Prices will go up, partially countering the decrease predicted by Duration.
12. Compute the Term Spread and the Butterfly Spread for the following data.
What shape does the yield curve have?

1-month yield 5-year yield 10-year yield

5.0% 8.0% 10.0%

14
Ans. The term spread is 5% and the Butterfly Spread is 1%. The shape of the
yield cure is increasing.
13. Compute the Term Spread and the Butterfly Spread for the following data.
What shape does the yield curve have?

1-month yield 5-year yield 10-year yield

6.0% 4.5% 4.0%

Ans. The term spread is -2% and the Butterfly Spread is -1%. The shape of
the yield cure is decreasing.
14. Compute the Term Spread and the Butterfly Spread for the following data.
What shape does the yield curve have?

1-month yield 5-year yield 10-year yield

3.0% 4.0% 3.0%

Ans. The term spread is 0% and the Butterfly Spread is 2%. The shape of the
yield cure is a hump.
15. Compute the Term Spread and the Butterfly Spread for the following data.
What shape does the yield curve have?

1-month yield 5-year yield 10-year yield

4.0% 3.0% 5.0%

Ans. The term spread is 1% and the Butterfly Spread is -3%. The shape of the
yield cure is an inverted hump.
16. You currently hold a 7-year fixed rate bond paying 5% annually. You
would like to hedge against changes in the level and the slope of the yield
curve and you plan to use a 1-year zero coupon bond and a 7-year zero
coupon bond. Use the following table to compute the adequate positions
in the hedging instruments.

maturity β1 β2 Z(t, T )
1.00 1.1150 -0.2540 0.9800
2.00 0.9940 -0.3010 0.9600
3.00 0.9640 -0.1470 0.9300
4.00 0.9330 0.0080 0.8900
5.00 0.9300 0.1620 0.8500
6.00 0.9260 0.3160 0.8100
7.00 0.9270 0.4230 0.7700
8.00 0.9270 0.5300 0.7300

Ans. The position in the short term bond should be -0.4651, while the position
in the long term bond should be -1.1231.

15
 17. You currently hold a 7-year fixed rate bond paying 1% annually. You
would like to hedge against changes in the level and the slope of the yield
curve and you plan to use a 2-year zero coupon bond and a 6-year zero
coupon bond as hedging instruments. Use the following table to compute
the adequate positions in the hedging instruments.

maturity β1 β2 Z(t, T )
1.00 1.1150 -0.2540 0.9800
2.00 0.9940 -0.3010 0.9600
3.00 0.9640 -0.1470 0.9300
4.00 0.9330 0.0080 0.8900
5.00 0.9300 0.1620 0.8500
6.00 0.9260 0.3160 0.8100
7.00 0.9270 0.4230 0.7700
8.00 0.9270 0.5300 0.7300

Ans. The position in the short term bond should be 0.4233, while the position
in the long term bond should be -1.4132.
18. You currently hold a 2-year fixed rate bond paying 1% annually. You
would like to hedge against changes in the level and the slope of the yield
curve and you plan to use a 1-year zero coupon bond and a 8-year zero
coupon bond as hedging instruments. Use the following table to compute
the adequate positions in the hedging instruments.

maturity β1 β2 Z(t, T )
1.00 1.1150 -0.2540 0.9800
2.00 0.9940 -0.3010 0.9600
3.00 0.9640 -0.1470 0.9300
4.00 0.9330 0.0080 0.8900
5.00 0.9300 0.1620 0.8500
6.00 0.9260 0.3160 0.8100
7.00 0.9270 0.4230 0.7700
8.00 0.9270 0.5300 0.7300

Ans. The position in the short term bond should be -1.9395, while the position
in the long term bond should be 0.0317.
19. What is the advantage of a factor model?
Ans. A factor model has the advantage that it is adjusted to the data. The
factors are not generated beforehand, but derived from the data itself. It
so happens that embedded in the interest rate data there are three factors:
slope, level and curvature (in addition to some more negligible factors).
Additionally, by obtaining factors this way, they are automatically inde-
pendent. This makes the hedging easier.
20. How many securities do you need to hedge three factors? Why?

16
Ans. To hedge three factors you need three securities, because the three factors
generate a system of equations with three unknowns. In order to solve it
you must include a security for each of these unknowns.
21. If you need three securities to hedge three factors, can you do the follow-
ing? Take two securities and make a third ”synthetic” security from these
two (i.e. it is the average of both prices). Use it to solve the system of
equations. Is this valid?
Ans. This is wrong, because it may lead to a singular matrix. This means that
the system of equations cannot be solved because one the equations is just
a transformation of another one. In order to be used to hedge a factor,
the instrument should be independent from the other two.

17
Chapter 5
Use the following table when needed:
T Z(t, T )
0.50 0.9940
1.00 0.9880
1.50 0.9740
2.00 0.9620
2.50 0.9460
3.00 0.9330
3.50 0.9170
4.00 0.8950
4.50 0.8770
5.00 0.8580
5.50 0.8340
6.00 0.8130
6.50 0.7990
7.00 0.7760
7.50 0.7570
8.00 0.7360

1. What is a forward discount factor?

Ans. A forward discount factor at time t defines the time value of money be-
tween two future dates, T1 and T2 > T1 .
2. Compute F (0, 3, 5), f2 (0, 3, 5) and f(0, 3, 5).
Ans. F (0, 3, 5) = 0.9196, f2 (0, 3, 5) = 4.2343% and f(0, 3, 5) = 4.1901%.
3. Compute F (0, 0.5, 1), f2 (0, 0.5, 1) and f(0, 0.5, 1).
Ans. F (0, 0.5, 1) = 0.9940, f2 (0, 0.5, 1) = 1.2146% and f(0, 0.5, 1) = 1.2109%.
4. Compute F (0, 4, 8), f2 (0, 4, 8) and f(0, 4, 8).
Ans. F (0, 4, 8) = 0.8223, f2 (0, 4, 8) = 4.9501% and f(0, 4, 8) = 4.8898%.
5. Compute F (0, 5, 6), f2 (0, 5, 6) and f(0, 5, 6).
Ans. F (0, 5, 6) = 0.9720, f2 (0, 5, 6) = 2.8573% and f(0, 5, 6) = 2.8371%.
6. Compute F (0, T − 0.5, T ), f2 (0, T − 0.5, T ) and f(0, T − 0.5, T ), up to year
four.
Ans. The following table summarizes the answers:

18
 T F (0, T − 0.5, T ) f2 (0, T − 0.5, T ) f(0, T − 0.5, T )
0.50 0.9940 1.2072% 1.2036%
1.00 0.9940 1.2146% 1.2109%
1.50 0.9858 2.8747% 2.8543%
2.00 0.9877 2.4948% 2.4794%
2.50 0.9834 3.3827% 3.3544%
3.00 0.9863 2.7867% 2.7675%
3.50 0.9829 3.4896% 3.4595%
4.00 0.9760 4.9162% 4.8568%

7. The term structure of interest rates can be upward sloping or downward

sloping. If this is so, can discount factors also be upward sloping or down-
ward sloping? E.g. Z(t, T1 ) < Z(t, T2 ) as well as Z(t, T1 ) > Z(t, T2 ).
Ans. No, this can’t be so. It must always be the case that Z(t, T1 ) > Z(t, T2 ),
otherwise the forward rate for an investment between T1 and T2 will be
negative.
8. Today you notice that forward rates are well above the spot rate. What
shape must the yield curve have?
Ans. It must be upward sloping, since spot rate is an average of forward rates.
9. You notice that forward rates are below the spot rate. What can you say
about the yield curve?
Ans. It must be downward sloping, since spot rate is an average of forward
rates.
10. What is the value of a Forward Rate Agreement with waiting period of
on year for a six-month loan (we have f2 (0, 1, 1.5) = 2.00%), at time t
(six-months after inception). For t we have the discount factors presented
at the beginning of this section. Assume a notional of $100 million.
Ans. The value of the FRA is -427,139.
11. What is the Forward Price to purchase a 1.5-year fixed rate Treasury
paying 5% semiannually, a year from now? At t = 0 we have the following
discounts:

T Z(0, T )
0.50 0.9680
1.00 0.9360
1.50 0.9040
2.00 0.8730
2.50 0.8445
3.00 0.8175
3.50 0.7924
4.00 0.7691

19
Ans. The Forward Price is 97.2262.
12. Suppose you have entered into the Forward Contract from the previous ex-
ercise, what is the value of the contract 6-months after initiation? Assume
that the discount factors are now the ones presented at the beginning of
this section.
Ans. The Value of the Forward Contract is now: 6.8671.
13. Determine the swap rate for the following maturities: 0.50, 1.00, 1.50,
2.00. Use the discount factors provided at the beginning of this section.
Ans. The values are c(0.50) = 1.21%, c(1.00) = 1.21%, c(1.50) = 1.76%,
c(2.00) = 1.94%.
14. Determine the swap rate for the following maturities: 0.25, 0.50, 0.75,
1.00, 1.50, 2.00. Use the following discount factors:

T Z(0, T )
0.25 0.9840
0.50 0.9680
0.75 0.9520
1.00 0.9360
1.25 0.9190
1.50 0.9040
1.75 0.8880
2.00 0.8730

Ans. The values are c(0.25) = 6.50%, c(0.50) = 6.56%, c(0.75) = 6.61%,
c(1.00) = 6.67%, c(1.50) = 6.78%, c(2.00) = 6.84%.
15. What is the value of a swap at initiation?
Ans. The value of the swap at initiation, using the appropriate swap rate, is
zero.
16. Value a 1.5 year swap, with swap rate 5.52%. Notional is 100 million. Use
the following discount factors.

T Z(0, T )
0.25 0.9848
0.50 0.9745
0.75 0.9618
1.00 0.9490
1.25 0.9353
1.50 0.9215
1.75 0.9084
2.00 0.8953

20
 You are told that this is a swap at initiation. Is the value accurate? Be
sure to take into account any payment frequency conventions on the swap.
Ans. The value of the swap is zero. You have to keep in mind that the swap’s
fixed leg is paid semiannually, not quarterly.
17. Consider the same swap as in the previous question. What is the value
of the swap three months after initiation, where the discount factors are
now:
T Z(0, T )
0.25 0.9840
0.50 0.9680
0.75 0.9520
1.00 0.9360
1.25 0.9190
1.50 0.9040
1.75 0.8880
2.00 0.8730

Ans. The value of the swap is now: 222,408.

18. If short term rates go up, what would happen to the swap rate?
Ans. If these rates go up, we would expect for obligations linked to these rates to
go up as well. This means that there will be a greater demand for swap-
pingg these obligations through a fixed-for-floating swaps. This would
drive up swap rates as well, as there is a greater demand for these agree-
ments.
19. Assume that the swap spread at the moment is large, compared to histor-
ical data. What would your expectations be? Will it increase, decrease or
stay the same? To what extent?
Ans. It is expected for the swap spread, the difference between Treasury and
LIBOR discounts to be small. If this difference is large, we would expect
it to shrink. Additionally it would shrink only to the extent that Trea-
sury discounts are still more expensive than LIBOR discounts, since these
include the probability of default by swap dealers, which the Treasuries
don’t have.
20. Use a swap to hedge the following Balance Sheet, so that parallel shifts in
the term structure don’t have an impact on the equity value:

Amount (billion) D
Assets 3.00 15.60
Liabilities 2.50 1.95

The swap used to hedge is 1.5 year swap, you know the following discount
factors:

21
 T Z(0, T )
0.50 0.9745
1.00 0.9490
1.50 0.9215

In order to get the answer, compute the following:

i. What is the adequate swap rate?
ii. What is the dollar duration of the swap?
iii. What is the value of equity and its dollar duration, prior to any
hedging?
iv. What is the value of notional needed so that the swap position hedges
any impact that parallel shifts in the yield curve may have on the
value of equity?
Ans. See the following:
i. The adequate swap rate is 5.52%.
ii. Dollar duration for the swap rate (assuming 100 notional) is -1.46.
iii. The value of equity is 0.5 billion, with dollar duration 13.65.
iv. Notional in order to cover make dollar duration for equity equal to
zero is N = 9.3492.

22
Chapter 6
1. What are the main differences between a forward contract and a futures
contract?
Ans. The main differences are:
i. Futures contracts are traded in a regulated exchange, while forward
contracts are traded in the over-the-counter (OTC) market.
ii. Futures contracts are ”standardized”, while forward contracts are
customized to clients’ requests.
iii. Profits and losses in futures contracts are marked-to-market. Forward
contracts are not.
2. What does mark-to-market mean?
Ans. Profits and losses from the futures contract trading activity accrue to
traders with daily frequency.
3. What is a margin call?
Ans. When someone enters a futures contract, they must put up a specific
amount with the exchange in order to meet the possible losses accrued
from the contract. If this account declines below a specific amount, called
maintenance margin, the exchange issues a margin call and the trader
must replenish the account to the initial margin.
4. What will be the value of a futures contract at maturity?
Ans. The value of the futures contract will be equal to the value of the under-
lying security.
5. Under what conditions are futures and forwards the same? Is this realistic?
Ans. Futures and forward contracts are the same under the following conditions:
i. The difference in timing of cash flows between forward and a futures
contract is ignored.
ii. The futures and forward contract payoffs occur at the same date.
Neither of these conditions is realistic.
6. What are the shortcomings of futures, when compared to forward con-
tracts?
Ans. The most important shortcoming of futures when compared to forward
contracts are:

23
 i. Basis Risk: The available maturity of the bond or of the particular
instrument we want to hedge may not coincide exactly with the one
offered by the futures contract. This leaves some residual risk in the
instrument, called basis risk (because we are not matching the basis
exactly).
ii. Cash flows arising from the futures position accrue over time, which
imply the need of the firm to take into account the time value of
money between the time at which the cash flow is realized and the
maturity of the hedge position.
7. What are the advantages of futures contracts, when compared to forward
contracts?
Ans. The advantages of futures contracts over forward contracts are:

i. Liquidity. It is easier to get in and out of a position because of

standardization. Forward contracts are not easily unwound, since
they were specifically made for a client.
ii. Credit Risk. The existence of a clearing house, which in addition
imposes certain margin requirement reduces credit risk substantially.
8. What is to tail the hedge?
Ans. To tail the hedge means to incorporate the time value of money into the
equation used to determine the optimal hedge ratio of a futures contract.
It usually involves multiplying the appropriate discount rate to the hedge
ratio.
9. What is the difference between a European option and an American op-
tion?
Ans. A European option can only be exercised at a given date, while the Amer-
ican option can be exercised at any moment in time.
10. What is a European Call option?
Ans. Given an underlying variable F (t), maturity T and strike price K; a Eu-
ropean Call option is a contract between two counterparties, option buyer
and option seller, according to which:
i. At maturity T the option buyer has the right to ask the option
seller for the payment of the following effective payoff: Payoff =
(max(F (T ) − K, 0)
ii. The option seller has the obligation to pay this amount to the option
buyer at T .
iii. In return for this right to obtain this payment (exercise) at T , the
option buyer pays an option premium to the option seller at time 0.

24
 11. What is a European Put option?
Ans. Given an underlying variable F (t), maturity T and strike price K; a Eu-
ropean Put option is a contract between two counterparties, option buyer
and option seller, according to which:
i. At maturity T the option buyer has the right to ask the option seller
for the payment of the following effective payoff: Payoff = (max(K −
F (T ), 0)
ii. The option seller has the obligation to pay this amount to the option
buyer at T .
iii. In return for this right to obtain this payment (exercise) at T , the
option buyer pays an option premium to the option seller at time 0.
12. What is an American Call option?
Ans. Given an underlying variable F (t), maturity T and strike price K; an
American Call option is a contract between two counterparties, option
buyer and option seller, according to which:
i. At any time before maturity T the option buyer has the right to ask
the option seller for the payment of the following effective payoff:
Payoff = (max(F (t) − K, 0)
ii. The option seller has the obligation to pay this amount to the option
buyer at T .
iii. In return for this right to obtain this payment (exercise) at T , the
option buyer pays an option premium to the option seller at time 0.
13. What is an American Put option?
Ans. Given an underlying variable F (t), maturity T and strike price K; an
American Put option is a contract between two counterparties, option
buyer and option seller, according to which:
i. At any time before maturity T the option buyer has the right to ask
the option seller for the payment of the following effective payoff:
Payoff = (max(K − F (t), 0)
ii. The option seller has the obligation to pay this amount to the option
buyer at T .
iii. In return for this right to obtain this payment (exercise) at T , the
option buyer pays an option premium to the option seller at time 0.
14. Today you notice that Pc(t, TB ) = 104. What is the payoff for a Eu-
ropean Bond Option maturing today with the following payoff function:
max(Pc (t, TB ) − K, 0), with K = 105?

Ans. The payoff of the option is zero.

25
 15. Today you notice that Pc (t, TB ) = 98.5. What is the payoff for a European
Bond Option maturing today with the following payoff function: max(K −
Pc (t, TB ), 0), with K = 100?
Ans. The payoff of the option is 1.5.
16. Today you notice that r4L (t − 1) = 2.8863%. What is the payoff for a
European Interest Rate Option maturing today with the following payoff
function: max(K − r4L (t − 1), 0), with K = 2.5 and N = 1 million?
Ans. The payoff of the option is 966.
17. Today you notice that r4L (t − 1) = 2.1129%. What is the payoff for a
European Interest Rate Option maturing today with the following payoff
function: max(r4L (t − 1) − K, 0), with K = 1.5 and N = 1 million?
Ans. The payoff of the option is 1,532.
18. You are given the following discount factors:

T Z(0, T )
0.50 0.9940
1.00 0.9880
1.50 0.9740
2.00 0.9620
2.50 0.9460
3.00 0.9330
3.50 0.9170
4.00 0.8950

You are told that the price of a European Call option on a 6-month zero
coupon bond, with T = 0.5 and K = 99.35 is 0.13. While the price of a
European Put option with the exact same specification is: 0.11. Are the
securities adequately priced?
Ans. No, according to Put-Call parity the price of the Call option should be
0.1561.
19. You are given the following discount factors:

T Z(0, T )
0.50 0.9940
1.00 0.9880
1.50 0.9740
2.00 0.9620
2.50 0.9460
3.00 0.9330
3.50 0.9170
4.00 0.8950

26
 You are told that the price of a European Call option on a 2-year fixed rate
bond paying 5% semiannually, with T = 2 and K = 101 is 4.6155. While
the price of a European Put option with the exact same specification is:
3.0500. Are the securities adequately priced?
Ans. Yes, according to the Put-Call parity the price of the Call option should
be 4.6155.

27
Chapter 7
1. Which are the main tools that the Federal Reserve have to conduct Mon-
etary Policy?
Ans. Open Market Operations, Reserve Requirements and the Federal Discount
Rate.
2. How does the Fed reach its desired target rate?
Ans. Through Open Market Operations.
3. Through Open Market Operations, how do you lower rates?
Ans. The Federal Reserve will buy Treasury Securities from banks and credit
their accounts at the Federal Reserve. Banks can use these additional
funds to lend money to other banks. These excess liquidity (i.e. increased
supply of funds) will bring down interest rates (i.e. the price at which the
funds are exchanged).
4. Through Open Market Operations, how do you raise rates?
Ans. The Federal Reserve will sell Treasury Securities from banks and credit
their accounts at the Federal Reserve. Banks that want to borrow funds
will have to pay a higher price, since funds have been used to purchase
securities. Lower liquidity (i.e. diminished supply of funds) will increase
interest rates.
5. What is the Fed’s mandate?
Ans. Promote employment, stable inflation and low long term interest rates.
6. Interpret the following regression explaining the Fed rate:
FF
rt+1 = α + β2 × XtP ay + β3 × X Inf

where: rtF F is the current Fed funds rate; XtP ay is Payroll Growth; and
XtInf is Inflation.
You are given the following table:

parameter coefficient std. error

α 1.5 0.70
β2 0.5 0.25
β3 0.8 0.20

You are also given the value of R2 = 0.5500.

Answer the following:
i. What is the interpretation of α? Does this make any economic sense?
ii. How well does Payroll growth explain Fed fund rates?

28
 iii. How well does inflation explain Fed fund rates?
Ans. For the model:
i. α is the intercept of the equation and it basically says that on av-
erage rates will be at least 1.5%. This does not have any economic
interpretation, it is mostly a term that is capturing variation on the
equation due to the weakness of the other variables.
ii. Payroll growth does a terrible job explaining future rates. It is not
statistically significant.
iii. Inflation is statistically significant and is in line with what we would
expect about the impact of inflation on rates. When inflation goes
up, interest rates will go up to take liquidity out of the market.
7. Interpret the following regression explaining the Fed rate:
FF
rt+1 = α + β1 × rtF F + β2 × XtP ay + β3 × X Inf

where: rtF F is the current Fed funds rate; XtP ay is Payroll Growth; and
XtInf is Inflation.
You are given the following table:

parameter coefficient std. error

α 0.4 0.30
β1 0.6 0.08
β2 0.4 0.14
β3 0.3 0.20

You are also given the value of R2 = 0.5500.

Answer the following:

i. What is the interpretation of α? Does this make any economic sense?

ii. How well do past rates explain present rates?
iii. How well does Payroll growth explain Fed fund rates?
iv. How well does inflation explain Fed fund rates?
v. Is this model better than the one presented previously?
Ans. For the model:
i. α is not statistically significant as expected.
ii. Past rates are statistically significant, and in line with the economic
intuition. We would expect for rates not to change much from their
past value, given the instability that frequent changes on the rate
would generate.

29
 iii. Changes in payroll are statistically significant and are in line with
what would be expected. When payrolls fall, the government would
be under pressure to lower interest rates to increase liquidity and
expand the economy. Not a very neoclassical approach, but the evi-
dence point to this happening.
iv. Inflation is not statistically significant in this case. The other vari-
ables capture the variation assigned to inflation in the previous model.
v. This model is better at explaining rates than the previous one, due
to the higher R2 .
8. Assume that you believe that the Fed funds rate is best explained by the
following:
FF
rt+1 = α + β1 × rtF F
where: rtF F is the current Fed funds rate; and each time step is a week.
You are given the following table:

parameter coefficient std. error

α 0.0001 0.0002
β1 0.9955 0.0020

You also find that standard error equals 0.33, and that r0 = 6%.
Answer the following:
i. What would your payoff be in a week for a Fed Funds Futures contract
that pays 100 minus the current Fed funds rate.
ii. What is the confidence interval for the Fed funds futures payoff? The
confidence interval is defined as: [x̄ + 1.96 × SEx̄ , x̄ − 1.96 × SEx̄ ].
Ans. The answers:
i. The payoff is 94.0270.
ii. The confidence interval for the contract’s payoff is [93.3802, 94.6738].
9. Is using Fed funds futures to forecast the Fed rate unbiased?
Ans. No, it is not unbiased. Futures prices include market participants’ expec-
tations on the Fed rate, but also their attitude towards risk.
10. What is the expectations hypothesis?
Ans. The expectations hypothesis links market participants expectations about
future rates and the current shape of the yield curve. It supposes that
future yields (being averaged with current ones) build the current term
structure. In other words, the expectations hypothesis states that long
term yields depend only on market participants expectations of future
yields.

30
 11. What is missing from the expectations hypothesis?
Ans. The expectations hypothesis assumes that future rates are known and,
therefore, not random. This means that there is no uncertainty about
these rates. This is false, future interest rates are uncertain. Yet the
principal problem is that by being uncertain and affecting the value of
market participants’ securities they are also a source of risk that is priced
in the securities. Thus the expectations hypothesis isn’t an adequate way
of explaining interest rates.
12. If market participants don’t expect yield to go up a year from now, can
the yield curve be upwards sloping? Why?
Ans. Yes. If market participants change their attitude towards risk (require a
higher premium to hold long term bonds) it may so happen that the yield
curve be upwards sloping without changing expectations on future rates.
13. How does inflation affect bonds?
Ans. Inflation affects purchasing power of coupons and principal payment from
bonds.
14. In what sense are bonds insurance against inflation? When does this not
hold?
Ans. To the extent that returns on a bond are above or the same as inflation,
we can say that bonds are insurance against inflation. When inflation
surpasses the rate of return on a bond, then this doesn’t holds since we
lost value.
15. What is a TIPS?
Ans. A TIPS or Treasury Inflation Protected Security is a Treasury security
whose principal is indexed to inflation, specifically, the Consumer Price
Index.
16. Can nominal interest rates or real interest rates be negative? Why? Why
not?
Ans. Negative interest rates can only occur in real variables. This is because
real rates are the rate of an investment net of inflation. If inflation is high,
then real interest rates will be negative. Nominal interest rates cannot be
negative.

31
Chapter 8
1. What is a mortgage?
Ans. A mortgage is a loan, usually used to finance an investment in real estate
(e.g. a house), that ammortizes simultanously its principal payments and
its interest payments.
2. What does securitization mean?
Ans. Securitization is a way of diversifying risk, in which several institutions
pool similar assets together in order to sell them to investors.
3. What is a Special Purpose Vehicle (SPV)?
Ans. An SPV is a stand-alone firm through which financial institutions pool
the assets together. It is created by these financial institutions in order to
formally buy the assets by raising the necessary capital from investors.
4. Prior to 2008, under what assumption were mortgages backed by Fan-
nie Mae and Freddie Mac considered to be ’safe’ investments? Was this
assumptions well founded?
Ans. The assumption was that these government-sponsored agencies would be
’bailed out’ if they were at risk of becoming insolvent. This assumption
proved correct when the government placed both firm under ’conservator-
ship’.
5. Fill data on the following tables representing the cash flow of a 2-year
mortgage that is paid semiannually with principal 1,000 and interest 5%:

t 0.0 0.5 1.0 1.5 2.0

i 0 1 2 3 4
Ai 0.9756 0.9518 0.9268 0.9060
Coupon
Principal (before)
Interest paid
Principal paid
Principal (after)

Ans. The results are:

t 0.0 0.5 1.0 1.5 2.0

i 0 1 2 3 4
Ai 0.9756 0.9518 0.9268 0.9060
Coupon 265.82 265.82 265.82 265.82
Principal (before) 1,000 1,000 759.18 512.34 259.33
Interest paid 25.00 18.98 12.81 6.48
Principal paid 240.82 246.84 253.01 259.33
Principal (after) 1,000 759.18 512.34 259.33 0.00

32
 6. Price the previous mortgage, assuming that the term structure of interest
rates is flat at 5%.
Ans. The mortgage is worth $1,052.29.
7. What is a prepayment option?
Ans. A prepayment option refers to the posibility that the mortgatge owner
has of paying, at any time, the outstanding principal on the mortgage in
order to terminate the contract.
8. When is it assumed that the prepayment option will be exercised, if mort-
gage owners act rationally?
Ans. It is assumed that a mortgage owner will prepay (refinance) the mortgage
if the market value of the mortgage becomes higher than the remaining
principal.
9. What does CPR stand for? What does it measure?
Ans. CPR is the Conditional Prepayment Rate and it is the annualized rate of
monthly prepayment of outstanding mortgages in a pool.
10. What does 100% PSA mean? How does it compare against 50% PSA and
200% PSA?
Ans. PSA refers to the Public Securities Association. Through its experience,
this association set an industry benchmark on prepayment speed (based
on CPR). At 100% CPR we have that:
• i. In the first month CPR is 0.2%.
• ii. CPR increases by 0.2% in each of the following 30 months.
• iii. After this period, CPR stays at 6% until maturity
Increasing or decreasing the PSA simply means that prepayment is ocur-
ring at a slower or faster rate than this scenario, respectively. For example,
50% PSA means that prepayment occurs at half of the speed presented
in the previous scenario, while 200% PSA means that prepayment occurs
twice as fast than presented in the 100% PSA scenario.
11. What is the main difference between a pool of mortgages and a pass-
through security from the same pool?
Ans. The main difference will be in the rate of interest charged. The pool of
mortgages will receive a given rate of interest, but only a portion of this
is passed along since it is used to pay off the institution in charge of the
securitization. So pass through rates are smaller than the actual mortgage
rate. The original pool and the pass through will have the same maturity.
12. What is negative convexity?

33
Ans. Negative convexity refers to the effect that changes in interest rates have
on some fixed income securities. For bonds it is usually thought that when
interest rates decrease, prices go up. Yet for some securities the opposite
occurs.
13. Do MBS have negative convexity? Why?
Ans. MBS do have negative convexity because as interest rates fall, more mort-
gage owners will exercise the prepayment option. This means that these
securities don’t gain value as regular bonds when interest rates fall, but
instead converge to the value of the principal.
14. What is the TBA market?
Ans. It is the ”To-Be-Announced” market. Which means that traders don’t
know the exact composition of these securiites when they start to bid for
the security. It is similar to the forward market.
15. What is a Collateralized Mortgage Obligation (CMO)?
Ans. Collateralized Mortgage Obligations are securities derived from MBS that
are structured with different risk-return characteristics in order to appeal
to different investors’ clienteles.
16. What is a tranche?
Ans. A tranche is a division on the total pool of assets to be paid in a given
sequence, sually named by A, B, C, and so on. A tranche will receive
the payments from the mortgage pool until a given amount of principal
is retired. The first tranches are less susceptible to risk (prepayment, and
other types) than the following ones.
17. What is a Planned Amortization Class (PAC)?
Ans. PAC are also a type of tranche, these are modeleded to have a deterministic
coupon given a range of PSA. The final tranche, called Companion Tranche
aborbs all of the prepayment risk.
18. What is an Interest Only (IO) strip?
Ans. Interest Only strips are securities that receive all interest payments from
the underlying pool of assets and none of the principal.
19. What is a Principal Only (PO) strip?
Ans. Principal Only strips are securities that receive all principal payments,
scheduled and unscheduled, from the underlying pool of assets and none
of the interest payments.
20. What happens to the value of an IO if interest rates fall?

34
Ans. If interest rates fall, more mortgage owners will prepay their debt. In turn
this means that future interest payments will not occur, so IO strips loose
value.
21. What happens to the value of a PO if interest rates fall?
Ans. If interest rates fall, more mortgage owners will prepay their debt. In turn
this means that principal payments will occur quicker. Given the time
value of money, the PO strips increase in value.

35
Chapter 9
You are given the following interest rate tree. Use it when required in the
exercises.
i 0 1
t 0.0 0.5
2% 4%
1%

1. What is the favored approach in the development of interest rate models?

CAPM?
Ans. The favored approach is to use no arbitrage, with this methodology we
mainly use simple traded securities to price more complicated derivatives.
2. What is a replicating portfolio?
Ans. A replicating portfolio of a security with payoffs V1,u and V1,d in the two
nodes u and d at time i = 1 is a portfolio of bonds that exactly replicates
the values of the security at time i = 1. That is, if Πi,j denotes the value
of the portfolio at time i in node j, we have Π1,u = V1,u and Π1,d = V1,d .
The value of the option at i = 0 equals the value of the portfolio Π0 = V0
3. Given the tree at the begining of this chapter, what is the value of a zero
coupon bond maturing in six months?
Ans. The value is 99.0050.
4. What values can a one year zero coupon bond take at t = 0.5?
Ans. It can be either 98.0199 or 99.5012.
5. What is the replicating portfolio for a European option on interest rates
with maturity at t = 0.5, rK = 2.5% and payoff: 100 × max(rt − rK , 0).
You use the two year zero coupon to replicate, which is currently trading
at 97.4790. Give values of N1 and N2 , as well as the price of the option
under this procedure.
Ans. N1 = 1.0075 and N2 = -1.0126, when we input into the portfolio formula:

Π0 = N1 × P0 (1) + N2 × P0 (2) = 1.0452

6. What is the replicating portfolio for a European option on interest rates

with maturity at t = 0.5, rK = 3.0% and payoff: 100 × max(rK − rt , 0).
You use the two year zero coupon to replicate, which is currently trading
at 97.4790. Give values of N1 and N2 , as well as the price of the option
under this procedure.
Ans. N1 = -1.3234 and N2 = 1.3501, when we input into the portfolio formula:

Π0 = N1 × P0 (1) + N2 × P0 (2) = 0.5865

36
 7. What is the replicating portfolio for an interest rate swap with maturity
at t = 0.5, rK = 2.0% and payoff: 100 × (rK − rt )/2. You use the two year
zero coupon to replicate, which is currently trading at 97.4790. Give values
of N1 and N2 , as well as the price of the option under this procedure.
Ans. N1 = -0.9975 and N2 = 1.0126, when we input into the portfolio formula:

Π0 = N1 × P0 (1) + N2 × P0 (2) = −0.0551

8. What is the market price of risk underlying the tree presented?

Ans. We have λ0 = −0.2018.
9. Using the risk adjusted discounted present value of future cash flows price
a European option on interest rates with maturity at t = 0.5, rK = 2.0%
and payoff: 100 × max(rt − rK , 0).
Ans. The price is 1.3936.
10. Using the risk adjusted discounted present value of future cash flows price
a European option on interest rates with maturity at t = 0.5, rK = 2.5%
and payoff: 100 × max(rK − rt , 0).
Ans. The price is 0.4399.
11. Using the risk adjusted discounted present value of future cash flows price
an interest rate swap with maturity at t = 0.5, rK = 1.5% and payoff:
100 × (rK − rt )/2.
Ans. The price is 0.1924.
12. What is the market price of risk?
Ans. The market price of risk is defined by the ratio between risk premium and
risk that is common to all interest rate securities. In other words it is the
amount of compensation that market participants expect to receive per
unit of risk that they hold.
13. For pricing purposes how important is it to know the true probabilities?
Ans. It is not important to know the true probabilities, as long as they are
consistent. This is shown by the fact the we use risk neutral probabilities
to price, knowing that they are not the true (risk natural) probabilities.
14. What is risk neutral pricing?
Ans. Risk neutral pricing means to deliberately modify the probabilities on
a tree or model, in order to set the market price of risk to zero. This
simplifies the calcualations made when pricing securities.
15. What is a risk neutral probability?

37
Ans. Risk neutral probability is the a special type of probability on a model
that makes the market price of risk equal to zero.
16. Assuming that there is a risk premium in the market (people worry about
risk and expect to be compensated for it), is risk neutral probability for an
up state (high interest rates) higher, lower or the same as the risk natural
probability?
Ans. Risk neutral probabilities tend to be higher than risk natural probabilities
since they should compensate market participants enough (by giving them
a higher probability of higher interest rates) in order to make them risk
neutral.
17. True or False: from a given risk neutral tree can you compute the mar-
ket participants’ expectation on the level of interest rates in the future?
Explain.
Ans. False. You cannot use a tree to compute market expectations since the
tree is computed in the risk neutral world, where probabilities are not the
the true probabilities. In order to predict the true value we need to use
the true probabilities.
18. Are forward interest rates equal to the market’s expectation of future
interest rates?
Ans. No. Current high forward rates might mean two things: either market
participants expect higher interest rates; or they are strongly averse to
risk, and thus the price of long term bonds is low today.
19. Why are forward interst rates and the risk neutral expected future interest
rates not the same?
Ans. The key to understand this is that prices are the relevant values, not in-
terest rates. But it should be noted that the relationship between interest
rates and prices is not linear but convex. When comparing the prices de-
rived from these rates we see that forward rates have to higher than risk
neutral expected future interst rates.
20. What is the risk neutral probability p∗ of the tree presented?
Ans. We have that p∗ = 0.7038.
21. Using risk neutral pricing obtain the value for a European option on inter-
est rates with maturity at t = 0.5, rK = 1.5% and payoff: 100 × max(rt −
rK , 0).
Ans. The price is 1.7419.
22. Using risk neutral pricing obtain the value for a European option on inter-
est rates with maturity at t = 0.5, rK = 2.0% and payoff: 100 ×max(rK −
rt , 0).

38
Ans. The price is 0.2933.
23. Using risk neutral pricing obtain the value for an interest rate swap with
maturity at t = 0.5, rK = 1.0% and payoff: 100 × (rK − rt )/2.
Ans. The price is 0.4399.

39
Chapter 10
You are given the following interest rate tree. Use it when required in the
exercises.
i 0 1 2
t 0.0 0.5 1.0
2.00% 4.00% 6.00%
1.00% 2.60%
0.12%

1. Using risk neutral pricing obtain the value for a 1.5 year zero coupon bond.
Assume that p∗ = 0.7038 is constant over time.
Ans. The price is 95.5267.
2. Using risk neutral pricing obtain the value for a call option on a 1.5 year
zero coupon bond with K = 99.00, maturity at t = 1. Assume that p∗ =
0.7038 is constant over time.
Ans. The price is 0.0813.
3. Using risk neutral pricing obtain the value for a put option on a 1.5 year
zero coupon bond with K = 97.40, maturity at t = 1. Assume that p∗ =
0.7038 is constant over time.
Ans. The price is 0.1709.
4. When talking about options, what is a straddle?
Ans. A straddle is a combination of long a call option and long a put option
with the same strike price.
5. Which of the following prices should be higher: a call option, a put option
or a straddle. All of them have the same maturity, underlying security
and strike price. Explain.
Ans. The most expensive one is the straddle, since it is actually the sum of the
other two options.
6. Using risk neutral pricing obtain the value for a straddle on a 1.5 year
zero coupon bond with K = 98.00, maturity at t = 1. Assume that p∗ =
0.7038 is constant over time.
Ans. The price is 0.9158.
7. Compute the values NtL and NtS for the dynamic replication strategy for
a call option on a 1.5 year zero coupon bond with K = 99.00, maturity at
t = 1. Assume that p∗ = 0.7038 is constant over time.
Ans. The following give a summary of the answer:

40
 NtS NtL
-0.0891 0.0000 0.0932 0.0000
-0.7534 0.7632

8. Compute the values NtL and NtS for the dynamic replication strategy for
a put option on a 1.5 year zero coupon bond with K = 97.40, maturity at
t = 1. Assume that p∗ = 0.7038 is constant over time.
Ans. The following give a summary of the answer:

NtS NtL
0.0813 0.2109 -0.0825 -0.2136
0.0000 0.0000

9. Compute the values NtL and NtS for the dynamic replication strategy for
a straddle on a 1.5 year zero coupon bond with K = 98.00, maturity at
t = 1. Assume that p∗ = 0.7038 is constant over time.
Ans. The following give a summary of the answer:

NtS NtL
-0.0567 0.1536 0.0683 -0.1485
-0.9800 1.0000

10. Why do we say that the dynamic replication strategy is self-financing?

Ans. Because with the capital gain on the replicating portfolio from a previous
period we have enough to purchase the new (rebalanced) portfolio for the
next period.
11. What is the difference between risk neutral probability and risk natural
probability?
Ans. Risk natural probability explains the state of the world, where market
participants are willing to take on risk for a given price. Risk neutral
probability is a probability that is deliberately altered in order to make
market participants risk neutral, this is done specifically for pricing pur-
poses.
12. In order to compute the spot rate duration do you use risk neutral prob-
abilities or risk natural probabilities?
Ans. You use risk neutral probabilities, since it is derived from pricing bonds
in different scenarios (see spot rate duration formula).
13. What is one major drawback from using empirical estimates to fit the
”true” interest rate tree?
Ans. One major drawback is that it may generate negative nominal interest
rates.

41
 14. How realistic is it to speak about negative interest rate in real terms?
Ans. Real negative interst rate can occur and have occured, as inflation may be
higher than nominal interest rates.
15. How realistic is it to speak about negative interest rate in nominal terms?
Ans. This is economically unreasonable since it means that investors are willing
to pay the goverment in order to loose money in the future.
16. Compute the spot rate duration for a call option on a 1.5 year zero coupon
bond with K = 99.00, maturity at t = 1. Assume that p∗ = 0.7038 is
constant over time.
Ans. Spot rate duration is -9.2354.
17. Compute the spot rate duration for a put option on a 1.5 year zero coupon
bond with K = 97.40, maturity at t = 1. Assume that p∗ = 0.7038 is
constant over time.
Ans. Spot rate duration is 8.1734.
18. Compute the spot rate duration for a straddle on a 1.5 year zero coupon
bond with K = 98.00, maturity at t = 1. Assume that p∗ = 0.7038 is
constant over time.
Ans. Spot rate duration is -6.7695.

42
Chapter 11
You are given the following interest rate tree. Use it when required in the
exercises.
t 0 1 2
3.00% 6.00% 9.00%
2.00% 4.00%
1.00%

1. What is the benefit of using an interest rate model when compared to

empirical estimates?
Ans. Interest rate models such as Ho-Lee and Black-Derman-Toy eliminate the
posibilities for negative interest probabilities that may occur in simple
empirical estimates.
2. What advantage does the Black-Derman-Toy model have over the Ho-Lee
model, when comparing the plausibility of the modeled interest rates?
Ans. Ho-Lee allows for the posilibity of negative interest rates.
3. What are the main differences between the Ho-Lee model and the Black-
Derman-Toy model?
Ans. The following are the differences:
i. The Ho-Lee model gives non-zero probability to negative interest
rates, ans small probability to high interest rates.
ii. The Black-Derman-Toy model gives essentially zero probability to
interest rates below 1%, but it assigns a much higer probability to
high interest rates.
4. You find that the Black-Derman-Toy model predicts a rise in the short
rate for both the next up period and the next down period. Given this
information you decide to short Treasuries, since a future rise in interest
rates will bring bond prices down. Is this right?
Ans. This is wrong, since the Black-Derman-Toy model is a risk neutral model.
The probabilities given are only good for pricing purposes, they are not
an indication of the level of future interest rates.
5. Assume that after you estimate the risk neutral model for the continously
compounded rate you arrive at the tree presented at the beginning of this
chapter. There is equal probability of moving up or down on the tree.
Compute the current zero coupon spot curve for all possible maturities.
Ans. We have: Z(0, 1) = 0.9704; Z(0, 2) = 0.9326; and Z(0, 3) = 0.8923.

43
 6. Assume that after you estimate the risk neutral model for the continously
compounded rate you arrive at the tree presented at the beginning of this
chapter. There is equal probability of moving up or down on the tree.
Price a floor that pays at time t + 1 the following cash flow:

CF (t + 1) = N × max(rK − r1 (i), 0)

where N = 100 and rK = 4%.

Ans. The price is 2.5731.
7. Assume that after you estimate the risk neutral model for the continously
compounded rate you arrive at the tree presented at the beginning of this
chapter. There is equal probability of moving up or down on the tree.
Price a floor that pays at time t + 1 the following cash flow:

CF (t + 1) = N × max(rK − r1 (i), 0)

where N = 100 and rK = 3%.

Ans. The price is 0.9357.
8. Assume that after you estimate the risk neutral model for the continously
compounded rate you arrive at the tree presented at the beginning of this
chapter. There is equal probability of moving up or down on the tree.
Price a 2-year cap that pays at time t + 1 the following cash flow:

CF (t + 1) = N × max(rK − r1 (i), 0)

where N = 100 and rK = 4%.

Ans. The price is 2.1645.
9. Assume that after you estimate the risk neutral model for the continously
compounded rate you arrive at the tree presented at the beginning of this
chapter. There is equal probability of moving up or down on the tree.
Price a 2-year cap that pays at time t + 1 the following cash flow:

CF (t + 1) = N × max(rK − r1 (i), 0)

where N = 100 and rK = 3%.

Ans. The price is 3.3233.
10. How do you compute the swap rate at initiation?
Ans. The swap rate at initiation is given by:
 
1 − Z(0, TM )
c = n × M
j=1 Z(0, Tj )

44
 11. Assume that after you estimate the risk neutral model for the continously
compounded rate you arrive at the tree presented at the beginning of this
chapter. There is equal probability of moving up or down on the tree.
Price a 2-year swap with N = 100 and c = 3%.
Ans. The price is 0.9899.
12. Suppose you want to hedge the cap with the swap, what is the hedge
ratio?
Ans. The hedge ratio is: 0.7431.
13. What is the difference between empirical volatility and implied volatility?
Ans. Empirical volatility refers to the standard deviation of past realized changes
in the short term interest rate. Implied volatility is the volatility needed
so that the price derived from the modeled matches exactly the value of
a security in the market.
14. Does empirical σ (based on past realizations) price caps, floors and swap-
tions acurately? On average does it overprice or underprice these securi-
ties?
Ans. Empirical volatility tends to underprice caps, floors and swaptions.
15. You find the implied volatility for a 5-year cap and you use it as an input
for your model (Ho-Lee). Does this solve the problem with volatility when
you want to price 1-year securities?
Ans. No it doesn’t. The 5-year cap volatility will work only for securities with
that maturity, but it will not price correctly securities with different ma-
turities. This is mainly because volatility is not constant over time.
16. What is the difference between flat volatility and forward volatility?
Ans. Forward volatility is the level of volatility at each step of the Black-
Derman-Toy model that matches the cap price for that step. Forward
volatility assumes that volatility changes at each step. Flat volatility can
be thought as an average of forward volatilities, and it is the single value
of volatility needed in order to match the model price with the observed
price for a given security. Note that flat volatility doesn’t assume that
volatility changes at each step, but instead maintains constant volatility
in order to price a single security.
17. In the context of the futures market, what does ’cheapest-to-deliver’ mean?
Ans. In a T-bond and T-note futures, the short side has the option to deliver
any security within a given class of deliverable treasury. Alsthough an
adjustment is made to standarize securities, still there is a bond that is
the least expensive to deliver at maturity. This bond is the chepest-to-
deliver.

45
 18. If you use caps and bonds to fit the Black-Derman-Toy model, can you
use the model to price the same caps and bonds?
Ans. No, you cannot. You need one set of securities to calibrate the model, and
then you can use the model to price other securities.

46
Chapter 12
You are given the following interest rate tree. Use it when required in the
exercises.
t 0 1 2
3.00% 6.00% 9.00%
2.00% 4.00%
1.00%

1. What is an American Call option?

Ans. An American Call option is a contract between two counterparties in which
one party (option buyer) has the right, but not the obligation, to buy a
given security at a predetermined price on or before a given maturity, and
the other party (option seller) has the obligation to sell such security.
2. Does a callable bond have an American option embedded in it?
Ans. Yes it does, because the issuer has the right to buyback the option at any
given time before the bond reaches maturity.
3. Does a student loan have an American option embedded in it?
Ans. Yes it does, becuase the person who takes out the loan can payback the
remaining principal at any time before maturity.
4. Does a mortgage have an American option embedded in it?
Ans. Yes it does, becuase the person who takes out the loan can payback the
remaining principal at any time before maturity.
5. What effect does an embedded option have on a security’s price?
Ans. An option is a security since it is a promise on contingent cash flows.
This means that, under no arbitrage, its price should be incorporated into
the price of the original security, thus, increasing the value of the original
security for the holder of the option.
6. Using the information provided at the beginning of this chapter, price a
3-year callable bond with coupon rate 5% and strike price at par.
Ans. The price of the callable bond is 100.
7. Using the information provided at the beginning of this chapter, price a
3-year callable bond with coupon rate 5% and strike price at par. There is
also a lockout period through which the option cannot be exercised until
t = 1.
Ans. The price of the callable bond is 100.4335.

47
 8. Using the information provided at the beginning of this chapter, price a
3-year callable bond with coupon rate 5% and strike price at par. There is
also a lockout period through which the option cannot be exercised until
t = 2.
Ans. The price of the callable bond is 101.8507.
9. You notice that when no lockout period is present and for coupons above
5%, the callable bond with strike at par is priced at par. What is hap-
pening?
Ans. Higher coupons increase the present value of the bond, this means that it
is more profitable to exercise the option early. So the amount received for
the bond is the strike price, which is par.
10. Why is it that as the lockout period becomes longer the price of the bond
increases?
Ans. This happens because an increase in the lockout increases restrictions on
the option, which will fall in value. As the option reduces the value of the
underlying bond, a fall in its price increases the value of the bond.
11. Using the information provided at the beginning of this chapter, price a
3-year callable bond with coupon rate 5% and strike price at par. There
is no lockout period.
Ans. The price of the callable bond is 100.0000.
12. What is negative convexity?
Ans. Negative convexity refers to the effect that changes in interest rates have
on some fixed income securities. For bonds it is usually thought that when
interest rates decrease, prices go up. Yet for some securities the opposite
occurs.
13. How is it that negative convexity is present on a callable bond?
Ans. Callable bonds allow the issuer to call back the security by paying face
value to the owner of the bond. When interest rates fall the value of
the bond normally increase, yet in this case there is a difference. When
interest rates fall and make the value of the bond higher than face value
the issuer will prefer to call it back and pay face value. This means that
as interest rates fall, the value of the bond converges to face value.
14. What happens when the issuer of an American option does not exercise
optimally?
Ans. Not exercising optimally increases the value of the bond for the holder
of the bond. This occurs because the holder now holds a security that
has appreciated in value above face value, which is what he would receive
under optimal exercise.

48
 15. Which is more valuable and American call option or a European call op-
tion?
Ans. The posiblity of exercising in more dates gives additional value to the
holder. So an American call option is worth more than an European call
option.
16. Why is a mortgage a type of callable bond?
Ans. Because at any time the mortgage owner may pay off the remaining prin-
cipal in order to get out of the contract, with no obligation to cover the
lost interest payments.
17. Do pass through securities have negative convexity?
Ans. Yes, the have negative convexity. As with the underlying pool of mort-
gages, pass through securities are exposed to prepayment risk which makes
the value of the securities to converge to the face value when interest rates
go down.
18. What is the relationship between changes in interest rates and changes in
value of an Interest Only (IO) strip?
Ans. IO strips move in the same direction as the interest rate (the opposite
than normal bonds). As interest rates fall, there is a higher probability
of prepayment. Higher prepayment means that interest rates originally
expected to be received will be forgone. This in turn reduces the value of
the IO strips.
19. What is the relationship between changes in interest rates and changes in
value of a Principal Only (PO) strip?
Ans. As interest rates fall Principal Only strips increase in value, as a higher
prepayment means that the bulk of the cash to be received is paid more
quickly. Given the time value of money, this earlier cash is bares additional
value.

49
Chapter 13
1. What is a Monte Carlo Simulation?
Ans. A Monte Carlo Simulation is a methodology of predicting the behavior of
a variable by simulating a large number of paths under which the random
component of the variable can take any value. The result is a large sample
of possible values for the variable from which we can infer its expected
value and other moments.
2. What is an Asian Interest Rate Option?
Ans. An Asian Interest Rate Option is an option whose payoff at maturity is
given by
a. For an Asian Call
max(average rate from 0 to T − rK , 0)

b. For an Asian Put

max(rK − average rate from 0 to T, 0)

3. Is the traditional tree methodology well-suited to price the following: an

option where the owner has the right to buy a bond at its lowest price
over some specified period.
Ans. No, this security, called a ”lookback” option is not well suited for the
traditional tree methodology because it is path dependant.
4. Is the traditional tree methodology well-suited to price the following: a
fixed-for-floating swap where LIBOR is the underlying rate.
Ans. Yes, tress can price well these types of securities.
5. When pricing zero coupon bonds, are results from the Monte Carlo simu-
lations on a tree the same as risk neutral pricing on a tree? Why?
Ans. They might not be the same, but as the number of simulations increase
the results will converge.
6. What is a standard error?
Ans. Standard error is the standard deviation of an estimate (e.g. the √
ones
obtained through Monte Carlo Simuations). It is defined as SE = σ/ N .
7. What is a confidence interval?
Ans. A confidence interval presents an interval under which there is 95% prob-
ability (or any other probability) that the estimate will be within such
interval. For the 95% interval we have:
[p̂ − 1.96 × SE, p̂ + 1.96 × SE]

50
 8. How many simulations are enough?
Ans. As many as we need to get standard errors which we feel comfortable with.
9. Given that simulations do not offer a closed form solution, can we still
calculate a price’s sensitivity to interest rate movements?
Ans. Yes, we can still do so through spot rate duration that prices the security
again with an increment in interest rates (e.g. 1 basis point).
10. How is spot rate duration defined in Monte Carlo simulations?
Ans. Spot rate duration is approximated by:

1 P̂ (r0 + dr) − P̂ (r0 )

−
P̂ (r0 ) dr

11. When pricing through Monte Carlo simulations on trees we are implic-
itly using risk neutral probabilities, this is also so when computing the
spot rate duration. Is this correct? Shouldn’t measures of sensitivity be
computed with risk natural probabilities?
Ans. No, when we review the spot rate duration formula we see that we are
actually pricing. Here we are not interested so much in estimating what
might happen, but in describing the security’s price sensitivity.
12. Why is it useful to price Mortgage Backed Securities (MBS) through
Monte Carlo Simulations?
Ans. Because we can incorporate additional factors affecting the prepayment
decision into the pricing model.
13. What additional factors may affect the prepayment decision?
Ans. Some additional factors affecting the prepayment decision are:
i. Random Event. For example the sale of the house.
ii. Seasonality. Homeowners tend to move much more over the summer
than in the winter.
iii. Forgetfulness. Some homeowners don’t pay attention to the fact that
interest rates are sufficently low to refinance their mortgage.
14. In the context of the prepayment of mortgages, what is seasonality?
Ans. Seasonaility is a factor that affects the prepayment decision, in the sense
that people don’t move as much in the winter as they do in other seasons.
15. How does seasonality affect the prepayment option? Is the link direct?

51
Ans. This factor does not affect the decision directly, instead it says that given
the fact that people decide to move from their house (because of some
random event as changing jobs) they will prefer to do it outside the winter
season.
16. How effective is pricing of Collateralized Mortgage Obligations (CMO) on
a risk neutral tree? Why?
Ans. The tree methodology has many problems for mortgages because it main-
tains constant the level of PSA, which is directly linked to the interest
rate through the prepayment option.
17. What advantages do Monte Carlo simulatons on a tree provide when pric-
ing MBS tranches?
Ans. Through Monte Carlo simulations we can adjust the level of PSA faced
under different interest rate scenarios by including this adjustment in the
paths to be taken by the simulation, incorporating the sensitivity of pre-
payment to changes in the interest rates.
18. What is a prepayment model?
Ans. A prepayment model is a model that predicts the amount of prepayment
to occur under different market conditions. It may include the factors
mentioned before (random events, seasonality and forgetfulness) as well
as others.

52
Chapter 14
1. Why do we need continous time models?
Ans. Because it allows us to consider the case in which underlying variables,
such as interest rates, move at a high frequency (e.g. daily or intradaily).
This brings realism and simplicity into our models, and, in some cases,
allows us to obtain analytical formulas to price and hedge securities.
2. What is a Brownian motion?
Ans. First, we define Δ = t/n where t is a lenght of time, and n is the number
of intervals into which we divide that length. Second,
√ we √define Zi as a
random variable with equal probability of being Δ or − Δ. We then
consider the following quantity:

n
Xt = Zi
i=1

So a Brownian motion is given by the stochastic variable Xt as n increases

to infinity, and thus Δ converges to zero.
3. What are the properties of a Brownian motion?
Ans. The main property is that if we take any two times t1 and t2 , then the
difference (Xt2 − Xt1 ) is normally distributed (as Δ goes to zero).
4. Show that: V ar[dXt ] = dt.
Ans. We know that:

m
Xt2 − Xt1 = Zi
i=1
which leads to: m 

V ar[(Xt2 − Xt1 )] = V ar Zi
i=1
From statistics we know that if some random variables are identically and
independently distributed, then the variance of the sum is equal to the
sum of the variances, so:

m 
m
V ar[Zi ] = Δ = m×Δ
i=1 i=1

In this case, given that the interval is [t1 , t2 ] we have:


t2 − t 1
Δ=
m
So we get:

t2 − t1
V ar[(Xt2 − Xt1 )] = m × = t2 − t1
m

53
 5. What is the Martingale property?
Ans. The Martingale Property states that the best forecast of the value of a
Brownian motion in the future is the value today. That is, if we know
that at t = 0 the value of the Brownian motion X0 , then for every t > 0:
E[Xt |X0 ] = X0
6. You put money into the stock market because you expect to make a profit
(although you might loose money). Does your capital follow a Martingale?
Ans. No, it doesn’t. Not unless you are unrational. You put your money in
because on average the stock market gives positive returns, not zero.
7. What is a differential equation?
Ans. A differential equation establishes a relation between the rate of change
of a function B(t) and its value at time t, B(t).
8. What is a solution to an Ordinary Differential Equation?
Ans. Let f(t) be a function of a variable t, and let G(·) a function that re-
lates f(t) to the rate of change of f(t) (this is an Ordinary Differential
Equation):
df
= G(f(t))
dt
Given and initial condition f(0) = k, f(t) is the solution, or satisfies,
the Ordinary Differential Equation if for every t its derivative df/dt equal
G(f(t)) and if indeed f(0) = k.
9. What two components do we include in a Continous Time Stochastic Pro-
cess?
Ans. We include a Brownian motion and a Differential Equation.
10. What is the main difference between the Ho-Lee and the Vasicek model?
Ans. Vasicek model includes a mean reverting process, while Ho-Lee doesn’t.
11. When dealing with a stochastic process what do we mean by a ’drift’ ?
Ans. The drift term of the stochastic process represents the predictable com-
ponent of the stochastic process.
12. When dealing with a stochastic process what do we mean by a ’diffusion’ ?
Ans. The diffusion term is the unpredictable component of the stochastic pro-
cess, due to the lack of predictability of the Brownian motion dXt .
13. What problem do both Vasicek and Ho-Lee models share?
Ans. They assign postive probability to the occurrence of negative interest rates
(nominal interest rates).

54
 14. For the Vasicek model, show that the as t → ∞ we have:
μ(r0 , t) = r̄
σ2
σ 2 (t) =
2γ
Ans. The distribution of interest rates under the Vasicek model is:
rt N (μ(r0 , t), σ 2(t))
where:
μ(r0 , t) = r̄ + (r0 − r̄)e−γt
σ2
σ 2 (t) =
(1 − e−2γt )
2γ
As t → ∞ all terms elevated to −t will go to zero. So we get the values
above.
15. What is Ito’s Lemma?
Ans. Ito’s Lemma provides the ”rules” of calculus to link the variation of an
underlying stochastic variable, such as the interest rate rt , to the price of
securities that depend on it.
16. According to Ito’s Lemma, what are the three components of the drift
term in an asset?
Ans. The three components are:
i. Capital gain (loss) due to the passage of time.
ii. Capital gain (loss) due to variation of interest rates.
iii. Convexity effect adjusted for variance (higher variance, higher impact of
convexity effect).
17. Show that:

dPt
E = rt dt
Pt
Ans. We know that:
dPt
= rt dt − (T − t)σdXt
Pt
So:


dPt
E = E[rt dt−(T −t)σdXt ] = E[rt dt]−E[(T −t)σdXt ] = rt dt−(T −t)σE[dXt ]
Pt
Recall that E[dXt ] = 0, so:


dPt
E = rt dt
Pt

55
 18. Show that:  

 2 
dPt √
E = (T − t)σ dt
Pt

Ans. We have:  2 
dPt
E = E[(rt dt − (T − t)σdXt )2 ]
Pt

= E[rt2 dt2 − 2rt (T − t)σdXt dt + (T − t)2 σ 2 dXt2 ]

= rt2 dt2 − 2rt (T − t)σE[dXt ]dt + (T − t)2 σ 2 E[dXt2 ]
Given that dt2 = 0, E[dXt ] = 0, and E[dXt2 ] = dt so:
 2 
dPt
E = (T − t)2 σ 2 dt
Pt

So taking square root of this we get:

 

 2 
dP √
E t
= (T − t)σ dt
Pt

19. Show that:


dPt
E × drt = −(T − t)σ 2 dt
Pt

Ans. Recall that drt = σdXt , so:


dPt
E × drt = E[(rt dt − (T − t)σdXt )(σdXt )]
Pt

= E[rt σdtdXt − (T − t)σ 2 dXt2 ] = rt σdtE[dXt ] − (T − t)σ 2 E[dXt2 ]

Given that E[dXt ] = 0, and E[dXt2 ] = dt so:


dPt
E × drt = −(T − t)σ 2 dt
Pt

56
Chapter 15
1. For a deterministic interest rate model, what would be the rate of return
on securities? Explain.
Ans. Given no arbitrage:
dZt
= rt dt
Zt
2. Why is it that in a deterministic interest rate world we have that:
dZt
= rt dt
Zt

Ans. Because a deterministic interest rate would not bear any risk on account
of varying interest rates, this means that under no arbitrage it should give
the same return as a the risk-free rate.
3. What is a Partial Differential Equation (PDE)?
Ans. A PDE is a differential equation on many variables, in this case r and t.
4. What is a solution to a PDE?
Ans. Given the following PDE:
∂Z ∂Z
+ γ(r̄ − r) = rZ
∂t ∂r
A solution to a PDE is a function of r and t such that: (i) if we take the
derivatives on the left hand side we get the right hand side; (ii) it satisfies
the boundary condition (e.g. Z(r, T ) = 1).
5. Does the following equality hold in the real world?
dZ
= rdt
Z
Why or why not?
Ans. It does not hold in the real world because the short term rate of return
on a bond is risky and should give a premium above the risk-free rate.
6. What do we need to build in order to be able to price any security through
no arbitrage?
Ans. We need to build a portfolio that is hedged against interest rate changes.
7. What relation should hold across all securities, given the no arbitrage
condition?

57
Ans. The following relationship should hold:
1 ∂ 2 Z1 2 1 ∂ 2 Z2 2
( ∂Z 1
∂t + 2 ∂r2 σ − rt Z1 ) ( ∂Z 2
∂t + 2 ∂r2 σ − rt Z2 )
=
∂Z1 /∂r ∂Z2 /∂r

8. What’s the intuition behind the following relationship:

1 ∂ 2 Z1 2 1 ∂ 2 Z2 2
( ∂Z 1
∂t + 2 ∂r2 σ − rt Z1 ) ( ∂Z 2
∂t + 2 ∂r2 σ − rt Z2 )
=
∂Z1 /∂r ∂Z2 /∂r

Ans. The key terms are:

i. (∂Zi /∂t) = Annualized dollar capital gain (or loss) due to the passage
of time;
1
ii. 2
(∂ 2 Zi /∂r 2 )σ 2
= Annualized dollar capital gain (or loss) due to con-
vexity and the stochastic nature of interest rates;
iii. rt Zi = Annualized dollar interest payments in order to borrow the
value Zi to purchase the bond;
iv. (∂Zi /∂r) = Annualized sensitivity of the bond price to change in the
interest rate.
The numerator of each of the expressions gives the annualized capital gain
return due to the passage of time or convexity of a leverage position in the
security. The denominator provides the ”risk” of the long position in the
security, expressed in terms of its sensitivity to changes in interest rates.
9. For the Vasicek model can we say that always m∗ (r, t) = m(r, t)? Explain.
Ans. No, m(r, t) is the drift parameter for the Interest Rate process, which
tries to describe the way interest rates move in reality. On the other
hand, m∗ (r, t) is constructed for pricing purposes and is defined by:
 
1 ∂2Z 2
∂t + 2 ∂r2 σ − rt Z
∂Z
∗
m (r, t) = −
∂Z/∂r

10. In the Vasicek model de we have level, slope and curvature in the term
structure?
Ans. Yes, we have level, slope and curvature.
11. How strong is the correlation among rates in the term structure obtained
from the Vasicek model? Is this realistic?
Ans. Rates on the term structure are perfectly correlated, this is a problem
since this is not true for the term structure of interest rates.
12. How can we obtain r̄ and γ in order to calibrate the Vasicek model?

58
Ans. We can obtain r̄ and γ from the time series of short term interest rates. r̄
can be computed as the average short term interest rate over the sample
period. γ can be approximated by regressing the changes in interest rate
(rt+δ − rt ) on rt × δ, where δ is the time between observations.
13. How can we obtain r̄ ∗ and γ ∗ in order to calibrate the Vasicek model?
Ans. First we note that for any choice of these two parameters, we can compute
the prices of zero coupons according to the Vasicek formula for every
maturity. We then compare the Vasicek zero coupons to the Treasury
STRIPS data we observe. We then search for parameters for which the
model prices are close, to some degree, to the data. In other words, find
values of r̄ ∗ and γ ∗ such that the following quantity is minimized (Non-
Linear Least Squares):

n
J(r̄ ∗ , γ ∗ ) = (Z M odel (0, r0; Ti ) − Z Data (0, Ti ))2
i=1

14. How can we obtain σ in order to calibrate the Vasicek model?

Ans. σ can be estimated directly from the time series of interest rates rt .
15. Does the Vasicek model match the term structure?
Ans. The Vasicek model is overly simple and doesn’t match the term structure.
16. You are given the following parameters: r̄ = 5%; γ = 0.32; r̄ ∗ = 6.5%;
γ ∗ = 0.46; and σ = 2.00%. Currently r0 = 3%. Using the Vasicek model
price a 2-year coupon bond paying 8% semiannually.
Ans. The price of the security is 107.1828.
17. What are the three steps for derivative pricing and hedging?
Ans. The three steps are the following:
i. Select an interest rate model (e.g. Vasicek).
ii. Estimate the parameters of the model, using available data, such as
zero coupon bonds.
iii. Price the derivative security using the model.
iv. Hedge the option exposure through a position in the underlying se-
curity.
18. What problem does the Cox-Ingersol-Ross (CIR) model solve when com-
pared to the Vasicek and Ho-Lee models?
Ans. It does not allow negative interest rates.
19. How strong is the correlation among rates with different maturities in the
term structure obtained from the CIR model?

59
Ans. As with the Vasicek model, the interest rates on the term structure are
perfectly correlated.

60
Chapter 16
1. What is a Replicating Portfolio?
Ans. A replicating portfolio (Pt ) is a portfolio, consisting of positions in an
interest rate security (Z1,t ) and cash (Ct ), that moves in the same fashion
as another interest rate security (Z2,t ). In other words we have, that if
Δ = ∂Z 1 /∂r
∂Z2/∂r then:
Pt = ΔZ2,t + Ct
replicates the return on a security Z1,t between t and t + dt, namely:

dPt = dZ1,t

2. What use does the Replicating Portfolio have?

Ans. It is a useful tool to hedge securities and to take a view on whether a
security may be mispriced and, thus, an arbitrage opportunity exists.
3. What means to rebalance the Replicating Portfolio?
Ans. The replicating portfolio follows the movements of the asset from one time
period to another, yet as the time interval increases it looses accuracy. In
order to reduce this we need to recompute the values of Δ periodically
and adjust the cash position.
4. How close should the value of the Replicating Portfolio be to the asset if
we increase the rebalancing frequency?
Ans. The higher the rebalancing frequency the tighter the relationship between
the replicating portfolio and the asset.
5. Can you think of any reason why rebalancing doesn’t always occur at
extermely short frequencies (instantenous) in the real world?
Ans. More frequent rebalancing leads to higher transaction costs.
6. What is a relative value trade?
Ans. A relative value trade seeks to take advantage of differences found between
the prices of zero coupon bonds observed and those computed from a
model, such as Vasicek.
7. What steps do we follow for a relative value trade?
Ans. You do the following:
i. Estimate the parameters for the interest rate model (e.g. Vasicek) in
order to best match prices.
ii. Confront the prices given by the model with the data and find out
whether they are in line with each other.

61
 iii. If the model does not agree with the data, according to the model
there is an arbitrage opportunity. You need to set up a strategy in
which you buy the cheap security and sell the expensive one.
iv. In the long run, both securities should converge so that cash coming
from one, covers cash going to the other one.
8. What instrument is used to hedge derivative exposure?
Ans. For hedging derivatives on an underlying asset, we use the underlying asset
itself.
9. What general principal do you follow, once an arbitrage opportunity is
found?
Ans. Buy cheap, sell dear.
10. What is theta?
Ans. Theta is the capital gain (loss) on a bond due to the passage of time:

1 ∂Π
Π ∂t

11. What is gamma?

Ans. Gamma is another way of calling convexity:

1 ∂2Π
Π ∂r 2

12. What is the theta-gamma relation?

Ans. The theta-gamma relation states that large convexity is always counter-
balanced by a large, opposite, theta.
13. Given the Fundamental PDE, explain the theta-gamma relation.
Ans. Suppose we sold a call option on a zero coupon bond and we put on a
position Δ in the unerlying zero coupon bond to hedge the interest rate
risk. The portfolio Π is riskless and earns the risk free rate, that is,

dΠ = rΠdt

The portfolio must satisfy the Fundamental PDE, that is:

∂Π ∂Π 1 ∂2Π 2
+ (η̃ − γr) + ν = rΠ
∂t ∂r 2 ∂r 2
However since the portfolio is Delta Hedged (∂Π/∂r) = 0, the relation is:

∂Π 1 ∂ 2 Π 2
+ ν = rΠ
∂t 2 ∂r 2

62
If we divied everything by Π we get:
 
1 ∂Π 1 1 ∂2Π
+ ν2 = r
Π ∂t 2 Π ∂r 2

The intuition for the Theta-Gamma relation is that a positive-value port-

folio with a high Theta is expected to make money because of the passage
of time. If it was to make more money than the risk free rate, it would
be pure arbitrage, because a trader could borrow at the risk free rate, set
up the portfolio, and wait. The negative convexity rebalances the pure
arbitrage: the volatility in interest rates tends in average to depress the
portfolio value.

63
Chapter 17
1. Can the following equation

∂V ∂V ∗ 1 ∂2V
rV = + m (r, t) + s(r, t)2
∂t ∂r 2 ∂r 2
subject to the boundary condition V (rT , T ) = g(rT , T ), be always solved
analytically?
Ans. No, for many models we can’t find a closed form solution and we need to
apply numerical methods to solve.
2. What is the Feynman-Kac Theorem?
Ans. Let V (r, t) be the price of a security, with final payoff V (rT , T ) = g(rT , T ),
satisfying the partial differential equation

∂V ∂V ∗ 1 ∂2V
R(r)V = + m (r, t) + s(r, t)2
∂t ∂r 2 ∂r 2
where R(r) is some function of r. Then V (r, t) is given by

T 
− R(ru )du
V (rt , t) = E ∗ e t g(rT , T )|rt

where the expectation E ∗ [·] is taken with respect to the probability dis-
tribution induced by the process

drt = m∗ (rt , t)dt + s(rt , t)dXt

3. How is the Risk Neutral process obtained?

Ans. The Risk Neutral or Risk Adjusted interest rate process is obtained from
the original interest rate process by substituting its drift rate m(r, t) with
the coefficient that multiplies the term ”∂V /∂r” in the Fundamental Pric-
ing Equation, which is m∗ (rt , t) (Risk Neutral Drift).
4. What is a Monte Carlo Simulation?
Ans. A Monte Carlo Simulation is a methodology of predicting the behavior of
a variable by simulating a large number of paths under which the random
component of the variable can take any value. The result is a large sample
of possible values for the variable from which we can infer its expected
value and other moments.
5. How can an interest rate process be simulated?

64
Ans. You start from an interest rate process such as:

drt = m∗ (rt , t)dt + s(rt , t)dXt

then we discretize the time interval [0, T ] in N = T /δ intervals of size δ.

Let the initial condition be the current√ interest rate r0 . We approximate:
drt ≈ rt+δ − rt ; dt ≈ δ; and dXt ≈ δ × t+δ where t+δ N (0, 1). With
this all we have to follow recursively ”Euler’s discretization scheme”:
√
rt+δ = rt + m∗ (rt , t)δ + s(rt , t) δt+δ

6. Using Monte Carlo Simulations, what steps do you need to follow in order
to price a coupon bond?
Ans. Once you have simulated the interest rate path, discount the payoff and
take expectations.
7. Is the price obtained from Monte Carlos Simulations exaclty the same as
the one obtained through an analytical formula?
Ans. No, when there is an analytical solution, the results are different but
converge as the number of simulations increase.
8. How can you increase the accuracy of the price given by the model when
using Monte Carlo Simulations?
Ans. By increasing the number of simulations.
9. What is a standard error?
J
Ans. The standard error of the simulated value V (r0 , 0) = J1 j=1 V j (r0 , 0) is
given by
Standard Deviation
Standard Error = √
J
where the standard deviation is computed as


1  J
Standard Deviation =  (V j (r0 , 0) − V (r0 , 0))2
J j=1

10. What is a confidence interval?

Ans. A confidence interval is an interval under which there is a given probability
that the real value of the parameter is.
11. How is a 95% conficende interval defined?
Ans. Confidence interval = [V (r0 , 0) − 2 × std.err., V (r0 , 0) + r × std.err.]
12. What is a range floater?

65
Ans. A range floater:
i. pays higher coupons than standard floating rate bonds,
ii. only pays when reference rate is within a range.
13. Why were range floaters so popular during the mid-nineties?
Ans. Because they appeared in a time where there were strong expectations
for low and stable interest rates. This allowed investors to enhance their
yields in a low interest environment as well as speculate on the movement
of interest rates.
14. What risks are involved in a range floater?
Ans. If the reference rate increases beyond the range the bond would earn less
than a fixed coupon bond.
15. From MCS, how can you compute ∂V /∂r ?
Ans. Using the Central Approximation we have:

∂V V (r0 + δ) − V (r0 − δ)
≈
∂r 2δ

16. There is a ”Forward Approximation” and a ”Central Approximation”, is

there a ”Backward Apporximation”? How can you compute it?
Ans. Yes, the Backward Approximation is:

∂V V (r0 − δ) − V (r0 )
≈
∂r δ

17. When computing ∂V /∂r, what is the difference between ”Central Approx-
imation” and ”Forward Approximation”? Which one is closer to the true
value?
Ans. The Central Approximation is better because it averages the values of the
Forward Approximation and the Backward Approximation.
18. How can you compute gamma?
Ans. The formula to compute Gamma is:

∂2V V (r0 + δ) + V (r0 − δ) − 2 × V (r0 )

2
≈
∂r δ2

19. How can you compute theta?

66
Ans. Recall the Fundamental Pricing Equation:

∂V ∂V ∗ 1 ∂2V 2
rV = + m (rt , t) + s (r, t)
∂t ∂r 2 ∂r 2
We can compute the values for all the terms except the ∂V /∂t term, so
all we have to do is:
∂V ∂V ∗ 1 ∂2V 2
= rV − m (rt , t) − s (r, t)
∂t ∂r 2 ∂r 2

67
Chapter 18
1. How do we define the market price of risk?
Ans. The market price of risk is given by the quantitiy:
1
λ(r, t) = (γ(r̄ − rt ) − γ ∗ (r̄ ∗ − rt )
σ
1 1
Defining two constants λ0 = σ (γr̄ − γ ∗ r̄ ∗ ) and λ1 = σ (γ
∗
− γ), we get:

λ(r, t) = λ0 + λ1 rt

2. You are planning to use Monte Carlo Simulations in order to simulate an

interest rate one quarter from now. Which probability do you use?
Ans. You use risk natural probabilities.
3. You are planning to use Monte Carlo Simulations in order to compute the
value of the range floater for different scenarios. Which type of probability
do you use?
Ans. You use risk neutral probabilities.
4. How do we go from Monte Carlo Simulations to security prices?
Ans. We use the Feynman-Kac theorem that states that the solution to the
fundamental pricing equation is given by an expectation. Then, thanks
to the Central Limit Theorem, we know that the expectation can be ap-
proximated by an average of simulated payoffs.
5. What is the ”delta” approximation?
Ans. It is a common way to approximate risk of a security by making the firs
order linear approximation, so the value of an interest rate security at an
interest rate level rt+δ , is often approximated through the linear Taylor
expansion:
δV
V (rt+δ ) ≈ V (rt ) + (rt+δ − rt )
δr
6. What problem does the ”delta” approximation have?
Ans. If the convexity of the security is particularly strong this approximation
may yield quite different results.
7. What factors explain long term yields?
Ans. The following explain long term yields:
i. Higher expected long term inflation.
ii. Higher risk aversion of market participants.

68
 iii. Higher amount of risk.
8. Explain the intuition behind the link between high long term yields and
higher expected long term inflation.
Ans. Higher expected inflation means that cash balances from long term bonds
will be worth less. In order to counter this, market participants expect
higher yields.
9. Explain the intuition behind the link between high long term yields and
higher risk aversion of market participants.
Ans. As risk aversion increases, market participants will require higher yields
in order to hold these securities.
10. Explain the intuition behind the link between high long term yields and
higher amount of risk.
Ans. A higher amount of risk pushes the market price of risk up, as market
participants expect to be compensated more.
11. Why is σy σi ρyi the amount of risk?
Ans. This is the ”economic risk” of holding nominal bonds. In particular, as
already mentioned, a security is risky not when it has high volatility per
se, but when it delivers little money when agents need it the most. Dur-
ing recessions or periods of low GDP, a security that pays little in these
states is risky. This is captured with ρyi < 0, since if the correlation
between expcected inflation and GDP growth is negative, it implies that
the nominal bond will suffer a capital loss exactly during recessions, when
investros need it the most. Given this negative correlation, the amount
of risk increases with the volatility of expected inflation σi and with the
severity of economic downturns, captured by the volatility of GDP growth
σy .
12. On what does λ depend?
Ans. The market price of risk depends on the coefficent of risk aversion, the
amount of risk and the convexity term.

69
Chapter 19
1. If a model dosen’t fit the term structure what can be happening?
Ans. Two things might be happening: there is an arbitrage opportunity or the
model is wrong. To know in which case we are in, we need to understand
the advantages and limitations of the models we use.

2. What advantage does the Ho-Lee model hold over the Vasicek model?
Ans. Ho-Lee model chooses its parameter in order to match the current term
structure of interest rates.
3. Can you engage on Relative Value Trades on zero coupons obtained from
the Ho-Lee model? Explain.
Ans. No, you cannot since you used the zero coupons to calibrate the model.
4. Why are values obtained from the Ho-Lee model generally higher than
does obtained from the Vasicek model?
Ans. In the Vasicek model, the interest rate is mean reverting which makes its
variance converge to a steady value. In Ho-Lee variance increase with the
lenght of maturity.
5. What are the drawbacks of the Ho-Lee model?
Ans. There are two major drawback for the Ho-Lee model:
i. The model is non-stationary. The process follows essentially a ran-
dom walk, and thus for very large T interest rates could grow to plus
or minus infinity.
ii. The term structure of volatility is flat.
6. Under the Ho-Lee model how does the volatility of long term bonds com-
pare to short term bonds?
Ans. It is the same, since the term structure of volatility is flat.
7. How realistic is the the term structure of volatility in the Ho-Lee model?
Ans. Empirically we know that the term structure of volatility is not flat, which
makes the Ho-Lee unrealistic in this sense.
8. What is the main difference of the Hull-White model with the Vasicek
model?
Ans. The main difference is that the central tendency (from mean reversion) is
time dependant (i.e. it changes over time).
9. In what aspect is the Hull-White model similar to the Ho-Lee model?

70
Ans. As with the Ho-Lee model, the term structure of interest rates is matched
exactly.
10. What happens to the term structure of volatility in the Hull-White model?
Ans. Under the Hull-White model we can also match the term structure of
spot-rate volatility.
11. Explain how each paramet in the Hull-White model is determined.
Ans. The Hull-White model for interest rate dynamics is:

drt = (θt − γ ∗ rt )dt + σdXt

where θt , γ ∗ and σ need to be determined. θt is used to fit the model

to the term structure of interest rates, while γ ∗ and σ are used to fit the
spot-rate volatilities.
12. When pricing options under the Hull-White, what are the important dif-
ferences with the Vasicek model?
Ans. The main differences are:
i. There is no differences between model prices and market prices.
ii. The parameters γ ∗ and σ have been estimated to best fit the term
structure of volatility, and thus the option price will likely be more
accurate. In contrast, in the Vasicek model, the parameter γ ∗ was
estimated to fit the term structure of interest rates.
13. Why are Hull-White prices for call options different from the prices ob-
tained in the Ho-Lee model?
Ans. The reason is twofold: First, the volatility estimate of yields at the one
year horizon in the case of the Hull-White model is substantially smaller
than in the Ho-Lee model. Second, the mean reversion of interest rates
implies that the sensitivity to interest rates is smaller in the Hull-White
model than in the Ho-Lee model.
14. Why are Hull-White prices for call options different from the prices ob-
tained in the Vasicek model?
Ans. Because instead of adjusting γ ∗ to fit the term structure of interest rates
we know use it to fit the term structure of volatility of spot rates.
15. What are the characteristics of Normal models?
Ans. The three important properties of Normal models are:
i. The zero-coupon bond price has the form Z(r, 0; T ) = eA(0,T )−B(0,T )r0 .
ii. The distribution of future interest rates is normally distributed.

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 iii. The option pricing formula is essentially identical, with the only dif-
ference stemming from the volatility σZ (T0 ; TB ).
16. What are the main drawback of Normal models?
Ans. The main drawback is that they give positive probabilities for negative
(nominal) interest rates.
17. What is a log-normal model? When are they used?
Ans. A log-normal model uses log(rt ) instead of rt for the model. This makes
it so that only positive rates are allowed.
18. What is the main drawback for log-normal models such as Black-Derman-
Toy and Black-Karasinsky?
Ans. The main drawback of these models is that they do not allow analytical
solutions as some of theri Normal counterparts.
19. How are Black-Derman-Toy and Black-Karasinsky related?
Ans. Black-Derman-Toy is a special case of Black-Karasinsky.
20. What is the main characteristic of an afine model?
Ans. Afine models allow for a closed form formula for bond prices.

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Chapter 20
1. What is a caplet?
Ans. A caplet is an option on interest rates with the following payoff:

N × Δ × max(rn (Ti ) − rK , 0)

2. What is a cap?
Ans. A cap is a set of caplets with same stike price and with different maturities
occuring within a set period (e.g. semiannually).
3. How is the pricing of a cap related to a caplet?
Ans. The price of a cap equals the sum of the caplets forming it.
4. What is a floorlet?
Ans. A floorlet is an option on interest rates with the follwing payoff:

N × Δ × max(rK − rn (Ti ), 0)

5. What is a floor?
Ans. A floor is a set of floorlets with same stike price and with different matu-
rities occuring within a set period (e.g. semiannually).
6. How is the pricing of a floorlet related to a floor?
Ans. The price of a floor equals the sum of the floorlets forming it.
7. What is an at-the-money cap?
Ans. An at-the-money cap is a cap for which strike rate rK equals the corre-
sponding swap rate.
8. What is flat volatility?
Ans. The Flat Volatility of a cap with maturity T is the quoted volatility σf (T )
that must be entered in Black’s formula for each and every caplet that
make up the cap, in order to obtain a dollar price for the cap.
9. What is forward volatility?
Ans. The Forward Volatility of a caplet with maturity T and strike rate rK
is the volatility of σfF wd (T ) that characterizes that particularly caplet,
independently of which cap the caplet belongs to.
10. You are given information on a 12-month cap, among which is the quoted
volatility, you then want to obtain the price fo the 6 month caplet, can you
simply take the quoted volatility and use as the input needed in Black’s
formula?

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Ans. No, this is simply a quoted volatility it can’t be used directly as a measure
of a caplet’s volatility.
11. What is the source of flat volatility?
Ans. The source of flat volatility is the need of a quoting reference that is
somewhat homogenous within different maturities.
12. What is the advantage of quoting securities in flat volatilities instead of
prices?
Ans. When coupons are added to a security or when we have different maturities
prices are dificult to compare, quoting in volatilities can help solve this
issue.
13. How do we extract forward volatilities from flat volatilities?
Ans. Follow these steps:
i. Use the quoted flat volatilities to obtain cap prices for all maturities.
ii. The shortes cap (maturing in six months) has consists of only one
caplet, so in this case flat and forward volatilities are the same.
iii. For the following maturities use the previously extracted forward
volatilities in such a way that only one caplet’s volatility (obviously
forward volatility) isn’t known. For this one, through some iterative
method, find the volatility needed in order to match the model price
with the observed price.
14. What determines the variation of the forward volatility and the shape of
the forward volatility curve?
Ans. Recall that the forward volatility embedded in caps reflects an insurence
premium, namely, the amoung of money that an investor is willing to pay
to be covered against a run up in interest rates. Such an insurence is more
valueble the higher is the uncertainty about future interest rates. This
leads to different shapes in the forward volatility curve.
15. What effect does mean reversion have on the shape of the implied forward
volatility curve?
Ans. The result is a hump shaped curve for the term structure of implied for-
ward volatility, given that the mean reverting process reduces volatility at
the long end.
16. What is the relation between forward volatilities from Black’s model and
forward volatilities from the Black-Dermand-Toy model?
Ans. In theory they are the same thing, and they converge as dt becomes
smaller.

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 17. What is a swaption?
Ans. A swaption is an option to enter into a swap.
18. What is the forward swap rate?
Ans. The forward swap rate is the level of c that makes the value of the forward
swap equal to zero.
19. What is the swaptions implied volatility?
Ans. As with caps, Swaptions dealers trade swaptions in terms of implied
volatility, that is, the volatility to insert in Black’s formula to obtain the
dollar value of a swaption.

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Chapter 21
1. According to the Fundamental Pricing Equation, what conditions must
V (r, t; T ) satisfy?
Ans. The interest rate security must satisfy:

∂V ∂V ∗ 1 ∂2V
rV = + m (r, t) + s(r, t)2
∂t ∂r 2 ∂r 2
subject to the boundary condition V (r, T ) = gT .
2. What does the Feynman-Kac formula say on pricing securities?
Ans. The Feynman-Kac formula says that the price of a security is given by:

T 
∗ ru du
E e t gT

3. What complications arise when computing

T 
E ∗ e t u gT
r du

for interest rate derivatives such as options?

Ans. The problem is that it is hard to evaluate this expectation, as the interest
rate rt enters twice in the formula:
T
r du
i. It enters in the discount term e t u
ii. It enters in the final payoff gT .
4. Given that gT0 = f(rt , ...), what new terms must we deal with when
computing V (r, t; T )?
Ans. If we have the payoff a function of rt then when getting the expectation we
have to take into account the covariance between the stochastic process
in the discount and the stochastic process in the payoff.
5. What does the change in numeraire technique accomplish?

T 
Ans. The change in numaeraire technique allows us to separate E ∗ e t u
r du

and E ∗ [gT ]. It does so by setting the value of R(r) in the Fundamental

Pricing Equation to zero, R(r) = 0.
6. From where does the change in numeraire technique get its name?

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Ans. It is called this because we normalize V (r, t; T ) by dividing it by another
security. For example:

V (r, t; T )
Ṽ (r, t; T ) =
Z(r, t; T )

We then use Ṽ (r, t; T ) instead of V (r, t; T ). We use one numeraire instead

of the other.
7. What are the two important differences in the Fundamental Pricing For-
mula, when applying the change of numeraire technique?
Ans. The two differences are:
i. The term ”rV ” disappears from the left hand side of the partial
differential equation.
∂ Ṽ
ii. The coefficent of ∂r now has one more term σZ (r, t)s(r, t).
The Fundamental Pricing Formula, thus, stands:

∂ Ṽ ∂ Ṽ 1 ∂ 2 Ṽ
0= + (m∗ (r, t) + σZ (r, t)s(r, t)) + s(r, t)2
∂t ∂r 2 ∂r 2

8. What is a forward risk neutral process?

Ans. A forward risk neutral process is a risk neutral process that has been
normalized by dividing it by another interest rate security.
9. Show that: V (r, t; T ) = Z(r, t; T )Ef∗ [gT ]
Ans. We know that:
V (r, t; T )
Ṽ (r, t; T ) =
Z(r, t; T )
If we rearrange this we get:

V (r, t; T ) = Ṽ (r, t; T )Z(r, t; T )

We know that the solution to the Fundamental Pricing Equation after the
numeraire change, subject to final condition: Ṽ (r, T ) = gT is:

Ṽ (r, t; T ) = Ef∗ [gT ]

so substituting this term we get:

V (r, t; T ) = Z(r, t; T )Ef∗ [gT ]

10. In order to obtain forward risk neutral dynamics, must we always use zero
coupons?

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Ans. No, we can use any traded security. It doesn’t matter if it has different
maturity as the derivative we are evaluating.
11. Given forward risk neutral dynamics, what can be said of a forward price?
Ans. Under the T - forward risk neutral dynamics, the forward price for delivery
at T is a martingale:

F (t; T ) = Ef∗ [F (T ; T )] = Ef∗ [gT ]

12. What requirement must a numeraire fulfill?

Ans. It should be a traded security.
13. What underlying assumption is there in any form of the Fundamental
Pricing Equation?
Ans. It assumes that there is a sufficent number of traded securities in order to
create the riskless portfolio.
14. How strong is the consistency among prices for different securities, when
using different numeraires?
Ans. Prices can become inconsistent, and lead to arbitrage opportunities.
15. In the most literal sense, are Heath-Jarrow-Morton type of models short-
term models?
Ans. No, Heath-Jarrow-Morton models concentrate on forward rate dynamics
instead of the short term interst rate. In other words maturity is fixed as
we move forward.
16. What is the only restriction that the Heath-Jarrow-Morton framework
impose?
Ans. Heath-Jarrow-Morton models require that as we reach maturity volatility
goes to zero, since bond prices become riskless.
17. What is the only input needed for pricing securities under the Heath-
Jarrow-Morton framework?
Ans. We need a function for volatility v(t, T ), which determines the risk neutral
process for the forward rate. From this process we can then price securities.

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Chapter 22
1. What are multifactor models?
Ans. Multifactor models are models that allow for more than one factor (that
is in addition to the interest rate) to be defined by a stochastic process.
2. When are multifactor models used?
Ans. When we want to allow independent variation in the level, slope and cur-
vature components of the yield curve.
3. Under the Vasicek model, what degree of correlation do different interest
rates have?
Ans. Rates on the term structure are perfectly correlated in the Vasicek model.
4. How is the multivariate Ito’s lemma defined?
Ans. This equation is defined as:
     
∂F ∂F ∂F 1 ∂2F 2 1 ∂2F 2
dPt = + m1,t + m2,t + s1,t + s2,t dt
∂t ∂φ1 ∂φ2 2 ∂φ21 2 ∂φ22
 
∂F ∂F
+ s1,t dX1,t + s1,t dX1,t
∂φ1 ∂φ1

5. Given that we now have two stochastic factors, when writing Ito’s lemma
as the following
     
∂F ∂F ∂F 1 ∂2F 2 1 ∂2F 2
dPt = + m1,t + m2,t + s1,t + s2,t dt
∂t ∂φ1 ∂φ2 2 ∂φ21 2 ∂φ22
 
∂F ∂F
+ s1,t dX1,t + s1,t dX1,t
∂φ1 ∂φ1
what are we implicitly assuming about them?
Ans. We are assuming that there is no correlation between both factors.
6. What conditions must V (φ1 , φ2 , t) satisfy?
Ans. V (φ1 , φ2 , t) must satisfy the Fundamental Pricing Equation, now defined
as:
∂V ∂V ∗ ∂V ∗ 1 ∂2V 2 1 ∂2V 2
R(φ1 , φ2)V = + m1,t + m2,t + s1,t + s
∂t ∂φ1 ∂φ2 2 ∂φ21 2 ∂φ22 2,t

and the boundary condition: V (φ1 , φ2; T ) = gT .

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 7. Show that, given:
dφ1,t = γ1∗ (φ̄∗1 − φ1,t )dt + σ1 dX1,t
dφ2,t = γ1∗ (φ̄∗2 − φ2,t )dt + σ2 dX2,t
through drt = dφ1,t + dφ2,t and rt = φ1,t + φ2,t, we get:
 
drt = γ1∗ (φ̄∗1 − rt ) + γ2∗ φ¯∗2 + (γ1∗ − γ2∗ )φ2,t dt + σ1 dX1,t + σ2 dX2,t

Ans. First you add both, so:

drt = γ1∗ (φ̄∗1 − φ1,t)dt + σ1 dX1,t + γ1∗ (φ̄∗2 − φ2,t )dt + σ2 dX2,t
Adding +γ1∗ φ2,t −γ1∗ φ2,t and regrouping the parenthesis gives the solution.
8. In the Vasicek one factor model, the short rate determines the model. In
the Vasicek two factor model, what rates drive the model?
Ans. In the two factor model it is the short rate and the long rate that determine
the rest of the rate dynamics in the term structure.
9. Why is it considered that implied volatility of interest rate options has a
”hump” shape?
Ans. Because of mean reversion long-term interest rate don’t become infinitely
volatile, this depresses this tail making the curve look like a hump.
10. What advantages does the 2-factor Vasicek have when fitting volatility?
Ans. Now the Vasicek model can better fit the term structure of volatility be-
cause it uses two factors to do so.
11. Is the 2-factor Vasicek model an afine model?
Ans. Yes, it is an afine model. It allows a closed form solution.
12. What modifications should be included to Ito’s lemma when we allow
correlation between the two factors?
Ans. The following term should be included in the drift term:
 2
∂ F
s1,t s2,t ρ
∂φ1 φ2

13. What conditions must V (φ1 , φ2 , t) satisfy, given correlation among the
factors?
Ans. V (φ1 , φ2 , t) must satisfy the Fundamental Pricing Equation, now defined
as:
∂V ∂V ∗ ∂V ∗ 1 ∂ 2 V 2 1 ∂2V 2 ∂2V
R(φ1 , φ2 )V = + m1,t + m2,t + 2 s1,t + 2 s2,t + s1,t s2,t ρ
∂t ∂φ1 ∂φ2 2 ∂φ1 2 ∂φ2 ∂φ1 ∂φ2
and the boundary condition: V (φ1 , φ2; T ) = gT .

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 14. Does the 2-factor Vasicek model fit the yield curve?
Ans. No, one of its main drawbacks is that it doesn’t fit the yield curve exactly.
15. What is the difference between using a model for finding arbitrage oppor-
tunities and using a model for pricing derivatives and other securities?
Ans. In the first case we assume that our model is correct and we check the
data to find a way of making a riskless (costless) profit. In the second
case, we hold the view that all prices are priced correctly and we use the
model as a way of linking the prices of some observed securities to others
that are more complex.
16. In the 2-factor Hull-White model, what is the benefit of introducing θt
(time dependent central tendency)?

Ans. It provides two benefits: First it allows the term structure to be fitted
perfectly. Second, it allows for the rest of the parameters to better fit the
volatility structure.
17. Can a solution always be found in order to price a security as proposed
by the Feynman-Kac formula?
Ans. It is not always posible to find a closed form solution, but when this fails
numeric methods can step in and give a solution.
18. What peculiarity of a yield curve steepner makes the use of 2-factor models
attractive?
Ans. A yield curve steepner depends on the relative value of different points
on the term structure of interest rates. If we didn’t use this models we
would have a deterministic term structure defined by the short rate. This
wouldn’t be optimal to analyze a security that depends on different points
along the yield curve. We would like for these two points to move, to a
certain degree, freely. This is why 2-factor models are more attractive in
this case.

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