FIXED INCOME

ASSIGNMENT 3
MOHIT RAKYAN (40928)
DENNIS FACIUS (40968)

Question 1
1.a) We have

1+
12
12
=
)

1+
1
12

Inputting values, r=4%; MP=1500

For T = 20 years or 240 months
We have, Max Borrowings MB = 247,532.787
For T = 30 years or 360 months
We have, Max Borrowings MB = 314,191.861
b)
T(months)
1
2
3
4
5
6
7
8
9
10

MB
247532.8
246857.9
246180.8
245501.4
244819.7
244135.8
243449.5
242761.0
242070.3
241377.2

MP
1500.0
1500.0
1500.0
1500.0
1500.0
1500.0
1500.0
1500.0
1500.0
1500.0

Interest
825.1
822.9
820.6
818.3
816.1
813.8
811.5
809.2
806.9
804.6

Principal
674.9
677.1
679.4
681.7
683.9
686.2
688.5
690.8
693.1
695.4

2.
Repo Haircut : In finance, a haircut is the difference between the market
value of an asset used as loan collateral and the amount of the loan. The
amount of the haircut reflects the lender's perceived risk of loss from the
asset falling in value or being sold in a fire sale. For example, if someone
wants to borrow 10 million dollars with a haircut of 10%, he gets only 9
million and needs to put in 1 million of equity himself. This 1 mill covers
the perceived risk of the lender.
CDO : A Collateralized Debt Obligation, or CDO, is a synthetic
investment created by bundling a pool of similar loans into a single
investment that can be bought or sold. An investor that buys a CDO owns
a right to a part of this pool's interest income and principal. They can be of
various types depending on the underlying asset. For example, when the
underlying asset are mortgages, it is called a CMO.

SIV : Structured Investment Vehicles, are a pool of investment assets that

attempts to profit from credit spreads between short-term debt and longterm structured finance products such as asset-backed commercial paper
and medium term notes. In short, SIV represent off-balance sheet vehicles
that invest in long term assets by borrowing short term.
3.a) Given we have 1 million in equity and can get a loan at an haircut of
1%. Using the unitary method we have
1% = 1
= 100 =
Therefore what we can actually raise = total assets haircut =
99million.
b) Here, the bank does not want to put in new equity, hence they need to
sell some assets. With the one million of equity, they now can only
collateralize a loan of 1million/0.2=5million. Hence, the loan amount is
5million*0.8 = 4million. Thus, they need to sell 95 million of the original
assets.
c) We assume the total debt amount to remain constant, hence we need to
cover the haircut on 100 million with new equity of
= %- = =
d) In the recent financial crisis, most market participants reduced their
exposure, and thus sold a huge portion of their assets. This led to volatile
and lower asset prices. Hence, the bank would not want to be exposed to
these market conditions, so we expect the bank to reduce its exposure by
selling assets, and therefore follow option b).

Question 2
1. a) Value of floating rate leg at initiation = 100. This is because it can be
thought of as a floating rate bond, with zero spread, which is always equal
to the principal.
b) At initiation, value of fixed leg = value of floating leg = 100.
c)
Time
1
2
3
4
5

Spot Rate
5%
7%
4%
6%
8%

The swap rate is given by,

=

Discount factor
0.9523
0.8734
0.8889
0.7920
0.6805

Swap Rate
5%
6.93%
4.09%
5.93%
7.63%

1 L ()
L ()

d)
Time
1
2

Rate
5%
7%

Discount Factor
0.9523
0.8734

RSTU = ( L + L

RSTU = 100 0.9523 7.63% 100 + 0.8734 7.63% 100 + 0.8734 100

RSTU = 100 101.27 = 1.27

Hence, the value of the floating rate leg is 1.27.

e) The value of the swap in d) is different from the one at initiation (which
is = 0). This is because the spot rate in the last 2 years has changed from
when the initial value of the swap was calculated.

2.a) 1 year spot rate = 3%

2 year spot rate = 4%
Now assuming $1 invested with no arbitrage,
1 1 + _ 1 + = 1(1 + a )(1 + a )
Time
Forward Rate
Annual
5.009%
Semi-Annual
2.502*2 = 5.004%
Continuous
5%
b) Given, Forward rate = 4.5%
Position
Long 2 yr
Short 2 yr
Short 1 yr
Net Profit

T0
-100
+100.49
+0.49

T1
+103.5
-103.5
-

T2
+108.16
-108.16
-

3)
a)
T
Spot
Discount
Swap rate

1
3%

2
3.4%

3
3.8%

4
4%

0.985221675 0.966847757 0.945099314 0.923845426

3.0%
3.4%
3.79%
3.99%

b) The company has to pay Libor +12bp for their bonds. As part of the
swap contract, they receive Libor and pay the 2 year swap rate of 3.99%.
Hence, the have to pay: Libor + 0.12% - Libor + 3.99% = 4.11%
=

4.11% 50
= 1.02652305
2

They receive 1.5 million for their services. Hence, the net cash flow in the
first three periods is 1.5 - 1.02652305 = 0.47347695.
In the last period, they have to pay the bond, hence the net cash flow is
0.47347695 million - 50 million = -49.52652305
4.a) Given, M=100; c=4%;y=5%;T=5yrs; semi annually
= gh + )h
Spot Price = P = 95.3557381

b) Forward price 6 months from now

Assuming 6 months = 1 Time period
L,_ =

a.j%k

a
_kL
l

= 95.744

c) Given Forward price = 90.744

Position
Long Forward
Short Bond
Lend
Profit

T0
-
95.36
(90.45)
4.905857519

T1
-90.744
-2
92.744
0

5.
BOND
A
B
C
D
Portfolio

Mac
Duration
0.988
1.955
2.923
3.924

Weights
0.250
0.350
0.400

1.000

Contribution to
Duration of Portfolio
0.247
0.684
1.169
0.000
2.100

Now we need to get to target modified duration of 1 to hedge the

portfolio. We have,
) l
=

o
1 2.1
=
= 0.2803

3.924
Since the values of the price of portfolio and the price of the forward are
not given we cannot expand further on the number of forwards needed.
However to hedge the position, we will need to short bond D as indicated
by the negative value of the answer ie H<0 as both F and P >0.

6. a) First, we obtain u and d:

= p
= kp

g
g

= L.aj
= kL.aj

_
_

= 1.28403
= 0.778801

Hence, with S=50 we have

= 64.2013
= 38.94
The payout (and therefore price at the end of year 1) of a put option
is given as
s g = max 0 ; g = max 0; 50 64.2013 = 0
y g = max 0 ; g = max 0; 50 38.94 = 11.06
Hence, the binominal tree for the put option is:
0
L

11.06

We know that L = + with

=

s z
0 11.06
=
= 0.43782
( ) (1.28403 0.778801) 50

and
=

y s 1.28403 11.06 0.778801 0

= L.L|_
= 27.0066
{g ( )

(1.28403 0.778801)
Hence,
= . + . = .

b) First, we obtain the risk neutral probability:

{ g
=
= 0.518596

Then the price of the put is the expected price:

 + ( ) .
=
= .
.
c)

As we now have a two-step tree, we find

= p
= kp

g
g

= L.aj
= kL.aj

L.j
L.j

= 1.19336
= 0.837967

Hence, the stock will move as follows

71.206
59.6682
50

50
41.8983
35.1094

The call price is given as

g = max 0 ; g
Hence, the prices will be

L.j

21.206
0

0
0
Again, we use
g = g +
Starting from the right, we obtain
21.206 0
L.j =
=1
(1.19336 0.837967)59.6682
=

1.19336 0 0.837967 21.206

= 49.01
L.L|L.j (1.19336 0.837967)

Hence,

L.j = 1 59.6682 49.01 = 10.6582

Similarly,
L =

10.6582 0
= 0.599798
1.19336 0.837967 50

1.19336 0 0.837967 10.6582

= 24.6329
L.L|L.j 1.19336 0.837967
= . . = .

7.

We start by calculating

_ =
_ =

(100/120) + 0.5(0.05 + 0.2a /2)

0.2

a =
a =

(g /) + ( )( + a /2)

= 1.04172

(g /) + ( )( a /2)

(100/120) + 0.5(0.05 0.2a /2)

0.2

= 1.18314

Using the normal distribution table we find

(_ ) = 1 (_ ) = 0.1492
(a ) = 1 (a ) = 0.119
Analogous to the pricing in the binomial model, we can interpret
(_ ) as the number of stocks and (a ) as the number of zero

bonds (with face value equal to the strike price) one has to buy in
order to replicate the call such that
g = g +
Now using the Black Scholes formula, we have
g = g (_ ) k{ ()kg) (a )
g = 100 0.1492 100 kL.LjL.j 0.199 = 0.992574
Hence, by the put call parity
g = g + k{ ()kg)
= . + k.. = .
8. a) We can find the yield of the bond with maturity 1 simply as the
yield to maturity that satisfies
97 =

100 + 5
1 + _

Hence,
_ = 8.247%
The spread is given as
g = g g
= . % . % = . %
For the two year bond, we have to adjust for the first coupon, which
has to be discounted by the one year yield:
92

3
100 + 3
=
1 + 0.08247 (1 + a )a

a = 7.44%
= . % . % = . %

Similarly, we adjust the three year bond for coupons in year one
and two:
118

16
16
100 + 16

=
1 + 0.08247 (1 + 0.0744)a (1 + )
= 9.087%
= . % . % = . %

b)

The spread has to be

= (1 + )

Rearranging, and solving for h (with = 1 - 0.4) we get

=

.
=
= . %
( + + ) ( + . + . ) ( . )

9. a) In the Merton model, we have

a =

() ( ) a /2

3 kL.L|j
0.5a
ln
5
6
2
a =
= 0.239838
0.5 5
Using the normal distribution table, we have
(a ) = 0.5948
The survival probability is 59.48%.
b)

Now we also need

_ =

() + ( ) a /2

3 kL.L|j
0.5a
ln
+5
6
2
_ =
= 1.35787
0.5 5
(_ ) = 0.9131
The firm will then be able to raise
g = (1 (_ )) + kh()kg) (a )
= ( . ) + k. . = .
10. a) By exercising the call early the investor loses the time value of the
option. Hence, instead of exercising, it is better to sell the option.
b) In this case, early exercise is a possibility for deep in-the-money
options. Early exercise is feasible in order to obtain the intrinsic
value. The cash can be invested to generate interest income.
11. a) We simply use
=

U (U{g , T{g )
a

T{g

(U{g , T{g ) = 0.4 0.04 0.03 = 0.013856

, , .
= ,

b) We have the variance of the hedged portfolio:

a
a = Ua Ua + a * a *&l
+ 2U ***(&l , U )

differentiating this with respect to H and setting equal to zero we

get
U (U , &l )
=
a

&l

Inputing into the original variance, we get

a =

Ua Ua

Ua (U , &l )a
Ua (U , &l )a
+
2
a
a
&l
&l
=

Ua Ua

Ua (U , &l )a

a
&l

= Ua Ua Ua Ua a
= ( )
Hence,
= , , = . %

c) The underlying asset is not perfectly correlated to the portfolio.

Hence, the variance of the overall position is not zero. Therefore,
the project is not perfectly hedged.