LSE 2014/FM413 Page 1 of 5

Summer 2014 examination

FM413
Fixed Income Markets


2013/2014 syllabus only not for resit candidates








Instructions to candidates

Time allowed: 2 hours

This paper contains three questions, divided in two sections (Section A and Section B). Answer only one
question from section A. Section B is compulsory. Section A is given a weight of 60%, whereas Section B is
given a weight of 40%.

Calculators are allowed in this examination. Keep the numerical accuracy up to 3 decimal places.


Good luck!
SECTION A
Question 1 [60 points]
Table 1 displays the four-period binomial tree containing the evolution of the discretely
compounded one-period rates. Each period in the tree equals one year. The tree is
tted using the Ho-Lee model. Recall that such a tree is developed by starting with the
original term structure of zero coupon bond prices for all maturities. We shall use 0.5
as the up-state probability and 0.5 as the down-state probability. These are, of course,
the risk neutral probabilities, not the actual probabilities. Finally recall the following
notation:
r
i,j
=

r
i+1,j
an up movement in interest rates
r
i+1,j+1
a down movement in interest rates
t = 0 1 2 3 4
(years)
i = 0 1 2 3 4
j =
0 10.50% 12.06% 13.61% 15.15% 16.72%
1 8.80% 10.30% 11.80% 13.32%
2 7.09% 8.54% 10.02%
3 5.38% 6.82%
4 3.71%
Table 1: The Risk Neutral Ho-Lee Interest Rate Tree tted to the zero coupon bonds.
(i) (5 points) Compute the price today (i.e. at t = 0) of a zero coupon bond of
maturity of 3 periods and for $1 face value.
(ii) (15 points) Determine the price today (i.e. at t = 0) of a European call option
on a 3-year zero coupon bond with face value equal to $100. The option has a
maturity equal to 2 years and a strike price equal to $90.
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(iii) (20 points) Recall that the payo of a plain vanilla cap as of time T
1
, T
2
, . . . , T is
CF(T
i
) = N max(r
n
(T
i
, T
i
) r
K
, 0)
i.e. on each caplet expiration date T
i
, the cap pays o the one-period rate minus
the strike rate if the former is higher and zero if the latter is higher. Note that
the payo determined at T
i1
= T
i
is made one period later, i.e. at time
T
i
. Consider a three-period cap on the one-period rate struck at r
K
= 9%. The
payments are annual, i.e. = 1, and the notional value of the cap is N = $100.
Given the interest rate tree in Table 1 nd the value today (i.e. at t = 0) of the
cap.
(iv) (20 points) Recall that in an interest rate swap the counterparty receiving a oat-
ing interest rate payment and paying a xed interest rate c has a payo equal
to:
CF(T
i
) = N (r
n
(T
i
, T
i
) c)
at time T
1
, T
2
, . . . , T. Note that the payo determined at T
i1
= T
i
is made
one period later, i.e. at time T
i
. Consider a three-period, xed-for-oating par
swap dened on the one-period rate and with annual payments. The swap rate is
c = 10.41% over a notional of N = $100. The payments are annual, i.e. = 1.
Given the interest rate tree in Table 1, compute the swap value tree.
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Question 2 [60 points]
(i) (10 points) What is the price of a zero-coupon bond with $100 face value that
matures in seven years and has a yield of 7%? We assume that the compounding
frequency is annual. What is the bonds modied duration?
(ii) (10 points) Use the modied duration to nd the approximate change in price if
the bond yield rises by 15 basis points.
(iii) (20 points) Today is t = 0. Assume that we have to make a payment of $100 in
one year and a half (at t = 1.5). Assume we can only invest in a risk-free discount
bond, with a face value of $100, that matures in one year (at t = 1), and in a
risk-free coupon bond, with a face value of $100, that pays an annual coupon of 8%
and matures in 3 years (at t = 3). Assume a at term structure of 7%. How many
units of each of the bonds should we buy in order to be perfectly immunized?
(iv) (20 points) Assume that a portfolio manager is considering the purchase of a
$100 face value US treasury with maturity equal to 10 years. Suppose that two
additional Treasury bonds, namely a 5- and a 30-year bond, are available for
trading: their characteristics are reported in Table 2 along with those of the 10-
year bond. How would the manger use the additional two bonds to implement
a barbell portfolio? Derive the composition of the barbell portfolio. In which
particular yield curve scenario is a barbell portfolio likely to generate positive
prots? Explain in detail.
Coupon Maturity (years) Price Duration Convexity
2
1
2
5 102.5954 4.520 23.4
3
3
8
10 100.8590 8.033 74.8
4
3
8
30 102.7802 16.611 389.7
Table 2: Data on Three Treasury Bonds.
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SECTION B
Question 3 [40 points]
This question asks to develop three mini-essays on valuation of xed-income securities.
(i) (15 points) Explain the key dierence between the Ho-Lee and the Black-Derman-
Toy interest rate models.
(ii) (10 points) Explain how to compute the risk-neutral probabilities from the zero
coupon prices.
(iii) (15 points) Explain the backward induction valuation methodology within the
binomial interest rate tree framework. Illustrate also how the backward induction
valuation methodology can accommodate intermediate cash ows, such as those
generated by a coupon bond.
END OF PAPER
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