Problem Set 1

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

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

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

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

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

d) find forward rate between time 0.5 and time 1

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

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

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

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

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

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

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

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

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

49(0.97) - 50(0.94) = 0.53

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

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

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

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

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

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

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

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

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

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

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

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

Find probabilities:

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

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

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

46.39

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

c) now making the tree with coupon included:

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