Options,FuturesandOtherDerivatives

Chap4
Questions

1.Abankquotesyouaninterestrateof14%perannumwithquarterlycompounding.Whatisthe
equivalentratewith(a)continuouscompoundingand(b)annualcompounding?

2.WhatismeantbyLIBORandLIBID.Whichishigher?

3.The6monthand1yearzeroratesareboth10%perannum.Forabondthathasalifeof18
monthsandpaysacouponof8%perannum(withsemiannualpaymentsandonehavingjust
beenmade),theyieldis10.4%perannum.Whatisthebond'sprice?Whatisthe18month
zerorate?Allratesarequotedwithsemiannualcompounding.

4.Aninvestorreceives$1,100inoneyearinreturnforaninvestmentof$1,000now.Calc.The
percentagereturnperannumwith:
(a)Annualcompounding
(b)Semiannualcompounding
(c)Monthlycompounding
(d)Continuouscompounding

5.Supposethatzerointerestrateswithcontinuouscompoundingareasfollows:
Maturity(months) Rate(%per
annum)
3 8.0
6 8.2
9 8.4

12 8.5
15 8.6
18 8.7

Calculateforwardinterestratesforthesecond,third,fourth,fifthandsixthquarters.

6.Assumingthatzeroratesareasin#5,whatisthevalueofanFRAthatenablestheholderto
earn9.5%fora3monthperiodstartingin1yearonaprincipalof$1,000,000?Theinterest
rateisexpressedwithquarterlycompounding.
 7.Thetermstructureofinterestratesisupwardsloping.Putthefollowinginorderofmagnitude:
(a)The5yearzerorate
(b)Theyieldona5yearcouponbearingbond
(c)Theforwardratecorrespondingtotheperiodbetween5and5.25yearsinthefuture
Whatistheanswertothisquestionwhenthetermstructureofinterestratesisdownward
sloping?

8.Whatdoesdurationtellyouaboutthesensitivityofabondportfoliotointerestrates.Whatare
thelimitationsofthedurationmeasure?

9.Whatrateofinterestwithcontinuouscompoundingisequivalentto15%perannumwith
monthlycompounding?

10.Adepositaccountpays12%perannumwithcontinuouscompounding,butinterestisactually
paidquarterly.Howmuchinterestwillbepaideachquarterona$10,000deposit?

11.Supposethat6month,12month,18month,and30monthzeroratesareresp.4%,4.2%,
4.4%,4.6%,and4.8%perannum,withcontinuouscompounding.Estimatethecashpriceofa
bondwithafacevalueof100thatwillmaturein30monthsandpaysacouponof4%per
annumsemiannually.

12.A3yearbondprovidesacouponof8%semiannuallyandhasacashpriceof104.Whatisthe
bond'syield?

13.Supposethatthe6month,12month,18monthand24monthzeroratesare5%,6%,6.5%,
and7%resp.Whatisthe2yearparyield?

14.Supposethatzerointerestratesw/comtinuouscompoundingareasfollows:

Maturity ZeroRate
1 2.0
2 3.0
3 3.7
4 4.2
5 4.5

Calc.Forwardinterestratesforthe2nd,3rd,4thand5thyears.

15.UsetheratesinProblem4.14tovalueanFRAwhereyouwillpay5%forthethirdyearon$1
million.

16.A10yr8%couponbondcurrentlysellsfor$90.A10yr4%couponbondcurrentlysellsfor
$80.Whatisthe10yrzerorate?
 17.Explaincarefullywhyliquiditypreferencetheoryisconsistentwiththeobservationthatthe
termstructureofinterestratestendstobeupwardslopingmoreoftenthanitisdownward
sloping.

18.Whenthezerocurveisupwardsloping,thezerorateforaparticularmaturityisgreaterthan
theparyieldforthatmaturity.Whenthecurveisdownwardslopingthereverseistrue.
Explainwhythisisso.

19.WhyareUSTreasuryratessignificantlylowerthanotherratesthatareclosetoriskfree?

20.Whydoesaloanintherepomarketinvolveverylittlecreditrisk?

21.ExplainwhyanFRAisequivalenttotheexchangeofafloatingrateofinterestforafixedrate
ofinterest.

22.A5yrbondwithayieldof11%(continuouslycompounded)paysan8%couponattheendof
eachyear.
(a)Whatisthebond'sprice?
(b)Whatisthebond'sduration?
(c)Usethedurationtocalc.theeffectonthebond'spriceofa0.2%decreaseinitsyield.
(d)Recalculatethebond'spriceonthebasisof10.8%perannumyieldandverifythatthe
resultisinagreementwithyouranswerto(c).

23.Thecashpricesof6mthand1yrTreasurybillsare94.0and89.0.A1.5yrbondthatwillpay
couponsof$4every6mthscurrentlysellsfor$94.84.A2yrbondthatwillpaycouponsof$5
every6mthscurrentlysellsfor$97.12.Calc.the6mth,1yr,1.5yrand2yrzerorates.

Answers

1.14%p.a.Quarterlycompounding.
Iftherateiscompoundedmtimesperannum,theterminalvalueoftheinvestmentisA*
(1+R/m)mnwheren=#ofyears,m=compoundingfrequency.
a)Continuouscompounding
Equivalentratecontinuouslycompoundedisgivenas:
eRc=(1+R/m)m=>Rc=mln(1+R/m)=>Rc=4*ln(1+0.14/4)=4ln(1.035)=0.1376
Henceratewithcontinuouscompounding=13.76%
b)Annualcompounding
Herem=1
HenceA(1+R1/1)=A(1+R4/4)4=>1+R1=1.0354=>R1=1.03541=>R1=14.75%with
annualcompounding.

2.LIBOR,theLondonInterbankRaterepresentstherateatwhichabankAiswillingtomakea
wholesale/largecashdepositatanotherbankB.TheLIBORraterepresentsaloanfrombank
AtobankB.
LIBID,theLondonInterbankBIDraterepresentstherateatwhichabankAiswillingto
acceptorpayforloansfrombankB.ItrepresentsaloanfrombankBtobankA.
 LIBOR,therateatwhichabankiswillingtoloanitscashishigherthanLIBIDwhichisthe
rateatwhichitiswillingtoborrowcash.ThereisusuallyasmallspreadbetweenLIBOR&
LIBIDrates.

3.Leti=[0,1....n],ti=0.5*in1
yti
TheBondPricePisgivenbyP=ceyti+(100+c) =8(e0.104*0.5+e0.104*1+
108*e0.104*1.5)=8*1.8505+108*0.88556=110.44
i=1

HencebondpriceP=$110.44
18monthzerorate
Priceofbond=PVofalldiscountedcashflowsreceived=n1
ceziti+(100+c)zntnwherezi=zerorateatperiodi,ti=periodi,
i=1

110.44=8(e0.1*0.5+e0.1*1)+108*ez*1.5=8*(0.95123+0.90484)+108*ez*1.5=14.8485
+108ez*1.5=>ez*1.5=0.8851=>1.5z3=ln(0.8851)=>z3=0.0814.
Hencez3=18monthrate=8.14%

4.$1100in1yrforaninvestmentof$1000now
a)%returnperannumw/annualcompounding
TerminalvalueFV=1100=A*(1+R/m)mnwheren=#ofyears,m=compoundingfrequency.
1100=1000(1+R)=>R=0.1
Hence%returnp.a.=10%
b)Semiannualcompounding
1100=(1+R/2)(1+R/2)*1000=>1.1=(1+R/2)2=>R/2=1.11=>R=9.762%per
annum.
c)Monthlycompounding
1100=1000*(1+R/12)12=>1.1=(1+R/12)12=>1+R/12=1.11/12=>R/12=1.11/121=>R
=9.569%perannum.
d)Continuouscompounding
FV=AeRcn
1100=1000eRcn=>1.1=eRc=>R=ln1.1=9.531%perannum.

5.TheexpressionfortheforwardrateRFisgivenbyRF=R2T2R1T1
___________
T2T1

Qtr2
a)Convertmaturitytoyearly.
T1=3mths=0.25
T2=6mths=0.5
RF=(8.2*0.58*0.25)/(0.50.25)=(4.12)/0.25=8.4%
 b)Don'tconverttoyearlybutusemonthly.
T1=3,R1=8%=2%qtrly

T2=6,R2=8.2%=2.05%qtrly

RF=(6*2.053*2)/(63)=(12.36)/3=6.3/3=2.1%qtrly=8.4%annualized.

Qtr3

Convertmaturitytoyearly.

T1=6mths=0.5T2=9mths=0.75

R1=8.2R2=8.4

RF=(8.4*0.758.2*0.5)/(0.50.25)=(6.34.1)/0.25=8.8%

Qtr4

Convertmaturitytoyearly.

T1=9mths=0.75T2=12mths=1
R1=8.4R2=8.5

RF=(8.58.4*0.75)/(10.75)=(8.56.3)/0.25=8.8%

Qtr5

Convertmaturitytoyearly.
T1=1T2=15mths=1.25
R1=8.5R2=8.6

RF=(8.6*1.258.5)/(0.25)=(10.758.5)/0.25=9%

Qtr6

Convertmaturitytoyearly.

T1=15mths=1.25T2=18mths=1.5

R1=8.6R2=8.7

RF=(8.7*1.58.1*1.25)/(0.25)=(13.0510.75)/0.25=9.2%

6.ValuationofFRAisgivenas:
VFRA=L(RFRK)(T2T1)eR2T2
Wewishtocalc.theforwardratebetweenmonths12&15onaquarterlybasis.
RF=9%,RK=9.5%
R2=Rateat1.25yrs=8.5,L=1M
VFRA=1000000(0.0950.09)*0.25*e0.085*1.25=1250e0.085*1.25=$1124

7.Orderofmagnitudeisasfollows:

Forwardratecorr.totheperiodbetween5and5.25yearsinthefuture>
5yearzerorate>Yieldona5yearcouponbearingbond
 8.Durationestimatesthechangeinthevalueofthebondportfolioforasmallchangeyinthe
yieldofALLthebondsintheportfolio.
Therelationshipisbetweenthedurationandtheweightedaverageofallthebondpricesinthe
portfolio.
Thelimitationsofthedurationmeasureinthiscaseare:

i.Itisassumedthattheyieldsofallbondswillchangebythesameamount.Whenallbonds
havewidelydifferentmaturitiesthisoccurswhenthereisaparallelshiftinthezerocoupon
yieldcurve,averyunlikelyscenario.
ii.Thedurationrelationshipholdsonlyforsmallchangesintheyield.

9.Calc.rateofinterestwithcontinuouscompoundingequivalentto15%perannumwith
monthlycompounding.
n=1
HenceAeR=A[1+Rm/12]12=>eR=[1+0.15/12]12=>R=12ln(1.0125)=0.1491=14.91%
HenceRateofInterestR=14.91%

10.12%paofcontinuouscompounding.
AeR=A[1+Rq/4]4=>e0.12=[1+Rq/4]4=>1+Rq/4=e0.03=>Rq=4(e0.031)=12.18%on
anannualbasis.
Hencequarterlyrate=12.18/4=3.045.
Interestpaideachquarter=0.1218*10,000*0.25=$304.50

Maturity ZeroRate
6 4
12 4.2
18 4.4
24 4.6
30 4.8

11.Price=PresentValueofCashFlows
PV=ceziti+(100+c)zntn

=4/2*(e0.5*0.04+e1*0.042+e1.5*0.044+e2*0.046)+102e2.5*0.048
=2*(e0.02+e0.042+e0.066+e0.092+51e0.12)=$98.04
12.3yearbond=>6intervals
Theyieldisgivenby

PV=ceyti+(100+c)ytn
c=8/2=4sinceitiscompoundedsemiannually
104=4(e0.5*y+e1*y+e1.5*y+e2*y+e2.5*y)+104e3*y
2626e3y=e0.5y+ey+e1.5y+e2y+e2.5y=>26=e0.5y+ey+e1.5y+e2y+e2.5y+26e
3y
WewillnowusetheNewtonRaphsonmethodtosolvetheaboveeq.
Thusf(y)=e0.5y+ey+e1.5y+e2y+e2.5y+26e3y26=0
f'(y)=0.5e0.5yey1.5e1.5y2e2y2.5e2.5y78e3y
Fromtheattachedspreadsheet,wegety=0.06407,henceyield=6.407%

13.Paryieldisthecouponratethatcausesthebondpricetoequalitsparvalue.
Hence,100=c/2*(e0.5*0.05+e1*0.06+e1.5*0.065)+(c/2+100)e2*0.07

=>c(e0.025+e0.06+e0.0975+e0.14)=200*(1e0.14)

=>c=200*(1e0.14)

(e0.025+e0.06+e0.0975+e0.14)

c=7.074
Henceparyield=7.074

14.Ratesfor2nd,3rd,4th,5thyrs
RF=[R2T2R1T1]/(T2T1)
Year2
RF=(0.03*20.02*1)/1=0.060.02=0.04=4%
Year3
RF=(0.037*30.02*2)/1=0.1110.06=0.051=5.1%
Year4
RF=(0.042*40.037*3)/1=0.1680.111=0.057=5.7%
Year5
RF=(0.045*50.042*4)/1=0.2250.168=0.057=5.7%

15.ValueofFRAisgivenbyVFRA=L(RFRK)(T2T1)eR2T2

Thefwdrate=4%foryear2onacontinuousbasis.Theratesshouldbewithacompounding
frequencyreflectingtheirmaturity.
HenceRFisgivenby

AeRcn=A[1+RF/m]mn,=>1+RF=e0.04=>RF=e0.041=4.08%annually
RK=5%
 VFRA=1000,000*(0.04080.05)e0.037*3=$8233.44

16.10yr8%couponbondprice=$90
10yr8%couponbondprice=$80
Calc.10yrzerorate.
Tosolve,wetakealongpositionin2ofthe4%couponbonds,andashortpositionin1ofthe
8%couponbonds.
Long
Wehave
80=2e0.5z1+2ez2+2ez3*1.5+2e2z4+...+2e9.5z19+(102)e10z20
=>160=4e0.5z1+4ez2+4ez3*1.5+4e2z4+...+4e9.5z19+204e10z20(i)

Short
90=4e0.5z1+4ez2+4ez3*1.5+4e2z4+...+4e9.5z19+104e10z20(ii)

(i)(ii)gives:
70=100e10z20=>e10z20=0.7=>10z20=ln0.7=>z20=0.1ln(0.7)=0.03567
Hence10yrzerorate=3.567%

17.Liquiditypreferencetheoryholdsthatinvestorsprefertopreservetheirliquidityandinvest
fundsforshortperiodsoftimewhileborrowersliketoborrowatfixedratesforlongperiods.
Thusresultsinthesituationwherebyfinancialintermediarieslikebankswouldfind
themselvesfinancingsubstantialamountsoflongtermfixedrateloanswithshortterm
deposits.Henceexcessiveinterestrateriskwouldresult.Inordertoavoidthisrisk,andmatch
depositorsandborrowerss,financialintermediariesraiselongtermratesrelativetofuture
shorttermrates.Thisreducesthedemandforlongtermfixedrateborrowingandencourages
investorstodeposittheirfundsforlongerterms.Sincelongtermratesareingeneralhigher
thanshorttermratesduetothisaction,yieldcurvestendtobeupwardslopingmoreoftenthan
theyaredownwardsloping.

18.Whenthezerocurveisupwardsloping,thezerorateforaparticularmaturityisgreaterthan
theparyieldbecausetheyieldonacouponbearingbondisaffectedbythefactthatsome
incomeisreceivedbeforethematuritydate,andtherateusedtodiscountthesepaymentswill
belowerthantherateusedtodiscountthepaymentatmaturity.Conversely,foradownward
slopingcurve,therateusedtodiscountthepaymentsforthecouponbearingbondarehigher
thantherateusedtodiscountthepaymentatmaturity.

19.USTreasuryratesaresignificantlylowerthanotherratesthatareclosetoriskfreeforthe
followingreasons:

i.Tbillsandbondsmustbepurchasebyfinancialinstitutionstofulfillavarietyofregulatory
requirements.ThisincreasesdemandfortheseTreasuryinstrumentsdrivingthepriceupand
theyielddown.
ii.TheamountofcapitalabankisrequiredtoholdtosupportaninvestmentinTbills&bonds
issubstantiallysmallerthanthecapitalrequiredtosupportasimilarinvestmentinother
instrumentswithverylowrisk.
 iii.IntheUS,Treasuryinstrumentsaregivenafavorabletaxtreatmentcomparedwithmost
otherfixedincomeinvestmentsbecausetheyarenottaxedatthestatelevel.

20.Aloanintherepomarketinvolvesverylittlecreditrsikbecauseofhowitisstructured.With
suchaloantheborroweragreestosellsecuritiestoanothercompanynowandbuythemback
atahigherprice.Thedifferencebetweenthesellingpriceandthebuybackpriceistheamount
ofinterestearned.
Iftheborrowerdoesn'thonortheirsideoftheagreement,thelenderkeepsthesecuritiesandif
thelenderdoesn'tcomeupwiththesecuritiestheborrowerkeepsthecash.Duetothis,thereis
verylittleriskofdefaultoneitherside.

21.InanFRA,onecompanyXwillreceiveinterestontheprincipalatthefixedrateofRKand
payinterestattherealizedrateofRM.TheothercompanyYwillpayinterestatthefixedrate
ofRK
andreceiveinterestrateattherealizedmarketrateofRM.Hencethisagreementamountsto
theexchangeofaflowingrateofinterestRMforafixedrateRKbetweenX&Y.

22.5yrbondwithyieldof11%pays8%couponattheendofeachyear.
a)Price=PVofcashflows
P=8*(e0.11+e0.22+e0.33+e0.44)+108e0.55=24.491+62.311=$86.801
b)Bondduration
D=c(tieyti)/Pwherezi=zerorateatperiodi,ti=periodi,
i=1

=[8*(e0.11+2e0.22+3e0.33+4e0.44)+108*5e0.55]/86.801=369.423/86.801=4.256

c)Effectof0.2%decreaseinbond'syield.
WehavethatP/P=Dy
=86.801*4.256*0.002=0.738
Hencebond'spricewillriseby0.739from86.801to$87.54
d)Bondpriceonbasisof10.8%perannumyield.
P'=8*(e0.108+e0.216+e0.324+e0.432)+108e0.54=$87.54
Hencethisisinlinew/theresultinc).

23.Cashpriceof6mthTbill=94.0
Cashpriceof1yrTbill=89.0
1.5yrbondthatwillpaycouponsof$4every6mthssellsfor94.84
A2yrbondthatwillpaycouponsof$4every6mthssellsfor97.12

6mthTbill
Price=94.0
Tbillpaysnocoupon
P=ceziti
c=100
94=100e0.5z0=>0.5z0=ln0.94=>z0=0.1238=>z0=12.38%
 1yrTbill
Price=89.0
Tbillpaysnocoupon
P=ceziti
c=100
89=100ez1=>z1=ln0.89=>z1=0.1165=>z1=11.65%

1.5yrTbond
Price=94.84
Tbondpayssemiannualcouponof$4eachperiod
P=cieziti
c=100
94.84=4(e0.12375*0.5+e0.1165)+104*ez*1.5=4(0.94+0.89)+104*ez*1.5=>
94.84=104*ez*1.5=>z3=0.1150=>z3=11.5%

2yrTbond
Price=94.84
Tbondpayssemiannualcouponof$4eachperiod
P=cieziti
c=100
97.12=5(e0.12375*0.5+e0.1165+e0.115*1.5)+105*e2z=5(0.94+0.89+0.8416)+105*e
z*1.5=>83.7622=105*e2z=>z =0.11299=11.3%
3

24.