Homework (Non-Graded)

FINA4120 – Spring

Non-graded questions for self-studies (topic 9 will not be covered in the final) only. You do NOT need to
hand in your answer. Solutions will be posted in the course system latter.

1. Imagine that on June 4, 2016, a forward contract is available under which you can contract to buy a 7%
coupon bond (semiannual coupon payments) with settlement on June 8, 2017 that matures on June 8,
2018 for $98.300 per $100 of face value. What is the implied forward yield on a bond equivalent basis?

2. Imagine that today is March 2, which is an expiration date for the Treasury bond futures contract, and
the closing futures price is $101. The following bonds both qualify for delivery:
Maturity Coupon Price Conversion Factor
(years) (semiannual pay) (per $100 face)
20 8.0% $110.677 1.0
16 6.7% $97.140 0.884

Which of the bonds is the cheaper to deliver? Explain briefly.

3. It is currently March, 2016. You are working in the Treasury department of a large corporation, and
your boss asks you to lock in a three-month borrowing rate today, for a loan that will be taken out in 9
months (i.e., the loan will run from Dec. 2016 to March 2017). Which of the following methods could
you use? (there may be more than one correct answer; indicate all correct answers)
I. In the spot market today, sell a one-year Treasury bill, and buy a nine month Treasury bill, both with
the same current price.
II. In the spot market today, buy a one-year Treasury bill, and sell a nine month Treasury bill, both with
the same current price.
III. Take a short position in a December 2016 Eurodollar futures contract.
IV. Take a short position in a June 2016 Eurodollar futures contract.

4. It is March, 2016. You expect a cash inflow of $200 million dollars at the beginning of September,
2016, and would like to lock in a 6 month investment (lending) rate on this amount using Eurodollar
futures at that time. The following information is currently available on the futures contracts:
(Each contract is for $1 million of 90 day Eurodollars)
Expiration Date Quoted Futures Price
June 2016 94.36
September 2016 94.15
December 2016 94.06
March 2017 94.02

a. Would you take a long or short position in the contracts?

 b. Which contract(s) would you use to take this position?
c. How many contracts would you use?

5. A corporation plans to issue $10 million of 10-year bonds in 3 months. At current yields the bonds
would have modified duration of 8 years. The T-note futures contract is selling at F0=100 and has
modified duration of 6 years. How can the firm use this futures contract to hedge the risk surrounding
the yield at which it will be able to sell its bonds? Both the bond and the contract are at par value. The
face value of the T-note futures is $100,000.

6. Company A has a preference for borrowing at a fixed rate, while company B wants to borrow floating.
They face the following rates if they go directly to the market to borrow:

Rates Offered
Fixed Floating
Company A 11% LIBOR + 1%
Company B 10% LIBOR + .5%

a. Propose a mutually beneficial swap.

b. How much does each company save (in terms of a lower interest rate) over what they would have
paid if they had borrowed directly at their preferred maturity?

7. The Daiwa bank raised $30 million for four years at a fixed interest rate of 7% by issuing a bond, and
then lent the funds to Micro-Technology Inc. The loan calls for a floating interest rate that changes
every year; the interest rate that Micro-Technology agreed to pay is LIBOR plus 400 basis points (4%).
At the same time, Daiwa Bank considers entering into a four year interest rate swap with an investment
banking firm, Nomura Securities, with a notional principal amount of $30 million.
The following four-year swap terms are available from Nomura:
(i) Nomura pays Daiwa bank 7.3% every year; and every year Daiwa bank pays Nomura
LIBOR plus 150 basis points (1.5%).
(ii) Daiwa bank pays Nomura 7.25% every year, and every year Nomura pays Daiwa bank
LIBOR plus 148 basis points (1.4%).
a. Which swap should Daiwa bank choose to hedge their position? What precisely is the risk that
Daiwa bank faces if it does not enter into the interest rate swap? How is this risk avoided by entering
the swap? Draw a diagram that summarizes the situation, and explain.
b. What is the interest rate spread that Daiwa bank would realize as a result of all the transactions (i.e.,
what is the spread between their effective borrowing and lending rate)?

8. Citibank serves as an intermediary in the interest rate swap market. In this role, they participate both as
 a fixed and floating rate payor. Their position is summarized as follows:
Swap 1: Citibank is Fixed Rate Payor Swap 2: Citibank is Floating Rate Payor
Notional Principal = $500 million Notional Principal = $500 million
Maturity = 5 years Maturity = 4 years
Pay 8.5% fixed annual coupon(semiannual payments) Receive 8.55% fixed annual coupon
(semiannual payments)
Receive LIBOR; reset semiannual Pay LIBOR; reset semiannual
Assume that the yield curve is currently flat in the 3 to 7 year maturity range.

a. Draw a diagram that summarizes their position, and briefly explain the benefit they get from
participating in this market as an intermediary.
b. Precisely describe their exposure to interest rate risk. That is, if Citibank carries this position
overnight, do they lose money if interest rates were to rise or if interest rates were to fall? Explain.
c. Citibank can use the Eurodollar futures market to hedge this exposure. Explain whether they would
need to take a long or a short position in the futures market. If we call today “time 0,” what are the
expiration dates in years (e.g., 1.6 years) of the futures contracts that they would use?

9. Assume the current LIBOR spot yield curve is:

Year Spot rate (EAY)

1 5%
2 6%
3 7.5%

What will be the swap rate for a 3-year interest rate swap?

10. Calculate the price of an option that caps the three-month rate, starting in 15 months time, at 13% (APR
with quarterly compounding) on a principal amount of $1,000. The forward interest rate for the period
in question is 12% per annum (APR with quarterly compounding), the 18-month risk-free rate
(continuously compounded) is 11.5% per annum, and the volatility of the forward rate is 12% per
annum.

11. Name at least two methods that can be used to enhance credit in a securitization, and briefly explain why
credit enhancement is a key factor in the success of this market.

12. As a portfolio manager responsible for the assets of a medium sized municipality, you get the following
sales pitch from a broker you recently met: “Take a look at these inverse floater IOs (Interest Only
mortgage-backed securities) that just came in! The yield looks good, and with the inverse floater, the rate
you receive increases when interest rates decline, so your normal prepayment risk is hedged.” Do you agree
that you would be hedged? Briefly explain why or why not.
13. In some mortgage-backed securitizations, payments are divided between interest only (IO) and principal
only (PO) securities. If you expect interest rates to fall sharply in the near future, are you better off investing
in an IO or a PO? Explain briefly.
14. True, False or Uncertain. Explain. The effective duration of a 30 year fixed rate mortgage could be
shorter than the effective duration of a 10 year fixed rate corporate bond with no attached options.