MTH402 Fixed income securities
Class Test
Instructions: Students are expected to complete the homework and quizzes
independently and the answers should contain the necessary steps, including
the program codes attached in the end of the answer. The answers without the
necessary steps or explanations would NOT be considered correct.
1. Let today be November 3, 2008.
(a) Use the LIBOR rate and the swap data on November 3, 2008 in Table
11.26 and fit the LIBOR curve.
(b) From the LIBOR discount curve, fit the Ho-Lee model of the interest
rates, with quarterly steps. You can use the LIBOR volatility reported in
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the text, or estimate the LIBOR volatility yourself. Data on LIBOR are
available on the British Bankers Association Web site (www.baa.org.uk).
(c) Compare risk neutral expected future interest rates to the continuously
compounded interest rates. How does the difference depend on the
assumed volatility of the interest rate? (Hint: For each assumed volatility
of the interest rate, you need to refit the tree to make sure that the tree
correctly reflects the forward rates. Do the exercise for 3 values of
volatility).
(d) Compute the value of 1-year, 2-year and 3-year cap. Compare your
value with the one in the data, in Table 11.26.
(e) Compute the value of a 5-year swap (the swap rate in Table 11.26) with
quarterly payments (i.e., assume that both floating and fixed payers pay
at quarterly frequency). Is the value of the swap obtained from the tree
what you would expect from first principles?
(f) Use the swap tree computed in Part (e) to compute the value of 1-year,
at-the-money swaption to enter into a 4-year swap.
2. On November 3, 2008, the AAA rated company HAL issued a 5 year,
corridor note with a quarterly coupon, according to the term sheet in Table
11.25. Given the Ho-Lee model fitted in Problem 1, compute the following:
(a) Obtain the value of the corridor note discussed in Table 11.25.
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(b) Compute the value of a straight quarterly coupon bond, and determine
the (annualized) coupon rate that generates a price similar to the one of
the corridor note. Is this coupon higher or lower than 5%? Comment.
(c) Compute the spot rate duration of the corridor note and of the straight
bond obtained in Part (b). Which one is higher? Why?
(d) Consider the future time t = 2 (step i = 8). Plot the value of the corridor
note at i = 8 against the interest rate scenarios at the same time. On
the same graph also report the values of the straight fixed coupon bond.
Comment on the difference between the two securities. Which one
appears to have negative convexity? Why?
(e) Consider the simple BDT model. Fit this model to the same data [again,
either use the LIBOR volatility in the text, or estimate it using the same
data as in Part (b)] and recompute the value of the corridor note. Is this
the same value you obtained using the Ho-Lee model? Comment.
Reference:
Pietro Veronesi (2010) Fixed Income Securities: Valuation, Risk, and Risk
Management, Wiley.
