Home Assignment II

Fixed Income and Derivatives

ICEF, Fall 2015
Due in class on December 8, 2015
1.

Suppose you see the following information on your Bloomberg screen:

Price of 5-year T-Note futures = 108-31/32nds. Delivery Month: September 2002

Price date = July 6, 2002
Coupon

Maturity

Bond cash price

(32nds)

Conversion factor

6.875

03/31/2007

104-31.75

0.95821

6.875

04/30/2007

104-30

0.9574

6.750

05/31/2007

104-12.50

0.9520

6.375

06/30/2007

102-28.75

0.9367

5.500

07/31/2007

99-08.75

0.9013

Suppose you want to hedge $10 mln. par amount of the 5 of 07/31/2007.
a) Calculate modified duration and DV01 of all bonds.
b) Calculate the gross basis of all bonds. Find the CTD bond and explain your choice.
c) Using the hedging ratio formula that utilizes DV01 determine how many September 5year futures contracts you will need to hedge the $10 mln. position in the 5

2. Ho-Lee model. The observed term structure of the zero-coupon bonds at time 0 is as follows:

P(0,T)

0.96

0.92

0.87

0.82

0.77

0.73

Using the notation of the lecture slides we have u(2)=1.01 and d(2)=0.96 and the tree is
recombining. Throughout the binomial tree the risk-neutral probability q is constant.
A put option expires at time 2 and is issued on a zero-coupon bond that matures at time 3. The
option exercise price is 0.96.
a) Determine the risk-neutral probability at any point in the tree
b) Determine the values of u(T) and d(T) for T=,3,4,5,6

Conversion factors are less than 1 because in this example they are calculated based on 8% coupon rather than
standard 6% convention common in the US.

c) Find the values of nodes of the binomial tree and put them in a table like we did in the class
d) For each of the outcomes at time 2 find the payoffs on the put option. Using the risk-neutral
probabilities and values of the obtained values for future zero-coupon bonds in the discount
factor find the time 0 price of the put option.
e) Find the time 0 price of the put option by constructing a replicating strategy, which uses the
zero-coupon bond maturing at time 3. (Hint: Reading Jarrow Chapters 6-9 could be helpful).
Compare the result to the price obtained in d) and comment.

3. Consider the following short-term interest rate tree (four 1-year periods):

0.338464
0.262012
0.196941
0.14318
0.1

0.245776
0.186493

0.137401
0.097916

0.17847
0.13274

0.095862

0.129596
0.09448
0.094106

a) Calculate the value at each node of the tree of a 5-year zero-coupon bond with face
value 100. What is the YTM on that bond?
b)

Calculate the price of an identical bond that would be callable at $75. Calculate the
YTM on that bond and the spread over the straight bond. What is the value of the
embedded call option according to the model?

c) Assume that the market price of the callable bond is $44. What is the OAS of the bond, that is,
what is the constant spread that must be added to all rates in the tree to make the model price
equal to the market price?
d) Redo question 2 for a call price equal to 80.
e) Assuming that the market price is 50, calculate the OAS for that bond.