MGT 6769 - Fixed Income Securities

Assignment 4 Prof. Hsu

This assignment must be submitted by the end of class on Wednesday, April 26th , 2017.
The assignment questions are to be completed in groups of up to three people. You must show
the details of your work in Excel spreadsheets. Please HIGHLIGHT your final answers. The
assignment will be marked based on (1) how you arrive at the solution, (2) is the solution
correct or does it make sense? (3) the presentation of your results. Remember, you must
present your work in a clear and concise manner. Make sure your spreadsheets are tidy, and
clearly labeled. This assignment consists of two parts: A and B.

PART (A) Discrete Time Models

1. Binomial Interest Rate Tree - 15 points
Use the following interest rate tree to answer the questions.

t=0 t=1 t=2

r2,2 = 0.1
r1,1 = 0.07
r0,0 = 0.04 r2,1 = 0.05
r1,0 = 0.03
r2,0 = 0.02

The probability of moving up or down on the tree is the same. Assume for simplicity
that each step is one year.

(a) Compute the price of a 1-, 2-, and 3-year zero coupon bond.
(b) Compute the swap rate, C, for a plain vanilla swap with annual cash flows and
maturing on t = 3. Recall the cash flows are given by
(1)
CFt,j (t + 1) = N × (rt,j − C),
(1)
where rt,j = ert,j − 1 is the annually compounded rate that corresponds to rt,j .
(c) Consider an option with maturity t = 1 with the following payoff
" (1)
! #
r1,j
s1 = max 0.98 × − Z1 (3), 0 ,
0.06

(1)
where r1,j is the annually compounded rate at time t = 1, and Z1 (3) is the zero
coupon at time t = 1 that pays $1 at time t = 3.

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 i. What is the value of this option?
ii. If you sell this option, how can you hedge it? Write down the hedging strategy
and confirm its performance at t = 1. Be precise in the description of the
steps.
(d) Procter & Gamble Leveraged Swap: In November 1993, P&G entered a swap with
Bankers Trust (BT) where BT would pay P&G a fixed rate r̄, and P&G would
pay BT a floating rate plus a spread. The spread was going to be equal to 0 at
time of initiation, and would be set at time t = 1 equal to the value s1 according
to the equation above. The spread remains constant thereafter. To provide an
example, suppose that the interest rate increases at t = 1 to r1,1 and decreases
afterwards to r2,1 . The spread is set to s1,1 at t = 1, implying that P&G has to
(1)
pay at time t = 1 simply r0,0 × N , at time t = 2, the cash flow (r1,1 + s1,1 ) × N ,
(1)
and at time t = 3 the cash flow (r2,1 + s1,1 ) × N . The notional amount, N , is 100.
(Remember that in swaps, the floating rate at time t determines the cash flows
at time t + 1.)
i. Assume the maturity of the leveraged swap is 3 years. What is the value of
the swap for P&G if r̄ = C, where C is the swap rate determined in Part (b)?
ii. Given your answer to part i, the value of r̄ that makes the swap value equal
0 at t = 0 is higher or lower than C? Provide a brief intuition.
iii. Using a spreadsheet, compute the value of r̄.

2. The Ho-Lee Model - 20 points

Use the following zero coupon bond table to answer this question.

Maturity (years) Price Yield

0.5 99.1338 1.74
1.0 97.8925 2.13
1.5 96.1462 2.62
2.0 94.1011 3.04
2.5 91.7136 3.46
3.0 89.2258 3.80
3.5 86.8142 4.04
4.0 84.5016 4.21
4.5 82.1848 4.36
5.0 79.7718 4.52

Consider the simple Ho-Lee model. Let’s fix the time step such that ∆ = 0.5. Let
rt,j be the continuously compounded interest rate in node j between steps i and i + 1.

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 Then, for every (i, j), the Ho-Lee model postulates that
√ 1
rt+1,j = rt,j + θt × ∆ + σ × ∆ with probability p =
2
√ 1
rt+1,j+1 = rt,j + θt × ∆ − σ × ∆ with probability p = ,
2
where θt are step-dependent free parameters and σ is a constant. Also, let Pt,j (k)
denote the price of a zero coupon bond at time t at node j with maturity at k.
Use the zero table given above to construct the interest rate tree up to 5 years and
compute the estimated θt for each step using the procedure outlined below.

(a) Find the root of the tree, r0,0 , using the 1-period zero bond.
(b) Given r0,0 , apply the laws of motion of interest rates stated above to find r1,0 and
r1,1 .
(c) Assuming σ = 0.0173, choose θ0 such that the fair value of the 2-period zero bond
equals to corresponding price in the data.
(d) Compute r1,0 and r1,1 using θ0 found in Part (C).
(e) Repeat the procedure iteratively with different zeros at higher maturities.

Discuss the advantages and drawbacks of the Ho-Lee model you have just operational-
ized.

PART (B) Continuous Time Models

1. Vasicek Model in Excel - 15 points
Consider the Vasicek model of interest rate

drt = γ(r̄ − rt )dt + σdXt .

Let γ = 1, r̄ = 5.4%, σ = 1%, r(0) = 0.17%, and dt = 1/252. Do the following

(a) Simulate the process over a 5 year period for various choices of γ and σ. Plot the
results. How does the process depend on these two parameters?
(b) Fix γ and σ, and simulate the process over a 5 year period for various choices of
the initial condition r(0). How does the process depend on the initial condition?

2. Practice using Ito’s Lemma - 10 points

Use Ito’s lemma to compute the law of motion of P = F (X), where X is a Brownian
motion, and F (X) given by

(a) F (X) = A + BX where A and B are two constants.

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 (b) F (X) = eA+BX where A and B are two constants.

3. Ito’s Lemma Applied to Interest Rates - 10 points

Let r follow the process
drt = γ(r̄ − rt )dt + σdXt .
Use Ito’s lemma to compute the law of motion of P = F (r), for F(X) given by

(a) F (r) = A + Br where A and B are two constants.

(b) F (r) = eA−Br where A and B are two constants.

4. Means and Variances - 10 points

In the previous exercise,

(a) Compute the expected capital gain return E[dP ] and decompose it into its com-
ponents.
(b) Compute the “diffusion” of the security σ. Is this parameter positive of negative?
How does it relate to the volatility (i.e. the standard deviation) of the security
P?

5. Vasicek Bond Pricing Formula - 20 points

Consider the following estimated Vasicek parameter: Today’s short-term interest rate

γ r̄ σ γ∗ r̄∗
0.3262 5.09% 2.21% 0.4653 6.34%

is r(0) = 2%. Use the pricing formula for the Vasicek zero coupon bond (with $1
principal) in the lecture notes.

(a) Use Ito’s lemma to compute the expected return E[ dZ

Z
] on zero coupon bonds with
1 year and 10 years to maturity. Which one has the highest expected return?
(b) Use Ito’s lemma to compute the volatility of returns. Which bond has the highest
volatility?
(c) Consider the risk premium for each bond, namely, E[ dZ Z
] − r(0)dt. How is this
related to the volatility just computed? That is, for each bond, compute the ratio
of risk premium to volatility. How does it differ across the two bonds? How does
it depend on the level of the short-term rate r(0)?