MFIN6003 Derivative Securities Dr.

Huiyan Qiu

Session Four/Five: In-Class Exercise on Interest Rate Forward Answers

1. The coupon rates on one-year, two-year, and three-year par coupon bonds are 5%, 5.97%,
and 6.91%.
a. What are the bond yields for one-year zero-coupon bond, two-year zero-coupon
bond, and three-year zero-coupon bond, respectively? (They are the discount rate
for cash flows in corresponding years.)
b. What is the implied forward rate from year 2 to year 3?
c. What is the forward price for a one-year zero-coupon bond which will be issued in
year 2?

Answers:
0 1 2 3

1+ C
1-yr par coupon 1
C 1+ C
2-yr par coupon 1

C C 1+ C
3-yr par coupon 1

Using the given coupon rate on the par coupon bond, we have
1-year par coupon bond: (1 + 0.05) P(0,1) = 1 → P(0,1) = 0.9524
→ r0(0,1) = 5%
2-year par coupon bond: 0.0597 P(0,1) + (1 + 0.0597) P(0,2) = 1
→ P(0,2) = 0.8900 → r0(0,2) = 6%
3-year par coupon bond: 0.0691 P(0,1) + 0.0691 P(0,2) + 1.0691 P(0,3) = 1
→ P(0,3) = 0.8163 → r0(0,3) = 7%

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MFIN6003 Derivative Securities Dr. Huiyan Qiu

b. An investor looking for 3-year long investment opportunities should be

indifferent between investing at the 3-yr zero-coupon bond or invesing at the
2-yr zero-coupon bond and then at the year 2 to year 3 implied rate.

[1+r0(0,2)]2[r0(2,3)+1] = [1+r0(0,3)]3

[1+r0(0,2)]2[r0(2,3)+1]

[1+r0(0,3)]3

[1 + r0 (0,3)]3 P(0,2) 1.073

 1 + r0 (2,3) = = = = 1.090284
[1 + r0 (0,2)]2
P(0,3) 1.06 2

 r0 (2,3) = 9.0284%

c. The forward price of a one-year zero-coupon bond which will be issued in

year 2 should be
1 1.062
P0 (2,3) = = = 0.9172
1 + r0 (2,3) 1.073

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MFIN6003 Derivative Securities Dr. Huiyan Qiu

2. Following table provides the information on zero-coupon bonds maturing at different

days.

Days to Maturity 90 180 270 360

Zero-Coupon Bond Price 0.99009 0.97943 0.96525 0.95238

a. What is the rate on an FRA for a 180-day loan commencing on day 180?
b. Suppose you are the counterparty for a borrower who uses the FRA to hedge the
interest rate on a $10m loan. What positions in zero-coupon bonds would you use to
hedge the risk on the FRA?

Answers:
a. The rate asked is r0(180,360).

0 180 360

$1
P(0,180)=0.97943
$1
P(0,360)=0.95238

1
 0.97943 = 0.95238
1 + r0 (180,360)
0.97943
 r0 (180,360) = − 1 = 2.8403%
0.95238

b. For the counterparty for a borrower, the cash flows are

0 180 360

Short FRA $10m[0.028403 – r180(180,360)]

Where r180(180,360) is the market interest rate at day 180. Obviously, the
counterparty is facing the future interest rate risk –– losing money if the rate
turns out to be high.

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MFIN6003 Derivative Securities Dr. Huiyan Qiu

To hedge:
1. Lend $10m on day 180 for 180 days
2. Long 10m 180-day bond
3. Short 10m×1.028403 360-day bond

Cash flows:

0 180 360

Short $10m[0.028403 – r180(180,360)]

FRA

1 – $10m $10m[1 + r180(180,360)]

2 – 10m×P(0,180) $10m

3 10m×1.028403×P(0,360) – $10m×1.028403

Total 0 0 0

Note: P(0,180) = 1.028403×P(0,360) by how the rate is calculated.