Hong Kong University of Science and Technology

FIXED INCOME SECURITIES (SAMPLE)

Final-term Exam

Question : Swaps
Two investors enter into a 2yr swap agreement at fixed rate of 6.4%. The payment will take place
quarterly. The notional amount of the swap is $25million and all payments (fixed rate and floating
rate) are quarterly based on “act/360” day count basis. The reference rate is 3-month LIBOR with the
following forward rates.

1. How much money would exchange hands at the time of the agreement? ZERO
2. If you have the view that the forward rates will be higher than what the market is
forecasting, would you prefer to be a receiver or a payer? PAYER
3. Without doing any calculations, which party (receiver vs. payer) will experience cash
inflows during the first payments? Why? The receiver gets a fixed rate of a longer
tenor that is higher than immediate short term forward rates in a normal upward
sloping curve.
4. 1 year and 3 months later, just seconds after the 5th payment takes place, the receiver
wants to unwind (close) the swap position. What is the value of the swap at this new
point in time (use the data on table 2)? For the RECEIVER=+144,111.36

5. What is swap price 1 year and 3 months later as of table 2? =5.61%

Table 2: Swap price in 1yr and 3months
Quarter Nr of Days Current ED Future The Forward The Floating Discount PV of Floating Formula 1 PV Fixed
3m
Starts in Quarter Libor Price Rates PERIOD Payments Factor Payments Find Fix Rate Payments

Period 6 90 5.0% 1.2500% 312,500 0.9877 308,642 6,172,840 394,811

Period 7 91 94.45 1.4029% 350,729 0.9740 341,607 6,155,076 393,674

Period 8 92 93.70 1.6100% 402,500 0.9586 385,819 6,124,116 391,694

Total 2.9202 1,036,068.00 18,452,031.49 1,180,179.36

Fixed
Rate 144,111.36 5.614926%

Table 2: Duration
Quarter Nr of Days Current ED Future The Forward The Floating Discount PV of Floating Formula 1 PV Fixed
3m
Starts in Quarter Libor Price Rates PERIOD Payments Factor Payments Find Fix Rate Payments

Period 6 90 5.0% 1.2500% 312,500 0.9877 308,642 6,172,840 346,600

Period 7 91 94.44 1.4054% 351,361 0.9740 342,214 6,154,923 345,594

Period 8 92 93.69 1.6126% 403,139 0.9585 386,412 6,123,809 343,847

Total 2.9201 1,037,268.04 18,451,571.38 1,036,042.17

Fixed
Rate (1,225.87) 5.621570%

6. What is the duration of this swap now?

Duration=-Change in Price/(P*change in yield)=-Value swap/notional *1/0.00001= -
(-1225.87)/25mio*1/(0.0001)=0.49

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Question: Par Asset Swap

Investor A buys $20milion of a 5yr bond with 6% coupon and 7% yield from the market. The coupons
are paid semi-annually. In order to hedge his cash flows he enters a swap agreement with a swap
dealer. The 5year swap rates are quoted at 6.2%/6.3%. The payments are semi-annual based on
6months Libor. The cumulative discount factor is 4.5.

1. What is the par asset swap spread? The upfront loss of 100-95.9 will be compensated by 10
semi-annual payments at = (100-95.9)/4.5=0.911 every 6months. The net annual cash is from
holding a fixed bond and swapping fixed for floating is 6%+ LIBOR+2*0.91-
6.3%=LIBOR+1.54. The par assets swap is 154basis points.
2. Can the par asset swap spread be negative? Yes, as long as the credit rating of the company is
better than that of banks. Banks provide libor rates. Negative spread means that the yield of
risky bond is above the government but lower than the bond issued from banks for the same
tenor.

Question : Credit Default Swaps

1. Calculate the quarterly payment of the two CDS agreements. Day accounting basis is
act/360.
2. If there is a default and that default is to be settled in cash, how much would the CDS
seller have to pay the CDS buyer in each case? Seller pays= notional x/(1-recovery rate)
The CDS buyer gets the recovery value from the market.
3. What is the implied default probability in each case? Probability=CDS/(1-recovery rate)

Quarterly Implied
CDS Notional Days in Premium Recovery Default
price Amount Quarter Payment rate Proba
3.0% $15,000,000 90 112,500 0.4 5.0%
4.5% $8,000,000 91 91,000 0.2 5.6%

CDS Notional Days in Recovery

price Amount Quarter rate
3.0% $15,000,000 90 0.4
4.5% $8,000,000 91 0.2

Question 6: Total Return Swaps

An investor wants $10mio exposure to bond X. He believes the credit spread will fall. He enters a
Total Return Swap Receiver while paying to the bank 6months US Treasury + 100bps. The tenor of
the Total Return Swap is 1 year. The six months US treasury rate is 2% initially and then 2.4% at the
end of first year. The coupon is paid semi-annually. The rest of the data at time zero and one year
later (the end of TRS deal) are as below: (note all the data are annualized)
Bond and other data at t=0 Bond and other data after 1year

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Maturity 5 yrs Maturity 4 yrs

Coupon 5% Coupon 5%
yield 5.5% yield 5.2%
PV 97.84 PV 99.286
10y UST 4.5 4y UST 4.7%
Credit spread 100bps Credit spread 50bps

What is the profit and loss for the total return receiver?
=2*10mio*5%/2+10mio *(99.286-97.84)% -10mio*[0.5*(2%+1%)+0.5*(2.4%+1%)]=324,600

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