2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

FINANCIAL MARKETS

Selected Problems

Part 1: Bond markets 1

Exercise #1
On 12/04/01 consider a fixed-coupon bond whose features are the following:
• Face value: $1,000
• Coupon rate: 8%
• Coupon frequency: semiannual
• Maturity: 05/06/04

What are the future cash flows delivered by this bond?

Compute the accrued interest, taking into account the Actual/Actual day-count basis.
Same question if we are now on 09/06/02.

Exercise #2
What is the price of a 5-year bond with a nominal value of $100, a yield to maturity of 7% with (annual
compounding frequency), a 10% coupon rate and an annual coupon frequency? Same question for a yield to
maturity of 8%, 9% and 10%. Conclude

Exercise #3
On May 17, 2013 (spot date: May 21, 2013), consider a French government bond whose features are the
following:
• Face value: €1
• Coupon rate: 3.25%
• Coupon frequency: annual
• Maturity: 04/25/2016
• Clean price: 108.590
• Accrued interest: 0.232

Justify the value of the accrued interest.

Determine the yield-to-maturity of this bond.
An investor wants to buy 10,000 bonds and hold them in his portfolio until April 25, 2014. Under what
conditions does the yield-to-maturity represent the effective yield of that investment?
Determine the modified duration, duration and convexity of this bond.
Use the modified duration and convexity to estimate the value impact of a 10 bps instantaneous decline in
interest rates.

Exercise #4
Let us consider the two following French Treasury bonds whose characteristics are the following:

Name Maturity (years) Coupon rate (%) Price

Bond 1 6 5 100
Bond 2 20 0 31.18

Your investment horizon is 6 years. Which of the two bonds will you select?
2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

Exercise #5
We consider two bonds with the following features:

Name Maturity (years) Coupon rate (%) Price YTM (%)

Bond 1 10 10 1,352.2 5.359
Bond 2 10 5 964.3 5.473

YTM stands for yield to maturity. These two bonds have a $1,000 face value and an annual coupon frequency.
An investor buys the two bonds and holds them until maturity.

Compute the annual return rate over the period supposing that the yield curve becomes instantaneously flat at
a 5.4% level and remains stable at this level during 10 years.
What is the rate level such that these two bonds provide the same annual return rate? In this case what is the 2
annual rate of the two bonds?

Exercise #6
You are a portfolio manager. You buy at time t=0 a French Treasury bond with annual coupon 6%, and maturity
4 years at a price of 100.5. Your investment horizon is 2.5 years. The reinvestment rate is supposed to be 4%,
the yield to maturity of the bond 5.5% at the end of your investment horizon.

Determine the annualized total return of the bond over the period.

Exercise #7
You own a 7% Treasury bond with $100 face value that has a modified duration of 6.3. The clean price is 95.25.
You have just received a coupon payment 12 days ago. Coupons are received semiannually.

If there are 182 days in this coupon period, what is the accrued interest?
Is the yield greater that the coupon rate or less than the coupon rate? How do you know?
Use the modified duration to find the approximate change in value if the yield were to suddenly rise by 8 bps.
Will the actual value change by more or less than this amount? Why?

Exercise #8
On January 23, 2013 your fixed-income portfolio is the following:

ISIN Coupon Rate (%) Maturity Date Clean Price (%) Par Value (€)
FR0000188989 4.00 04.25.13 100.91 125 000
FR0000187361 5.00 10.25.16 116.08 275 000
FR0010192997 3.75 04.25.21 114.87 50 000
FR0010466938 4.25 10.25.23 118.57 250 000
FR0010371401 4.00 10.25.38 116.24 450 000

Compute the accrued interest of each bond.

Determine the market value of the portfolio.
Determine the modified duration, duration and convexity of the portfolio.
Estimate the yield-to-maturity of this portfolio.
2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

Part 2: STIR Forward and Futures contracts

Exercise #1
A firm plans to lend € 2 million for three months commencing in three months. Current interest rates for 3 and
6 months are 1.470 % and 1.703 % respectively.

Using a forward transaction, what should the firm do to hedge its interest rate risk?
Compute the forward rate the bank will propose assuming a spread of 50 bps.
Determine the positions taken by the bank to hedge its position.
What happens at maturity assuming an observed rate of 1.600%?

Exercise #2
Consider a 6x12 FRA on 6-month Euribor and the current term structure of interest rates: 3
Maturity (year) 0.5 1 1.5 2
Yield on zero-coupon 4.00% 4.20% 4.30% 4.37%

Calculate the fixed rate on this FRA. Explain the underlying logic.
A corporate treasurer wishes to hedge against an increase in future borrowing costs due to a possible rise in
short-term interest rates. What position should he take (long or short) on this 6×12 FRA? Why?

Exercise #3
A firm plans to invest €50 million in 6 months from now for 3 months. It plans to buy a zero coupon product
with a maturity of 3 months after the date of issuance (it will mature in 9 months from today). The rate of this
transaction will depend on the level of the 3-month interest rate prevailing in 6 months. The treasurer wishes
to lock in the interest rate and is considering how to achieve this objective. The Euribor yield curve prevailing
today is as follows:

Maturity (months) 6 9
Yield 1.705% 1.874%

Calculate the 3-month forward rate for a transaction starting in 6 months.

Consider buying forward in 6 months a 3-month zero coupon product (9 months to maturity as of today) for a
price (set today) of €50 million. What would be the face value of this zero coupon?
Consider next taking a position on a 6x9 FRA? What would be the fixed rate on the FRA? What position should
the treasurer take (long or short)? Explain.

Exercise #4
A corporate treasurer wishes to hedge a 3-month borrowing commencing in 3 months for a €10 million
amount. The current price of a 3x6 FRA is 1.441/1.541%.

What position should the treasurer take on this 3x6 FRA?

What happens 3 months later if the observed 3-month rate is 1.550%?
What happens 3 months later if the observed 3-month rate is 1.430%?

Suppose that 1 month later, the need for cash is gone. The current price of a 2x5 FRA is 1.300/1.400%.

What should the treasurer do?

Compute the final PL assuming that the observed rate at maturity is 1.550%?
Compute the final PL assuming that the observed rate at maturity is 1.430%?

Exercise #5
The current price of a 3x6 Euribor FRA is 1.500% while the Euribor yield curve prevailing today is as follows:

Maturity (months) 3 6
Yield 1.049% 1.272%
2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

Is there any arbitrage opportunity?

Illustrate the arbitrage operation assuming that the 3-month Euribor observed at maturity is a) 1.550%; and b)
1.430%.

Exercise #6
On November 24, 2011, a firm plans to invest €20 million for a 3-month period commencing on December 21,
2011. The price of the December maturity of the 3-month Euribor contract is 98.600 while the current 3-month
Euribor rate is 1.474% pa. Note that the last trading day of the December futures contract is December 19 and
the Delivery day is December 21.

What should the treasurer do to hedge his position?

Using the following information regarding the price evolution of the futures contract, determine the end of the
day P&L and the variation margin. Remember that the initial margin is €850 per contract and that the 4
maintenance margin is €850 per contract.
What is the final result of the hedging position?

Settlement Spot 3-month

Date
Price Euribor rate
11/24/2011 98.615 1.474
11/25/2011 98.615 1.475
11/28/2011 98.625 1.477
11/29/2011 98.670 1.477
11/30/2011 98.765 1.473
12/01/2011 98.780 1.469
12/02/2011 98.710 1.469
12/05/2011 98.700 1.470
12/06/2011 98.695 1.472
12/07/2011 98.725 1.472
12/08/2011 98.615 1.470
12/09/2011 98.585 1.437
12/12/2011 98.585 1.430
12/13/2011 98.590 1.426
12/14/2011 98.585 1.423
12/15/2011 98.590 1.419
12/16/2011 98.585 1.417
12/19/2011 98.582 1.418

Exercise #7
On December 21, 2011, a financial operator observes the following 3-moth Euribor Futures quotes:

Maturity Futures’ price

MARCH 2012 98.910
JUNE 2012 99.020

He decides to simultaneously buy 10 March 2012 contracts and sell 10 June 2012 contracts. He plans to
liquidate his position before the end of February 2012.

What is the strategy of the operator? Explain.

Exercise #8
Few months ago, a company issued a floating rate bond with €40 million principal amount. This bond will be
repaid in three years and its coupon rate is equal to 3-month Euribor + 25 bps. At the last payment date (one
month ago), the 3-month Euribor rate was 0.935% pa.
The treasurer fears a rise in the money market rates and is worried about the coupon which will be paid 5
months later. The current 2-month and 5-month Euribor rates are 0.820% and 1.228% respectively. On the
other hand, the 2x5 FRA quote is 1.490% – 1.510%.
2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

Explain why a forward-forward transaction is not suited to hedge the present situation.
Determine the position the treasurer should take on the FRA to hedge his position.
Two months later, the observed 3-month Euribor rate is 1.500%. Determine the result of the hedged position?

Exercise #9
An FRA market maker sells a €100 million 3x6 FRA at a rate of 1.650%. The current 3-month and 6-month rates
are 1.036% and 1.334% respectively.

Determine the risk of the market maker’s position.

Determine the position he should take to hedge his position.
Assuming that the 3-month Euribor rate observed on the FRA settlement date is 1.700%, determine the result of
the hedged position.
5
Exercise #10
It is March 12, 2013 and a treasurer realizes that on June 19 the company will have to issue €5 million of
commercial paper with a maturity of 90 days. The current price of the June 3-month Euribor contract is quoted
99.790. The last trading day of the June contract is June 17, 2013.

How should the treasurer hedge the company’s exposure?

What is the result of the hedging position if the 3-month Euribor rate observed at delivery date is 0.250%.
Comment this result.

Exercise #11
On February 17, 2012 the June maturity of the 3-month Euribor contract quote is 99.17 while the Euribor rates
were those proposed in Appendix 1. Note that the spot settlement date is February 21, 2012 and that the Last
trading day of the 3-month Euribor Future contract is June 18, 2012 (118 days from spot settlement date).

Appendix 1: Euribor rates (February 17, 2012)

Settlement Duration
Maturity Rate (%)
Date (days)
1-month 0.610 03/21/12 29
2-month 0.820 04/23/12 62
3-month 1.036 05/21/12 90
4-month 1.134 06/21/12 121
5-month 1.228 07/23/12 153
6-month 1.334 08/21/12 182
7-month 1.399 09/21/12 213
8-month 1.460 10/22/12 244
9-month 1.514 11/21/12 274
10-month 1.561 12/21/12 304
11-month 1.608 01/21/13 335
12-month 1.664 02/21/13 366

Is there an arbitrage opportunity? If any, describe and quantify the positions to take advantage of it.

Exercise #12
It is March 12, 2013 and you observe the June and September 3-month Euribor quotes are respectively 99.790
and 99.775. You decide to construct a bear calendar spread, selling the near-term contract and buying the far-
term contract.

How can you justify your position?

Determine the result of this calendar spread if the near-term STIR prices move higher (99.800) and longer-term
STIR prices move lower (99.770).
2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

Part 3: Fixed-income Futures contracts

Exercise #1
On January 31, 2011, the price of the Euro-bund contract for the March 2011 maturity was 123.70.

Based on the information available in appendix 1 and 2:

a. Justify the conversion factor calculations.
b. Determine the theoretical value of the contract.
c. Determine the implied repo rate.
d. Determine the result of a cash-and-carry arbitrage.
e. Determine which of the 3 bonds available for delivery is the cheapest-to-deliver.

The money market rate is 0.956% pa. 6

Appendix 1: Deliverable bonds – Maturity: Mach 2011
Settlement date: March, 10 2011
Code ISIN Coupon (%) Maturity Conversion Factor
DE0001135390 3.25 04.01.2020 0.815645
DE0001135408 3.00 04.07.2020 0.790231
DE0001135416 2.25 04.09.2020 0.734383

Appendix 2: Information on deliverable bonds (On January, 31 2011)

Accrued
Code ISIN Issue date Clean price YTM (%) M.Duration
interest
DE0001135390 13.11.2009 101.16 0.2582 3.099 7,637
DE0001135408 30.04.2010 98.90 2.2849 3.134 7,906
DE0001135416 20.08.2010 93.07 1.0233 3.095 8,343

Exercise #2
On February 12, 2010, the price of the Euro-bund contract for the September 2010 maturity was 121.75.

Based on the information available in appendix 1 and 2:

a. Justify the conversion factor calculation.
b. Determine the theoretical value of the contract.
c. Determine the implied repo rate.
d. Determine the result of a cash-and-carry arbitrage.
e. Determine which of the 3 bonds available for delivery is the cheapest-to-deliver.

The money market rate is 1.003% pa.

Appendix 1: Deliverable bonds – Maturity: September 2010

Settlement date: September, 10 2010
Code ISIN Coupon (%) Maturity Conversion Factor
DE0001135382 3.50 04.07.2019 0.832496
DE0001135390 3.25 04.01.2020 0.807685

Appendix 2: Information on deliverable bonds (Spot date: February 16, 2010)

Accrued
Code ISIN Issue date Clean price YTM M.Duration
interest
DE0001135382 22.05.2009 102.70 2,589 3.161 7,73
DE0001135390 13.11.2009 100.50 0,846 3.188 8,28
2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

Exercise #3
On February 17, 2012 an investor has a nominal amount of €50 million in a bullet bond whose gross price (in %
of the face value) and modified duration are, respectively, 92.971 and 7.56.
To hedge his position, the investor is considering the June 2012 expiry month of the FGBL Future contract. On
February 17, the future contract price is 136.68. The settlement date of the contract is June 11, 2012 (111 days
from spot settlement date).

Using information in Appendix 1 to 4, determine the number of FGBL contract to be bought or sold to hedge the
position.

Appendix 1: Euribor rates (February 17, 2012)

Settlement Duration
Maturity Rate (%)
Date (days) 7
1-month 0.610 03/21/12 29
2-month 0.820 04/23/12 62
3-month 1.036 05/21/12 90
4-month 1.134 06/21/12 121
5-month 1.228 07/23/12 153
6-month 1.334 08/21/12 182
7-month 1.399 09/21/12 213
8-month 1.460 10/22/12 244
9-month 1.514 11/21/12 274
10-month 1.561 12/21/12 304
11-month 1.608 01/21/13 335
12-month 1.664 02/21/13 366

Appendix 2: FGBL Contract – Deliverable bonds – Expiry Month: June 2012

Settlement date: 06/11/12
Deliverable Bond ISIN Coupon Rate (%) Maturity Date Conversion Factor
DE0001135424 2.50 01.04.2021 0.770614
DE0001135465 2.00 01.04.2022 0.714926

Appendix 3: Deliverable bonds data (February 17, 2012)

Accrued
ISIN Issue Date Clean Price YTM M. Duration
interest
DE0001135424 11.26.10 106.08 0.32787 1.75348 7.929
DE0001135465 11.25.11 100.68 0.48147 1.92305 8.847

Appendix 4: Cash flow schedule of the deliverable bonds

Number of days between the spot settlement date (February 21, 2012) and the Future contract settlement
date (June 11, 2012): 111 days.
2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

DE0001135465 Bond

Last Coupon Spot Next Coupon

Issue date Date Date Date

11.26.10 01.04.11 01.04.12 02.21.12 04.01.13

39
8
48

365 366

DE0001135424 Bond

Spot
Issue Date Next Coupon
Date
Date

11.25.11 02.21.12
01.04.10 01.04.12 01.04.13

40 48

365 366

Exercise #15
On April 21, 2006 the fund manager of FEM is worrying about a possible rise in the French government bond
interest rates and wishes to hedge is portfolio, which composition is given below (€100 million par value):

Quantity (in
Bond Maturity Date Clean Price Market value
million)
OAT 0 % 25/04/2007 97,00 15 14 550 000,00
OAT 0 % 25/04/2011 84,55 53 44 811 500,00
OAT 0 % 25/04/2016 66,35 24 15 924 000,00
OAT 0 % 25/04/2021 43,10 8 3 448 000,00
100 78 733 500,00
2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

At this date, the September maturity of the FGBL contract quotes 115.57. The money market rate for a 4-
month period is 2.877% pa. The list of deliverable bonds for the September maturity is:

Deliverable Coupon Rate Maturity Issue Date Conversion Clean Price Accrued
Bond (%) Date Factor Interest
Bund 3,250% 3.25 04.07.15 20.05.05 0.815814 95,60 3,03
Bund 3,500% 3.50 04.01.16 25.11.05 0.825181 96,20 1,45
Nota: The delivery date of the September contract is 09/11/2006

Determine the position the manager should take to hedge his portfolio.

Exercise #16
It is March 12, 2013 and you hold a portfolio of French bonds with the following characteristics: 9
Clean price of the portfolio €12,005,639.78
Accrued interest €252,150.68
Modified duration 4.56

The price of the June Mid-term Euro-OAT Futures contract (FOAM) is 124.73. The underlying asset of the future
contract is a 4.5 to 5.5 years French Government bond delivering a 6.00% coupon. Appendices 1 to 3 contain
information about the deliverable bonds of the contract.

Determine the position required to fully hedge this portfolio.

Determine the position required if you only want to reduce your interest risk of your bond position to one
quarter of the current exposure.

Appendix 1: FOAM Contract – Deliverable bonds – Expiry Month: June 2013

Settlement date: 06.10.2013
Deliverable Bond ISIN Coupon Rate (%) Maturity Date Conversion Factor
FR0010604983 4.00 04.25.2018 0.917461
FR0011394345 1.00 05.25.2018 0.790962
FR0010670737 4.25 10.25.2018 0.921278

Appendix 2: Deliverable bonds data (March 12, 2013)

Accrued
ISIN Issue Date Clean Price YTM M. Duration
interest
FR0010604983 04.03.2008 115.38 3.540 0.909 4.575
FR0011394345 05.25.2008 100.23 0.803 0.954 5.003
FR0010670737 10.02.2008 117.53 1.630 1.022 5.040

Appendix 3: Deliverable bonds – Cash flow schedule

Number of days between the spot settlement date (March 14, 2013) and the Future contract settlement date
(June 10, 2013): 88 days.
2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

FR0010604983

Spot
Date

04.25.12 03.14.13 04.25.13 04.25.14

42 10

365 365

FR0011394345

Spot
Date

05.25.12 03.14.13 05.25.13 05.25.14

72

365 365

FR0010670737

Spot
Date

10.25.12 03.14.13 10.25.13 10.25.14

225

365 365
2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

Part 4: Options contracts

Exercise #1
A portfolio manager holds a portfolio whose benchmark is the CAC40 index. He would like to lock-in the
performance of his portfolio. A CAC40 option contract with a strike price of 3,850 points (current value of the
index) quotes 98.9. Portfolio composition is the following:

Number Market
Stock Price
of shares value 
A 280 120 33 600 1,65
B 500 20 10 000 0,98
C 600 70 42 000 1,42
D 250 40 10 000 0,85 11
E 80 55 4 400 0,98
Portfolio 305 100 000

What should the portfolio manager do to hedge his position?

Determine the effectiveness of the hedge position if the CAC40 index increases by 5%? decreases by 5%?

Exercise #2
A fund manager would like to boost the performance of his portfolio by selling a CAC40 call option with a strike
price of 3,800 points and a premium of 103.8. Portfolio composition is the following:

Number Market
Stock Price
of shares value 
A 1 100 40 44 000 1,20
B 600 60 36 000 0,75
Portfolio 100 80 000

Determine the portfolio performance under various scenarios.

Exercise #3
A firm needs to borrow €50 million in three months for a 6-months period. The treasurer who wishes to lock-in
his financing cost asks his bank for a forward-forward transaction. Spot market rates are the following:

3-months: 3.36% - 3.39%

9-months: 3.47% - 3.50%

If the bank takes a 20 bps margin, determine the forward rate proposed by the bank.

Consider now a 3x9 FRA based on 6-month Euribor rate. The price of this FRA is 3.60%.

What should the treasurer do to hedge his position?

What happens at the settlement date if the settlement rate is 3.82%? Same question if the settlement rate is
3.50%.

Consider now a call option on a 3x9 FRA based on 6-month Euribor rate. The strike price is 3.60% and the
premium is 0.30% (i.e. 0.30% x 50 million x 2/12).

What should the treasurer do to hedge his position?

What happens at the settlement date if the settlement rate is 3.82%? same question if the settlement rate is
3.50%?
Graphically represent the financing cost of the firm depending on the observed settlement rate in the following
situations: a/ no hedge; b/ hedging with FRA contracts ; and c/ hedging with options on FRA.
2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

Exercise #4
A firm contracted a rollover credit repayable over 5 years. Interests based on the 6-month LIBOR rate are paid
semiannually. To hedge his position against a possible rise in the 6-month LIBOR rate, the bank offers a 5-year
cap option with the following characteristics: a 1 million CHF nominal value; 3.5% strike price; 6-month LIBOR
rate as reference rate; 2% flat premium.

Explain why a cap option is ideally suited in this case.

If the 6-month LIBOR rates observed at the two first maturities of the cap are 3.8% and 1.9% respectively, what
is the P&L of the hedging position?

Consider now that the firm can hedge his position by combining a long position in a 5-year 3.5% cap and a short
position in a 5-year 2% floor option. The premium of the floor is 0.7% flat.
12
If the 6-month LIBOR rates observed at the two first maturities of the cap are 3.8% and 1.9% respectively, what
is the P&L of the hedging position?

Exercise #5
Some times ago, a firm issued a 3-year floating rate notes based on the 6-month Euribor rate plus a 15 bps
marging. The firm still wants to profit from advantageous interest rates but fears about a possible rise in
interest rates within the next months. The bank quotes a 3-year cap option with a 3.000% strike price at a 20
bps premium and a 3-year floor option with a 2.750% strike price at a 20 bps premium.

Considering hedging using only one option, what should the firm do? What happens at the maturity of the
option if the settlement rate is 2.850%?
To reduce the cost of its hedging position, the firm decides to combine two options and construct a collar.
Describe the positions. What happens at maturity if the observed settlement rate is 2.850%?
Graphically represent the two hedging strategies.

Exercise #6
A fund manager holds a German Government Bonds portfolio whose market value is €40 million. The modified
duration of the portfolio is 8.2. The Euro-Bund futures contract quote is 113.00. The cheapest-to-deliver bond
price is 95.98 and its modified duration is 7.18. The conversion factor of the CTD bond is 0.849220.

What should the manager do to hedge his portfolio?

Consider now that the premium of an Euro-Bund Futures contract with a strike price of 113.00 is 0.39. What
should the manager do? Determine the result of the hedged position depending on the price of the Futures
contract.
2A ENSIMAG 2014-2015 Financial Markets – Selected Problems

Part 5: Swaps

Exercise #1
Companies A and B have been offered the following rates per annum on a €20 million 5-year loan:

Fixed rate Floating rate

Company A 5.0% Euribor + 0.1%
Company B 6.4% Euribor + 0.6%

Company A requires a floating rate loan; company B requires a fixed-rate loan. Design a swap that will net a
bank, acting as intermediary, 0.1% per annum and that will appear equally attractive to both companies.

Exercise #2 13
On June 15, 2001, a firm issues a 3-year maturity bond at a 5% fixed rate with a notional principal of €10
million. The issuer who expects a decrease in interest rates in one year wishes to transform its debt into a
floating-rate debt. Market conditions for a 2-year 6-month Euribor swap beginning in one year are the
following: Euribor against 4.5% or Euribor+0.5% against 5%. What is the swap he enters? Give the detail of the
swap cash flows.

Exercise #3
An €100 million interest rate swap has a remaining life of 10 months. Under the terms of the swap, 6-month
Euribor is exchanged for 7% per annum (compounded semiannually). The average of the bid-ask rate being
exchanged for 6-month Euribor in swaps of all maturities is currently 5% per annum with continuous
compounding. The 6-month Euribor rate was 4.6% per annum two months ago. What is the current value of
the swap to the party paying floating? What is the value to the party paying fixed?