HW #3 Solutions

7.7. Using the information in Table 7.1:

Years to Zero Coupon Zero Coupon One-Year Implied
Maturity Bond Yield Bond Price Forward Rate
1 6.00% 0.943396 6.00000%
2 6.50% 0.881659 7.00236%
3 7.00% 0.816298 8.00705%

a. Compute the implied forward rate from time 1 to time 3.

The implied forward rate solves (1+.07)^3 = (1.06)(1+rf)^2

7.5035%

b. Compute the implied forward price of a par 2-year coupon bond that will
be issued at time 1

The forward price of a bond that will be

The implied 1-year and 2-year forward bond prices at time 1 are:
1-year: 0.9345588397
2-year: 0.8652757495

The par coupon rate would thus be:

Par coupon: 7.4854%

The implied forward price of the bond is then computed based on the one
and two year forward zero-coupon bond prices
Bond price: 1

7.8. Suppose that in order to hedge interest rate risk on your borrowing, you enter
into an FRA that will guarantee a 6% effective annual interest rate for 1 year on
$500,000.00. On the date you borrow the $500,000.00, the actual interest rate is
5%. Determine the dollar settlement of the FRA assuming
a. Settlement occurs on the date the loan is initiated.

Since you are the borrower, the settlement amount is equal to the difference
the actual and the agreed upon interest rates (Rm - Rk) times the notional
principal amount. Furthermore, since we are settling at initiation rather than
at the end of the FRA period, we have to discount that settlement amount to
the present (using the actual market interest rate):

Settlement: -$4,761.90

b. Settlement occurs on the date the loan is repaid.

 Here the amount is the same, except we do not discount it to the future because
the agreement is settled at the end of the FRA period:

Settlement: -$5,000.00

7.15. Consider the implied forward rate between year 1 and year 2, based on Table 7.1.
a. Suppose that r0(1,2) = 6.8%. Show how buying the 2-year zero-coupon
bond and borrowing at the 1-year rate an implied forward rate of 6.8%
would earn you an arbitrage profit.

As the problem suggests, we can buy the 2-year bond and sell 1-year bond to
to construct a synthetic lending opportunity at the implied forward rate of
7.00238%. We would finance this with a forward borrowing agreement at 6.8%
to create the arbitrage opportunity.

Transaction t=0 t=1 t=2

Sell 1-yr bond 1 -1.06
Buy 2-yr bond -1 1.134225
Borrow forward 1.06 -1.13208
TOTAL 0 0 0.002145

We get something out of nothing, with no risk involved. We finance the

purchase of the 2-year bonds by selling the 1-year bonds, and finance
the repayment of the 1-year bonds with the forward borrowing agreement.
Thus, for zero net investment, we get a free .2145 cents in period 2.
Of course, there is no reason to stop at $1, and we could scale up this
transaction to the limits of our borrowing capacity. Also note that we
could adjust the amounts of the transaction so that we have zero net cash
flows in future periods and capture the arbitrage profit today instead of at
time 2:

Transaction t=0 t=1 t=2

Sell 1-yr bond 1 -1.06
Buy 2-yr bond -0.998109 1.13208
Borrow forward 1.06 -1.13208
TOTAL 0.001891 0 0

b. Suppose that r0(1,2) = 7.2%. Show how borrowing the 2-year zero-
coupon bond and lending at the 1-year rate an implied forward rate of
7.2% would earn you an arbitrage profit.

Here we simply reverse the transactions described above:

Transaction t=0 t=1 t=2

Buy 1-yr bond -1 1.06
 Sell 2-yr bond 1 -1.134225
Lend forward -1.06 1.13632
TOTAL 0 0 0.002095

7.17. A lender plans to invest $100m for 150 days, 60 days from today. (That is, if
today is day 0, the loan will be initiated on day 60 and will mature on day 210.)
The implied forward rate over 150 days, and hence the rate on a 150-day FRA, is
2.5%. The actual interest rate over that period could be either 2.2% or 2.8%.
a. If the interest rate on day 60 is 2.8%, how much will the lender have to
pay if the FRA is settled on day 60? How much if it is settled on day 210?

The interest rate is higher than the rate of the FRA, so the lender must pay
the borrower. If the FRA is settled on day 60, the payment made by the lender
to the borrower is:

Settlement: $291,828.79

If the FRA is settle on day 210, the payment is

Settlement: $300,000.00

The lender pays the borrower, because we are in the state of the world in
which the lender does not need protection: Interest rates have risen, and
thus he makes a payment to bring back the interest he earns to 2.5%.

b. If the interest rate on day 60 is 2.2%, how much will the lender have to
pay if the FRA is settled on day 60? How much if it is settled on day 210?

Now the interest rate is lower than the FRA rate, so the borrower pays the
lender. If the FRA is settled on day sixty the payment is:

Settlement: -$293,542.07

If the FRA is settle on day 210, the payment is

Settlement: -$300,000.00

The lender is paid by the borrower, because we are in the state of the world
in which the lender’s protection pays off: Interest rates have gone down, and
thus she is compensated for the loss in investment proceeds. The payment
from the borrower brings the interest earned back to 2.5%