Solutions November 2020 Class Test

Question 1 (a)
Question
Suppose that a financial institution has agreed to pay 6-month LIBOR and receive 4% per
annum (with semi-annual compounding) on a notional principal of £100 million. The swap
has a remaining life of 15 months. The LIBOR rates with continuous compounding for 3-
month and 9-month and 15-month maturities are 5%, 5.5% and 5.7% respectively. The 6-
month LIBOR rate at the last payment was 4.3% (with semi-annual compounding). What is
the value of the swap to the financial institution? Please show all workings.

Valuation in Terms of Bonds – Pricing equations for a fixed rate bond

(Bfx) and a floating rate bond (Bfl)

n
Bfx   ke  riti  Le  rntn
i 1

Bfl =(L  k * )e  r1t1

£100m x 4.0% = £4.0m (therefore six month fixed payments are
£2.0m)
(Bfx) = 2.0e-0.05(3/12) + 2.0 e-0.055(9/12) + 102.0 e-0.0575(15/12)
(Bfx) = 1.975156 + 1.919178 + 94.92602
(Bfx) = £98.82m
k* =0.5 x 4.3% x 100m = £2.15m
(Bfl) = (100 + 2.15) e-0.05(3/12)
(Bfl) = £100.88m
Therefore, the value of the swap to the financial institution is
(Bfx) - (Bfl) = £98.82m - £100.88 = -£2.06m
Question 1 (b) This question has been incorporated into this year’s tutorial sheet 2
Question
(i) Companies AAA and BBB have been offered the following rates per annum on a $100
million, 5-year loan:

Fixed rate Floating Rate

Company AAA 5.25% LIBOR

Company BBB 5.85% LIBOR + 30bp

Company AAA requires a floating rate loan, while company BBB requires a fixed rate loan.
Design a swap that provide a bank, acting as intermediary, 5 basis points per annum and
which divides the remaining gains in the swap equally between AAA and BBB. Please draw
the associated flow diagram.

(ii) When a swap contract is entered into, it is typically considered to be “at the money,”
what does this mean?

Answer
(i) AAA borrows fixed at 5.25%, since it has a greater comparative advantage in the fixed
rate markets over BBB.

BBB borrows floating at LIBOR + 30bp since its comparative advantage is in floating rate
borrowing.

Total gain from the swap is 0.3% (30 basis points)

FI facilitates the swap and receives 0.05% (5 basis points).

AAA benefits 0.125% (12.5 basis points) as will BBB.

AAA’s effective borrowing cost after the swap is floating at LIBOR - 0.125%.
BBB’s effective borrowing cost after the swap is fixed at 5.725%.
(ii) When a swap contract is entered into, it is typically considered to be “at the money,”
what does this mean?

This means that the value of the swap to the respective parties entering into the swap is the
same when, for example, the swap is valued as one element of a fixed rate bond and the
other element of the swap valued as a floating rate bond. That is, the total value of fixed
interest rate cash flows over the life of the swap is equal to the expected value of floating
interest rate cash flows.
Question 1 (c)

Question

The following information is for US Government Treasury yields and swap rates for five
different maturities.
1 Year 3 Year 5 Year 7 Year 10 Year

US Treasury yield 0.121 0.311 0.387 0.540 0.645

(%)

US Swap rate (%) 0.679 0.452 0.473 0.534 0.610

Calculate the swap spread for each maturity. What changes in market and economic
conditions may have occurred or be expected to occur to cause the swap spread to change
across the maturity spectrum?
Answer
The Swap Spread, at a given maturity, refers to the difference between the swap rate for
that maturity and the yield on a government bond of the same maturity.
1 Year 3 Year 5 Year 7 Year 10 Year

Swap spread 0.558 0.141 0.086 -0.006 -0.035

The negative swap spread of for 7 and 10 year maturities is not what might be expected.
Because of credit risk and counterparty risk one would expect the swap spread to be
positive. The negative rates may be an indicator that the market expects government bond
rates to rise or perhaps events have given rise to doubts about the Government in question
being able to honour its debt.
Question 2 (a) This question has been incorporated into this years’ tutorial sheet 2
(although I inadvertently double counted the income from writing the call – this error has
been rectified in the answer below.
Question
S0 = £2.15; X = £2.30; T = 3 months; r = 0.04; Call price C = £0.18; Put option price P = £0.24.
Are these options mispriced? If so, construct an arbitraged based strategy to take advantage
of this mispricing. Why is this arbitrage strategy appropriate?
Answer
S0 = £2.15; X = £2.30; T = 3 months; r = 0.04 (continuously-compounded); c = £0.18; p =
£0.24.

c + Xe -rT = p + S0 ; p = c + Xe -rT - S0

if c = £0.18

p = 0.18 +2.30e-0.04 x 0.25 - S0; p = 0.18 +2.277115 – 2.15; p = £0.3071 [30.71p]

Therefore the market price of the put [24p] is too low and/or the market price of the call [18p]
is too high. Arbitrage strategy is purchase the put option, purchase the share, and short (write)
the call option.

Cost of this strategy is 24p + £2.15 – 18p = £2.21

Therefore to finance this strategy the arbitrageur borrows £2.21 at 4% for 3 months. At the
end of the strategy arbitrageur repays

£2.21e0.04 x 0.25 =£2.2322 (£2.23)

If ST > X at the end of the strategy

- put expires worthless

- share worth at least £2.30
- (note arbitrageur will be exercise on the call and will be required to sell the share
at the exercise price of £2.30 to honour the call option that the arbitrageur sold)

Therefore this strategy yields £2.30 if ST > X, which is greater than the cost of the strategy
£2.2322. Therefore the risk free profit is 6.78p.

If ST < X at the end of the strategy

- exercise the put and sell the share for £2.30

- call expires worthless

Therefore the strategy yields £2.30 which is greater than the cost of the strategy £2.2322.

Therefore the above has established a riskless arbitrage strategy to profit from the call/put
mispricing. The risk free profit is £2.30 - £2.2322 = 6.78p
Question 2 (b)
Question
Bank of America is currently trading at $25. You expect its share price will fall, but a fall
below $21 is unlikely. Options on Bank of America are available with exercise prices of
$21.50, $24.00, $26.50 and $29.00. What options-based trading strategy would you
structure to incorporate your views? Why would you structure this strategy? Detail the
components of the strategy.
Answer
In general, a bear spread using calls is a strategy where you short a call with a low exercise
price and go long a call with a higher exercise price.
In this instance short a call option with strike $21.50 (X1 in diagram below). You expect the
share price to fall to but perhaps not below $21. So selling the call at $21.50 is quite
aggressive as you are getting close to your expected maximum fall, however the advantage
is the premium you will receive will be high (as it allows the purchase of Bank of America
from you at a lowish exercise price).
Also you go long a call option at strike $26.50 (X2 in diagram), where X1 < X2. This protects
you if the market doesn’t move as you expect , rather rises. Buying the X2 call limits the
downside loss in the strategy. However, it also reduces the benefit: a part of the X1-strike
call's premium is now used to purchase the X2 call.
Question 2 (c) This question has been incorporated into this year’s tutorial sheet 5
Question

Consider a 4-month European put option on a share where the current share price is 20
pence, the exercise price is 22 pence, the risk-free interest rate is 2.25% per annum, and the
volatility of the underlying share is 25% per annum.

(i) Use a two-time-step tree to calculate the price of the European put option.

(ii) If the put option was American, with all other characteristics the same, what would
be the price of the option?

Answer

p = 0.4929; 1-p = 0.5071; ert = 1.0039; u = 1.1075; d = 0.9030

See tree diagram

[(0.4929 x 0) + (0.5071 x 2)] e-0.025 x 0.1667 = 1.010443

[(0.4929 x 2) + (0.5071 x 5.692777)] e-0.025 x 0.1667 = 3.858184

[(0.4929 x 1.010443) + (0.5071 x 0.3.858184)] e-0.025 x 0.1667 = 2.445401

Strike price = 22
Discount factor per step = 0.9963
Time step, dt = 0.1667 years, 60.83 days
Growth factor per step, a = 1.0038
Probability of up move, p = 0.4929
Up step size, u = 1.1075
Down step size, d = 0.9030
24.52901
0
22.14904
1.010443
20 20
2.445401 2
18.05947
3.858184
16.30722
5.692777
Node Time:
0.0000 0.1667 0.3333