FIS 2024 HW 3 and 4

Fixed Income Securities
Homework 3 & 4
1. Given a current one-period spot rate of S0 = 5%, upward and downward parameters of
u = 1.1, d= 1/1.1, and probability of spot rate increasing in one period of q = 0.5.
Generate a two-period binomial tree of spot rates.
a. Using a binomial tree approach, calculate the value of a three-period. An option-
free bond paying a 5% coupon per period and with a face value of 100. (4 marks)
b. Using the binomial tree, calculate the value of the bond, given it is callable with a
call price of 100.
c. Using the tree, calculate the value of the bond given it is putable in periods 1 and 2
with a put price of 100.
2. Suppose a Savings and Loan association buys an interest rate cap with the following
terms: The reference rate is the six-month treasury bill rate; the cap will last for five
years; payment is semi-annual; the strike rate is 5.5%; and the notional amount is $19
million. Suppose further that at the end of the six-month period, the six-month treasury
bill rate is 6.1%.
a. What is the amount of payment that the Savings and Loan Association will receive?
b. What would the seller of this cap pay if the six-month treasury rate were 5.45%
instead of 6.1%?
3. Consider the following interest-rate swap:

• the swap starts today, January 1 of year 1 (swap settlement date)
• the floating-rate payments are made quarterly based on actual / 360
• the reference rate is three-month LIBOR
• the notional amount of the swap is $40 million
• the term of the swap is three years
Answer the below questions.
(a) Suppose that today’s three-month LIBOR is 5.7%. What will the fixed-rate payer for
this interest rate swap receive on March 31 of year 1 (assuming that year 1 is not a leap
year)?
(b) Assume the Eurodollar futures price for the next seven quarters is as follows:
Quarter starts Quarter ends No. of Days in Eurodollar futures
Quarter price
April 1 year 1 June 30, year 1 91 94.10
July 1 year 1 September 30, year 1 92 94.00
October 1, year 1 December 31, year 1 92 93.70
January 1, year 2 March 31, year 2 90 93.60
April 1 year 2 June 30, year 2 91 93.50
July 1 year 2 September 30, year 2 92 93.20
October 1, year 2 December 31, year 2 92 93.00
Compute the forward rate for each quarter.

(c) What is the floating-rate payment at the end of each quarter for this interest-rate
swap?
4. Below are two portfolios with a market value of $500 million. The bonds in both
portfolios are trading at par value. The dollar duration of the two portfolios is the
same.
Issue Years to Maturity Par value (in $ millions)

Bonds included in Portfolio I
A 2.0 120
B 2.5 130
C 20.0 150
D 20.5 100
Bonds included in Portfolio II
E 9.7 200
F 10.0 230
G 10.2 70

(a) Which portfolio can be characterized as a bullet portfolio?
(b) Which portfolio can be characterized as a barbell portfolio?
(c) The two portfolios have the same dollar duration; explain whether their performance
will be the same if interest rates change.
(d) If they will not perform the same, how would you go about determining which would
perform best, assuming that you have a six-month investment horizon?
5. A manager wishes to hedge a bond with a par value of $20 million by selling Treasury
bond futures. Suppose that (1) the conversion factor for the cheapest-to-deliver issue
is 0.91, (2) the price value of a basis point of the cheapest-to-deliver issue at the
settlement date is 0.06895, and (3) the price value of a basis point of the bond to be
hedged is 0.05954.
(a) What is the hedge ratio?
(b) How many Treasury bond futures contracts should be sold to hedge the bond?
6. Consider a convertible bond as follows:

par value = $1,000;
coupon rate = 9.5%
market price of convertible bond = $1,000
conversion ratio = 37.383
estimated straight value of bond = $510
yield to maturity of straight bond = 18.7%
Assume that the price of the common stock is $23 and that the dividend per share is $0.75
per year.
(a) Calculate each of the following: (1) conversion value, (2) market conversion price,
(3) conversion premium per share, (4) conversion premium ratio, (5) premium over
straight value, (6) favourable income differential per share, and (7) premium payback
period.
(b) Answer the below questions if the price of the common stock increases from $23 to
$46.
a. What will be the approximate return realised from investing in the convertible
bond?
b. What would be the return realized if $23 had been invested in the common
stock?
c. Why would the return on investing in the common stock directly be
higher than investing in the convertible bond?

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Fixed Income Securities

3. Consider the following interest-rate swap:

Compute the forward rate for each quarter.

Issue Years to Maturity Par value (in $ millions)

Answer the below questions.

6. Consider a convertible bond as follows:

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