15.

437 Midterm Review: Solutions to Exercises

Michael Abrahams - 10/14/2014

Exercise 4.1 (Swaps)

We use the replication approach to compute the swap rate. To set the value of the swap at
initiation to zero, the value of the oating side must equal the value of the xed side.
Value of the oating side. The oating side makes one payment at the end of period 4
based on a notional of $2.5M. From the recitation slides we know how to value this oating
payment:
$2.5M (0.912 0.883) = $0.0725M.

Value of the xed side. The value of each xed payment must be multiplied by the
appropriate notional amount:
s
s
s
s
(0.970)+$1.5M
(0.941)+$2M
(0.912)+$2.5M
(0.883) = $3.2065M s
$1M
2
2
2
2
We nd a swap rate equating the value of both sides:

$0.0725

s =

$3.2065s
0.0226.

Exercise 4.2 (Old Exam)

To nd out whether to accept the oer or not we must nd the value of the existing position.
forward contract, it could do so on better terms than the counterparty's oer. By selling a
newly initiated two-year forward on 100,000 pounds of copper, your rm would no longer
be exposed to copper price risk and would lock in ($4.00  $3.20)*(100,000) at the delivery
date. The present value of this amount is $72,000, which is more than the counterparty is
oering. The rm should reject the oer.
The value of the options is redundant here, but we could undertake a replicating strategy
using options and end up with the same result.
Exercise 4.3 (Old Exam)

Suppose that each of the options covers one share of stock. The current values of the three
securities could be expressed in the following way:
First security = 1000 P V (Dividends)
Second security = 1000(call on ABC with a strike price of $100).

Third security =1000 (zero coupon bond with a principal of $100

1000(put on ABC with a strike price of $100).

Finally, we can rewrite
First security = 1000 shares of ABC  second security  third security.
Exercise 4.4 (Forward on a Swap)

To begin attacking this problem we need to know the xed payments of the swap. Applying
the basic swap price formula we have

1 Z4
s
1 0.8
=
=
2
Z1 + Z2 + Z3 + Z4
(0.95 + 0.9 + 0.85 + 0.8)
s = 0.1143.
To nd the forward price we use the formula from the slides:

=
=

F V [Current Spot PriceP V (Foregone Cashows)]

1
[0P V (Foregone Cashows)].
.90

What is PV (forgone cash ows)? We forgo paying xed payments and receiving oating
payments six months and one year from now.
The value of the foregone xed payments is:

0.1143
0.1143
)(100)(0.95) + (
)(100)(0.90) = $10.57
2
2

The value of the foregone oating payments is:

(1 Z1 )(100) + (Z1 Z2 )(100) = 1(100)0.9(100) = $10.

$10 - $10.57 = -$0.57. Notice that the net value of forgone cash ows is actually negative
in this case - because the term structure slopes upward, the xed side pays a premium in
terms of a higher rate today to lock in a xed payment in the future.
Plugging this in, we nd the futures price is

F =

1
[0 (0.57)]F = $0.63.
.90