15.

437

Spring 2014
J.C. Cox

SOLUTIONS
FOR
THE MIDTERM EXAM

1)

Let Zj be the price of a zero coupon bond with j semiannual periods

remaining.

The current value per dollar of principal of a floating rate

payment to be received

j semiannual periods from now is (Zj-1 Zj) . The

fixed rate, X , of the swap must be set so that the current value of the fixed
payments equals the current value of the floating payments. This requires
that
(X / 2) [ Z1 + Z2 + Z3 + Z4] = 2 (Z2 - Z3) + 2 (Z3 Z4) .
The proper fixed rate for the swap is 3.08%.

2)

Your firms swap is equivalent to being long a 5% fixed coupon bond

and short a floating rate bond. Since the floating rate bond has a value of par
on reset dates, the value of the swap is the premium over par for a 5% bond.
Equivalently, the value of your swap can be expressed in terms of an annuity.
A newly initiated 4% swap has a value of zero. The positive value of your
swap comes from the additional 1% per year your firm will receive over the
next five years.
Let A be the current value of a five-year annuity making semiannual
payments of $1 per year.

Given the current swap rate, a bond with

semiannual coupons of 4% per year will sell for par. The value of this bond
can be viewed as the value of the coupons plus the value of the principal, so
.04 (100,000,000) A + .82 (100,000,000) = 100,000,000
A = 4.5
The value of the swap is
.01 (100,000,000) A = 4,500,000 ,

which is the same as the premium over par for a 5% bond with a principal of
$100,000,000.

3)

Your goal is to use the forwards to construct a short position in the

thirty-year bond and a long position in two shares of stock. A short position
in the thirty-year bond is equivalent to a short position in one bond forward
and a short position in a one-year zero coupon bond with a principal of
$(98+10).

A long position in two shares of stock is equivalent to a long

position in two equity forwards and a long position in a one-year zero coupon
bond with a principal of $2(54). The zero coupon bond positions cancel out, so
you should be long two equity forwards and short one bond forward.

4)

The proper forward price for the standard contract is the striking price

for which the put and call are equal. The proper forward price is thus $100.
With the flexible contract, the seller will choose to deliver as little as possible
when the final spot price exceeds the forward price and as much as possible
when the final spot price is less than the forward price. Letting S* be the
final spot price and F be the forward price, the value of the contract on the
delivery date can be written as

75 (S* F)

if S* > F

125 (S* F)

if S* F

This same final payoff is provided by a portfolio that is long 75 calls and short
125 puts, each with a striking price of F. The proper forward price is thus the

striking price for which the price of 75 calls equals the price of 125 puts.
From the table, we find that the proper forward price for the flexible contract
is $80.

5)

This question can be answered with exactly the same reasoning that

led to the put - call parity relation. Buying the call is equivalent to buying
the put, buying one share of DEF, and shorting one share of XYZ. The proper
value of the call is thus $( 15 + 90 100) = $5. The zero coupon bond price is
irrelevant; it has no role in answering the question because here the present
value of the striking price is simply the current price of one share of XYZ.