MIT Sloan School of Management

J. Wang 15.407
E52-456 Fall 2003

Problem Set 2: Fixed-Income Securities

Due: September 30, 2003

1. Explain the terminology and the differences between (i) spot interest rate (ii) forward
rate and (iii) yield to maturity.

2. A 3-year treasury bond has a face value of $1000 and annual coupon of 8%. The 1-year
spot rate is r1 = 2%, and the 1-year forward rates for the next two years are r2 = 4%
and r3 = 5%

(a) Compute the price of the t-bond?

(b) Calculate the YTM of the t-bond.
(c) Calculate the 2- and 3-year spot interest rates.
(d) We do not know for sure that the interest rate in one year will be 4%. Explain, in
details, why the forward rates provide sufficient information for us to compute the
price of the bond.
(e) Explain why the answer in part (d) applies to t-bond but not corporate bonds.

3. (Deriving the yield curve from treasury bonds)From the Wall Street Journal, September
15 issue, the following treasury bonds trade at the prices below:
Coupon Maturity Ask Price
4.75 Feb 2004 101.53125
2.125 Aug 2004 100.96875
7.5 Feb 2005 108.71875
6.5 Aug 2005 109.28125
5.625 Feb 2006 108.90625
2.375 Aug 2006 100.625
6.25 Feb 2007 112.5
3.25 Aug 2007 102.125
3 Feb 2008 100.375
3.25 Aug 2008 100.625
We will try to re-create the yield curve by looking at the prices of some t-bonds. We will
still make some simplifying assumptions: There are 30 days for each month, and each
bond in the table makes semi-annual payments on the 15th of February and August.
(notice the coupon rate above are annualized; you only receive half of that each time a
coupon is paid)

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 (a) The quoted price of the bond is often called the ”Clean Price” (or quoted price).
The actual price you have to pay is the ”Dirty Price” (or invoice price), which is
the quoted price plus the accrued interest. If it is x days after the last coupon date
and time between coupons is y days, then for a bond of coupon rate C, the accrued
x
interest is simply C ∗ 2y . Calculate the dirty price of all bonds.
(b) Re-create all the spot rates. Calculate the 5-month interest rate from the February
04 bond, and then get the 11-month rate, and so on
(c) Price (i) a t-bond that has 6.125% coupon rate that matures on August 15, 07 (ii)
A STRIP that expires on Aug 15, 08.
(d) The actual price of the strip you calculated is $80.90625. Is it lower or higher than
the price you calculated. Could you give a reason to the discrepancy? (Hint: The
bid-ask spread of the strip is 3/32, but in general the bid-ask spread of t-bond is
only 1/32)

4. There are three bonds being traded in the market. The following table summaries their
characteristics:
Bond CF1 CF2 CF3 YTM
A 100 100 1100 4%
B 200 500 500 3.5%
C 500 0 200 3%

(a) Using a combination of the three securities, construct discount bonds of maturities
of 1,2 and 3 years.
Suppose you hold 100 units of bond B. Assuming you want to hedge against interest
rate risk.
(b) Calculate the modified duration of the three bonds.
(c) Use bond A only, you want to hedge the duration risk. What position are you
going to take?
(d) Now suppose, immediately after you made your hedge, the 1,2 and 3-year spot
rates all increase by 1%. Compute the prices of the bonds now. What is your net
gain/loss for your hedged portfolio? Repeat the same exercise if the change is a
decrease of 1% instead. Explain why you don’t have zero change in wealth although
you have a modified-duration of zero.
Note: In practise, it is costly to hedge using actual bonds. Traders usually use
futures on the bond as hedging instruments. We will come back to this later.

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5. (Swap Pricing) A Swap is a contract where one party pays another one with a fixed
payment every period, and the other part pays a floating rate in return. In standardized
contract the floating rate is usually 3-month or 6-month LIBOR, and at each payment
date, the current LIBOR rate determines the size of payment on the next payment date.
We will try to price a 3-year swap. The floating leg pays 6-month LIBOR semi-annually
and we need to determine the rate on the fixed leg. The following information is given:

Maturity 0.5 1 1.5 2 2.5 3

LIBOR 4.4% 5.0% 5.4% 5.6% 5.8% 5.9%

(a) Briefly explain what LIBOR is. (Go to http://www.bba.org.uk or other references)
(b) For now, assume that all cash flows are risk-free, and use LIBOR as the risk free
rate. A floating rate bond is a bond that pays variable interest each period, and the
payment in the next period is usually set when the previous payment is made. By
taking positions in a floating rate bond (that pays 6-month LIBOR) and a discount
bond, explain how you can replicate the floating leg (all floating payments).
(c) Similarly, use a coupon bond and a discount bond to replicate the fixed leg that
pays x2 % semi-annually.
(d) Find the value of x such that the equalize the value of the floating and fixed legs.
This is the swap rate. We will talk about swaps again later in the course.

6. Collateralized Debt Obligations. Consider the following risky bonds:

Bond Maturity (yrs) Face ($) Coupon (%)

X 1.0 $1000 0%
Y 1.0 $1000 0%

These bonds are risky because there is a possibility that their respective issuers default
(i.e. don’t repay the entire face value of their issued bond to bondholders). Each issuer
has a 25% probability of defaulting. These default risks are independent in the sense
that the probability of both firms defaulting equals (0.25)2 . In the case of default, X
doesn’t repay any of its principal while Y repays half of it.

A collateralized debt obligation (CDO) pools risky debt securities (like X and Y ) into an
investment vehicle that is sold off in reconfigured pieces called tranches. Cashflows from
the original securities are passed-through to the tranches according to a specific rule. The
rule is generally hierarchical in the sense that there is a most senior tranch that receives
the first $P payments, a slightly less senior (called more junior ) tranch that receives the
next $Q payments, and so forth. In industry, this type of investment vehicle most often
pools illiquid debt instrument like mortgages (called collateralized mortgage obligations).

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Consider a CDO made by pooling one X and one Y bond. It is split into two tranches.
The senior tranch has a face value of $500 and the junior tranch has a face value of
$1500. Assume the price of the X and Y bonds are $688.07 and $825.47 respectively
while the risk-free rate is 5%.

(a) What is the value of the junior tranch? (Hint: Use arbitrage arguments.)
(b) What is the YTM on the junior tranch? Is it different from that of the the senior
tranch? Why?
For the next part, assume that a credit derivative (exotic) that pays you $100
ONLY if Y default and X does not, trades at $10.
(c) To improve the quality of the junior tranch, the issuer decides to further divide the
junior tranch into $1,000 of junior and $500 of equity. Junior has priority of claim
over equity. The issuer keeps to equity tranch to ensure investors that they will
be interested in enforcing the payments from the two bonds. Calculate the value
of the new junior and equity tranches. Is the total value of these two tranches the
same as the original junior tranch? Explain.