MIT Sloan School of Management
J. Wang 
15.407 
E52456 
Fall 2003 
Problem Set 2: FixedIncome 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 3year treasury bond has a face value of $1000 and annual coupon of 8%. The 1year spot rate is r _{1} = 2%, and the 1year forward rates for the next two years are r _{2} = 4% and r _{3} = 5%
(a) 
Compute the price of the tbond? 
(b) 
Calculate the YTM of the tbond. 
(c) 
Calculate the 2 and 3year 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 tbond 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 recreate the yield curve by looking at the prices of some tbonds. We will still make some simplifying assumptions: There are 30 days for each month, and each bond in the table makes semiannual 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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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 interest is simply C ∗ _{2}_{y} . Calculate the dirty price of all bonds.
Recreate all the spot rates. Calculate the 5month interest rate from the February 04 bond, and then get the 11month rate, and so on
Price (i) a tbond 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 bidask spread of the strip is 3/32, but in general the bidask spread of tbond is only 1/32)
(b)
(a)
x
(c)
4. There are three bonds being traded in the market. The following table summaries their characteristics:
Bond 
CF _{1} 
CF _{2} 
CF _{3} 
YTM 
A 100 
100 
1100 
4% 

B 200 
500 
500 
3.5% 

C 0 500 
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 3year 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 modiﬁedduration 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 3month or 6month 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 3year swap. The ﬂoating leg pays 6month LIBOR semiannually 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)
(b)
(c)
(d)
Brieﬂy explain what LIBOR is. (Go to http://www.bba.org.uk or other references)
For now, assume that all cash ﬂows are riskfree, 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 6month LIBOR) and a discount bond, explain how you can replicate the ﬂoating leg (all ﬂoating payments).
Similarly, use a coupon bond and a discount bond to replicate the ﬁxed leg that
pays ^{x} % semiannually.
2
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 passedthrough 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).
3
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 riskfree 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. 
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