Table of Contents

Question 1 ......................................................................................................................................................................... 2
Question 2 ......................................................................................................................................................................... 3
Question 3 ......................................................................................................................................................................... 4
Question 4 ......................................................................................................................................................................... 4
Question 5 ......................................................................................................................................................................... 6
Question 6 ......................................................................................................................................................................... 9

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Question 1
The swap rate can be determined using the formula

where

T = 1/2
Rearranging the formula above and we get
(

))

From the given question,

T = 0.5
Substiting these numbers into the equation above, we can get

Part b)
Thus, for a par swap where the market value is zero, the duration is equal to the modified
duration.
The DV01 of the swap is calculated by consider the par swap as the coupon bond with coupon
rate as swap rate.
Thus,
(
(

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Question 2
Part a)
The price of the zero maturing at time 1 is in fact equal to the sum of asset A and asset B. It is
because if we consider the payoff of asset A and asset B together at time 0.5, we can see that
the payoff is $1 for sure. So the payoff is in fact equal to a risk-free bond. Thus, we can deduce
the zero maturing at time 1 from the sum of asset A and B together
In that case, the zero maturing at time 1 becomes (0.97+0.99)/2 = $0.97 * 0.97 = 0.9409

Part b)
The price of the zero maturing at time 0.5 is in fact equal to the sum of asset A and asset B. It is
because if we consider the payoff of asset A and asset B together at time 0.5, we can see that
the payoff is $1 for sure. So the payoff is in fact equal to a risk-free bond. Thus, we can deduce
the zero maturing at time 1 from the sum of asset A and B together
In that case, the zero maturing at time 1 becomes $0.48+$0.49 = $0.97

Part c)
The risk neutral probability, p, can determined by using the formula

In verbal terms, it means that the present value of asset A should be equal to the expected
payoff of the claim A, discounted at risk-free rate
Price of Asset A = E(G) * DF0.5
E(G) is the expected payoff of the claim
DF0.5 is the discount factor of a 0.5 year zero
Thus,
0.48 = (p*1 + (1-p)*(0)) * 0.97
Solving p and we get
p= 0.49484

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Question 3
Part a)
10.93% =8%*EXP(0.2*0.5+0.3*SQRT(0.5))
8%
7.15% '=8%*EXP(0.2*0.5+0.3*SQRT(0.5))
Part b)
$1 par of a zero maturing at 0.5 =

$ 0.9615

Part c)
Time 0

Time 0.5 DF
10.93% 0.899043
8%
7.15% 0.932147

$1 par of a zero maturing at 1 =

0.88 <= 0.5 * (0.899+0.932)*0.9615

Question 4
The value of the interest rate cap is equal to the discounted payoff of the contingent claim. The
payoff at time 0.5 of the interest rate cap is equal to the discounted payoff.
Thus
The payoff at each node is determined by the interest rate tree below
Part a)
Payoff
Time 0

Time 0.5
0.00276 <=max(Node - 5.25%,0)

0.001347
0 <=max(Node - 5.25%,0)
Value

134,700

Partvalue
b) of the interest rate cap equals to notional * % premium of IR cap.
The
Time 0
Time 0.5
The IR cap premium equals to the
expected
payoff of the option discouted at 0.5 year zero.
0 <=max(
5.25%-r,0)
0.004417
Thus the value is
0.00905 <=max( 5.25%-r,0)

c = 0.5*(0+0.00276)*0.976086 = 0.001347
Value
$ 441,679
Thus the value of the option is 0.001347 * $100million = $134,700.
Similarly, we determine the same result in part b)
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If the interest rate option has a cap at 5.25%, it is like an interest rate put option. The payoff
diagram of the rate can be shown as below

Part b)
Time 0

Time 0.5
0 <=max( 5.25%-r,0)

0.004417
0.00905 <=max( 5.25%-r,0)
Value

441,679

c = 0.5*(0+0.00905)*0.976086 = 0.004417
Thus the value of the option is 0.004417 * $100million = $441,679.

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Question 5
Part ai)

Part a) i)
Time 0

Time 0.5
9.10%

0.9565

7.16%

0.9655

7.60%

Time 0
4*0.9634+104*0.9258=

Time 0.5
104*0.9565

99.476

104*0.9655

100.412

100.1368

Part a) ii)
Duration

(4*0.5*0.9634+104*1*0.9258)/100.1368=

$Duration
Partb)
Time 0
ex: 100.1368-100

0.981
0.0098

Time 0.5
MAX(104*0.9565-100,0)

MAX(104*0.9655-100,0)

0.412

0.1368

wait: 0.5* (0+0.412)*0.9634 0.1985

Because, the value of waiting is greater than exercising, thus, wait

Option price

0.1985

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Part c)
The value of the callable bond equals to the value of noncallable in part a) - value of American call in part b)
Thus,
The price of the callable bond is

100.1368-0.1985=

99.938

Part d)
Because the call is not exercised, thus, the value is equal to an European call
By put-call parity
European call + PV(K) = European put + Current Price
Thus, European put = European call + PV(K)- Current price of par bond
Now the current price of the bond is
100.1368
The present value of $100 par bond with strike 100 is
Thus, the price of european put is

100.1368
0.1985

Part e) i)
Swap = Fixed rate bond from part a) - floater
Swap=

0.1368

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Part e) ii)
Suppose the swap is cancelable, at no cost, at the option of the party
paying fixed, at either time 0 or time 0.5 (immediately after the swap payment). What
is the value of this cancelable swap from the viewpoint of the party who is long the
swap, i.e., from the viewpoint of the party who is receiving fixed?
Swap cancelable by short party = Callable swap = Swap - Receiver swaption (call on
swap) with 0 strike
Call on 8% swap with 0 strike = par call on 8% bond from (2b)
Callable swap = 0.1368 - 0.1985 = -0.0617
Part eiii)
Swap cancelable by long party = Putable swap = Swap + Payer swaption (put on swap)
with 0 strike
Put on 6% swap with 0 strike = par put on 6% bond from (2d)

Part eiii)
Swap cancelable by long party = Putable swap = Swap + Payer swaption (put on swap)
with 0 strike
Put on 6% swap with 0 strike = par put on 6% bond from (2d)
0.0617

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Question 6
Part a)

Period Ending Initial bal

Time 0.5
Time 1.0

Scheduled
Interest
Principal
payment
10000 $
5,188
250 $
5,062 $
5,188 $
127 $

Ending
A interest
Bal
4,938 $ 5,062
125
5,062 $
$
2

A
B
B interest
principal
principal
$ 4,938
125
0
$
62
125
5000

Part b)
Whole mortgage
Time 0
Prepay:

Value:

Time 0.5
5188*0.9731=

5048.4

5188*0.9787371=

5077.7

10000

(5188+0.5*(5048.4+5077.7))*0.9760

10,005.02

Tranche A
Time 0
Prepay:

Time 0.5
(62+2)*0.9731=
=(4938+125+0.5*(62.3+62))*0.9760
$
5,002.15

Tranche B
B tranche = Whole mortgage - Tranche A

62.3

62

$ 5,002.88

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Part c)
Whole mortgage
Time 0
Prepay:

Time 0.5
min(5062,5188*0.9731)=

5048.4

min(5062,5188*0.9787371)=

5062.0

10000

Wait:

(5188+0.5*(5048.4+5062))*0.9760

9,997.36

Tranche A
Time 0

Time 0.5
(62+2)*0.9731=

Prepay:

=(4938+125+0.5*(62.3+62))*0.9760
$
5,002.15

Tranche B
B tranche = Whole mortgage - Tranche A

62.3

62

$ 4,995.22

Part d)
The mortgage will become half of the value of mortgage in Part b and part c)
Thus, whole tranche
$ 10,001.19
Tranche A

$ 5,002.15

Tranche B

$ 4,999.05

Scheduled
Interest
Principal
payment
10001.19 $
5,188 250.02975 $
5,063 $
5,188 $
125 $

Period Ending Initial bal

Time 0.5
Time 1.0

Ending
A interest
Bal
4,938 $ 5,063 125.0149
5,063 $
$
2

A
B
B interest
principal
principal
$ 4,938 125.0149
0
$
62 125.0149
5000

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