SOLUTION FOR FINAL EXAM (GRA 6539)

JUNHUA ZHONG

1. Graphical analysis
2
(a) Convexity is defined as V1 ddrV2 . The value function has negative convexity over
[0, r1 ] , zero convexity on r1 and positive convexity over [r1 , ∞] according to
the graph. Denote the vertex of value function as [rm , Vm ]. Duration, which is
defined as − V1 dVdr is positive over [0, rm ], negative over [rm , ∞]. On the graph
you provide in the solution, the second derivative turns from negative
to positive somewhere between r1 and r3 , if I haven’t interpreted the
graph in the wrong way, V should turn from concave to convex at
point r1 . Please check it again.
(b) The hedging portfolio has a value function mirrored to the original portfolio,
with V = v, v ≥ 0 as the axis.
(c) Point r1 is very special, where the duration of value function for original portfolio
is +∞. The value function of the hedging portfolio has have a duration of −∞
at r1 . We could know more about the value function of the hedging
portfolio, given the graph on figure 2, no matter how the value graph
move parallelly along the vertical axis. The first derivative of the
value of hedging portfolio should be negative somewhere between 0
and r2 .
(d) The hedging portfolio should have a positive duration over [r2 , r3 ], with positive
convexity over [r2 , r1 ] (where the holder is earning money from the volatility),
negative over [r1 , r3 ] (where the holder is losing money from the volatility).

2. Simple sensitivity
(a) Since the term structure is flat at 5%, this spot rate 5% does not depend on
the time-to-maturity. We can assume parallel yield shifts. We know the original
portfolio is  
2
3
The new portfolio is denoted as
 
n2
n3
The price of 2 types of bonds are denoted as p2 and p3 . The durations are
D2 and D3 respectively. The value of the portfolio is P . Zero financing cost and
double portfolio duration is given as
     
p2 p3 n2 2p2 + 3p3
· =
p2 D2 p3 D3 n3 4p2 D2 + 6p3 D3

Date: December 13, 2009.

1
2 JUNHUA ZHONG

Since all the bonds are traded at par, the coupon rate for all bonds is 5%.
The pricesare all equal to each other. The duration for two-years coupon bond is
1 0.05 1.05 1
  0.05 0.05 1.05

D2 = 1.05 1.05 + 2 1.052 = 1.8594 . Similarly, D 3 = 1.05 1.05 + 2 1.052
+ 3 1.053 = 2.7232 .
The system can be further simplified into
     
1 1 n2 5
· =
1.8594 2.7232 n3 4 × 1.8594 + 6 × 2.7232
We can solve for n2 = −11.7631 and n3 = 16.7631, which means that the
investor has to short sell 11.7631 units of two year bonds and buy 16.7631 units
of three-year bonds. (The duration for the original portfolio is 2.3778.
The new portfolio is the twice of that, 4.7555.)
(b) (I am assuming the face value of the zero coupon bond is $ 100.) We know the
for zero coupon bonds, the duration is equal to their maturities. Hence, D2 = 2
100
and D5 = 5. The price for 2-year maturity bond is p2 = 1.05 2 = 90.7029. The
dollar value invested in the 2-year bond is −2500, i.e. to short 27.5625 units.
Missing $ in front of 1000 in the problem.

3. Term structure and uncertainty

(a) If the shorter-maturity spot rates are expected to be flat, i.e. the one-year
rates are all equal to each other, then the implied term structure is flat as well
(Maybe I haven’t captured the meaning of the question, but to my knowledge
it is inconsistent with what is given to us to show). The yield is equal to this
one-year rate throughout the time horizon.
(b) If we assume that the spot rates are expected to increase, the implied term
structure is upward sloping. I think the risk premium demanded for long
position of long term bonds are equivalent to assuming upward sloping
expectation.

4. Term structure and trees

(a) The tree can be built up as
0.17
;
www
ww
w
ww
0.09 / 0.09
ww;
ww
www
w
0.05G 0.13
GG ww;
GG ww
GG ww
G# ww
0.05 / 0.05

(b) You are right.

(c) You are right.

5. Corporate bonds
erT −d
(a) We know p = u−d . Given that r = .05, u = 169/130 = 1.3 and d = 117/130 =
0.9, we have T = 0.7498.
 SOLUTION FOR GRA 6539 3

(b) The ’otherwise equivalent riskless bond’ is interpreted as the bonds we are using
to replicate the portfolio. In addition, it’s assumed that the date for the valuation
is the date 0. P = 130e−0.05×0.75×2 = 120.6066532.
+ −
(c) By typical binomial valuation with Bt = e−rh [pBt+h (1−p)+Bt+h ], r = 0.05, h =
0.75, p = 0.3455, the down node in 0.75 yrs is given by 109.6448. The up node
is 125.2153. This tree is
Year: 0 0.75 1.5
Ordinary bond 110.7913 125.2153 130
109.6448 130
105.3

(d) Yes, you are right on the answers. Prior to maturity, the bond holder, the bond
holder values the bond as the greater of its conversion value and the value of
letting the bond live on more period. We can compare the end nodes for the
mq
value of normal bonds with the asset value per share after conversion n+mq At ,
to capture whichever is higher. Similarly to other nodes.

Year: 0 0.75 1.5

mq
n+mq At 100 130 169
90 117
81

Based on above, we can build up the payoff tree of the convertible bonds

Year: 0 0.75 1.5

Convertible 115.1111N C 138.1950N C 169
109.6448N C 130N C
105.3N C

115.1111, 138.1950 and 109.6448 are from typical binomial evaluation.

(e) If ”‘any time before maturity”’ includes the period 2. The company only choose
to exercise the call on the nodes above with label N C (Not to convert) from the
end nodes.
Year: 0 0.75 1.5
Call Schedule 120 120 120
Callable 106.9576N C 120C 169
106.3167N C 120C
105.3

At the (2,1) node, the passive managers choose to call bonds at 24. By
binomial evaluation, the second nodes values are: (1,2) is 131.8911 and (1,1) is
106.3167. Convertible holder chooses not to convert. Now it’s passive managers’
turn to choose call or not, node (1,2) is chosen to be called. The value of each
of the corporate bonds is 21.3915.
If ”‘any time before maturity”’ does not include the end period, which means
bonds cannot be called but can be converted at end periods.
Notes: possible printing error on $ 24.
4 JUNHUA ZHONG

Year: 0 0.75 1.5

Call Schedule 120 120 NA
Callable 109.0556N C 120C 169
109.6448N C 130N C
105.3N C

(f) Now the proactive manager always moves first. If ”‘any time before maturity”’
includes the period 2. I adopt $ 26, i.e. the company is calling at par. The
manager compares ordinary corporate bonds’ end value with the strike price
and not to call at the end periods. At node (1,2), the manager chooses to call
since she rationally expects that if not the bond holder will choose to convert!

Year: 0 0.75 1.5

Call Schedule 130 130 130
Callable 112.3837 130 130
109.6448 130
105.3

If the call price is $ 24, the end nodes are the same as in the above tree.

Year: 0 0.75 1.5

Call Schedule 120 120 NA
Callable 109.0556 120C 169
109.6448 130
105.3

Notes:
– Clearly define the ’before maturity’. If the bond holder has the option to
convert at the end period (at maturity) why not the same case with bond
issuers?
– 24 or 26?