FINA0804/3323 Fixed Income Securities

Dr. Huiyan Qiu

Homework Assignment #4
Due: November 21, Monday, drop in TAs box by 6PM
1. An investor owns a call option on bond X with a strike price of 100. The coupon rate on
bond X is 9% and has 10 years to maturity. The call option expires today at a time when
bond X is selling to yield 8%. Should the investor exercise the call option? Why or why
not?
2. An investor wants to protect against a rise in the market yield on a Treasury bond.
Should the investor purchase a put option or a call option to obtain protection? Why?
3. Value a three-year interest rate floor with a $10 million notional amount and a floor rate
of 4.8% using the following binomial interest-rate trees. Assume the payoff for the floor
is annual.

4. Using the following instruction, complete a spreadsheet to compute the two-year and
five-year key-rate duration profiles of four-year bonds. For the purpose of this question,
key-rate shifts are in terms of spot rates.
a. In Column A put the coupon payments dates in years, from 0.5 to 5 in increments
of 0.5. Put a spot rate curve, flat at 3%, in Column B. Put the discount factors
corresponding to this spot rate curve in Column C. Now price a 3% and an 8%
four-year coupon bond under this initial spot rate curve.
b. Create a new spot rate curve in Column D by adding a two-year key rate shift of
10 basis points. (Apply the same rule as presented in the lecture note for
computing all other rates.) Compute the new discount factors in Column E. What
are the new bond prices?
c. Create a new spot rate curve in Column F by adding a five-year key rate shift of
10 basis points. (Apply the same rule as presented in the lecture note for
Assignment 4

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FINA0804/3323 Fixed Income Securities

Dr. Huiyan Qiu

computing all other rates.) Compute the new discount factors in Column G. What
are the new bond prices?
d. Use the results in parts (a) through (c) to calculate the key-rate duration profiles
of each of the bonds.
e. Sum the key-rate duration for each bond to obtain the total key-rate duration.
Calculate the percentage of the total duration attributed to each key rate for
each bond. Comment on the results.
f. What would the key-rate duration profile of a four-year zero coupon bond look
like relative to those of these coupon bonds? How about a five-year zero coupon
bond?
5. Continue with the setting and results of Question 4. Verify that a 3% two-year bond has
a duration of 1.925 that is completely concentrated as a two-year key-rate duration.
How would one hedge the key-rate risk profile of an 8% four-year bond with a 3% twoyear bond and the 3% four-year bond? Note that the total value of the 8% bond and of
the hedge need not be the same. Comment on the result.

Assignment 4

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