Group Homework #1 – Topics 1 to 4

This group homework assignment reviews materials covered in class for Topics 1 to 4. The
assignment can be done in a group of no more than THREE students. Write ALL the group
members’ names on the cover sheet.

Please hand in along with your answers any supporting calculations and graphs (if necessary). Your
work should be neat and well organized so that I can easily find your solutions to each of the
questions. This assignment is due in class on Tuesday, April 5, 2016. The solutions will be handed
out on the same date.

No Arbitrage Pricing and Risk-Neutral Probabilities

1) Consider a step-up bond of XYZ Corporation.

The bond has 3 years to maturity, promising to pay 3% coupon in one year, 4% coupon in two
years, and 5% coupon in three years. The payments are risk-free. The coupons are paid annually
on a par of $100. The step-up bond is currently priced at $92.

Imagine that currently in the market, ONLY the following three risk-free bonds are available:

Maturity Coupon Rate Price

(in years) (annual payments) (per $100 face)
1 0% $ 95.238
2 0% $ 89.000
3 5% $ 94.923

Maturity is in years, coupons are paid annually, and prices are quoted per $100 face value.

Suppose you can buy and short sell all bonds without transactions costs.

a) What are the YTMs associated with the three bonds listed in the table?

b) Given the prices of the four bonds, show that there is an arbitrage opportunity. (Hint: Can
you replicate the cash flows of the step-up bond using those of the other three bonds?)

c) Construct a portfolio of "step-up bond", 1-year zero, 2-year zero and 3-year 5% coupon bond
such that you get positive cash flow today and no negative cash flows in the future. Show the cash
flow table with net cash flows and cumulative cash flows over time.

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2) At time 0.5, the price of $1 par of a zero maturing at time 1 will be either $0.96 or $0.98. The
current price of the zero maturing at time 1 is $0.94 and the current price of the zero maturing
at time 0.5 is $0.97. Consider also a claim that pays off $1 at time 0.5 if the zero maturing at
time 1 is worth $0.96, and 0 otherwise. This information is summarized in the payoff
diagrams below.

Time 0 Time 0.5

1
Zero maturing at time 0.5 0.97
1

0.96
Zero maturing at time 1 0.94
0.98

1
Claim ?
0

a) Determine a portfolio of the 0.5- and 1-year zeroes that has the same payoff as the claim at
time 0.5.
b) What is the value of the claim today in the absence of arbitrage?
c) What are the risk-neutral probabilities of the two possible time 0.5 values of the zero maturing
at time 1?

3) At time 0.5, the price of $1 par of a zero maturing at time 1 will be either $0.96 or $0.98. The
risk-neutral probability of the each outcome is 50%. The current price of $1 par of a zero
maturing at time 0.5 is 0.97.

Time 0 Time 0.5

1
Zero maturing at time 0.5 0.97
1

0.96
Zero maturing at time 1 ?
0.98

a) What is the price at time 0 of the zero maturing at time 1 in the absence of arbitrage?

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 b) Multiple choice question. Pick one answer.

Question: Which of the two zeroes above has the higher true expected return from time 0
to time 0.5?

Answer 1: The 0.5-year zero.

Answer 2: The 1-year zero.
Answer 3: They have the same true expected return.
Answer 4: There is not enough information provided to tell.

4) At time 0.5, the price of $1 par of a zero maturing at time 1 will be either $0.97 or $0.99.
Consider two other assets. Asset #1 pays off $1 at time 0.5 if the price of the zero maturing at
time 1 is $0.97 and pays off 0, otherwise. Asset #2 pays off $1 at time 0.5 if the price of the zero
maturing at time 1 is $0.99 and pays off 0, otherwise. The prices today of Assets #1 and #2 are
both $0.49. This information is summarized below.

Time 0 Time 0.5

0.97
Zero maturing at time 1 ?
0.99

1
Asset #1 0.49
0

0
Asset #2 0.49
1

a) What is the price today of the zero maturing at time 1 in the absence of arbitrage?

b) What is the price today of the zero maturing at time 0.5 in the absence of arbitrage?

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Dynamic Trading Strategies and Interest Rate Modeling

5)
a) Construct an interest rate tree according to the method presented in class with step size h =
0.5, volatility  = 0.2, drift m = 0.1, and initial 0.5-year rate r = 8%. The tree should give
short rates out to time 0.5.
b) What is the time 0 price of $1 par of a zero maturing at time 0.5?
c) What is the time 0 price of $1 par of a zero maturing at time 1?

6) Show that a term structure model with flat yield curves and parallel yield curve shifts contains
arbitrage opportunities as follows. Consider the following model: At time 0 the yield curve is
flat at 8%. At time 0.5 there are two possible states, the yield curve is either flat at 10% or flat at
6%. This is depicted below:

Time 0 Time 0.5

Yield curve flat at 10%
Yield curve flat at 8%
Yield curve flat at 6%

a) Draw a tree containing the time 0 price and the two possible time 0.5 payoffs (or prices) for
three different assets: a zero maturing at time 0.5, a zero maturing at time 10, and a zero
maturing at time 30, $100 par value each.
b) Consider a portfolio of 0.5- and 30-year zeroes that replicates $100 par of the 10-year zero, or
in other words, that has the same value as $100 par of the 10-year zero in both states at time
0.5.
(i) Determine the par amounts of the 0.5- and 30-year zeroes in this
replicating portfolio.
(ii) What is the cost of this replicating portfolio at time 0?
c) Describe an arbitrage opportunity in this market and indicate the arbitrage profit.
d) Suppose we change the yield on the 10-year zero to eliminate the arbitrage opportunity. What
would the yield have to be?

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7) Prices of zeroes at time 0 and time 0.5 are listed in order of maturity in the tree below:

Time 0 Time 0.5

0.9678
0.9713 0.9349
0.9433
0.9146 0.9745
0.9483

Consider a forward contract to buy, at time 1, $1 par of the zero maturing at time 1.5.
a) What is the forward price, agreed upon at time 0, to pay at time 1, for $1 par of the zero
maturing at time 1.5, that makes this contract worth zero at time 0?
b) What is the interest rate delta of this forward contract?