This document presents a problem set involving interest rate derivatives. It provides an interest rate tree and asks students to: [1] Use the tree to find the risk neutral probability and price a 3-year zero coupon bond. [2] Calculate the 1-year expected returns for investors in 2-year and 3-year zero coupon bonds. [3] Value a 3-year range bond that pays coupons if interest rates are within a given range, and calculate its 8% Value-at-Risk over 2 years under the two given probability scenarios.
This document presents a problem set involving interest rate derivatives. It provides an interest rate tree and asks students to: [1] Use the tree to find the risk neutral probability and price a 3-year zero coupon bond. [2] Calculate the 1-year expected returns for investors in 2-year and 3-year zero coupon bonds. [3] Value a 3-year range bond that pays coupons if interest rates are within a given range, and calculate its 8% Value-at-Risk over 2 years under the two given probability scenarios.
This document presents a problem set involving interest rate derivatives. It provides an interest rate tree and asks students to: [1] Use the tree to find the risk neutral probability and price a 3-year zero coupon bond. [2] Calculate the 1-year expected returns for investors in 2-year and 3-year zero coupon bonds. [3] Value a 3-year range bond that pays coupons if interest rates are within a given range, and calculate its 8% Value-at-Risk over 2 years under the two given probability scenarios.
This document presents a problem set involving interest rate derivatives. It provides an interest rate tree and asks students to: [1] Use the tree to find the risk neutral probability and price a 3-year zero coupon bond. [2] Calculate the 1-year expected returns for investors in 2-year and 3-year zero coupon bonds. [3] Value a 3-year range bond that pays coupons if interest rates are within a given range, and calculate its 8% Value-at-Risk over 2 years under the two given probability scenarios.
FM405E - Fixed Income Securities and Credit Markets 2021/22
The London School of Economics
Problem Set 3 Interest rate derivatives I
Consider the interest rate tree in the Table below. Assume that each interval of time represents 1 year. All entries are continuously compounded interest rates.
i=0 i=1 i=2
r2,uu = 9%
r1,u = 6%
r0 = 4% r2,ud = r2,du = 4%
r1,d = 3%
r2,dd = 2%
You received mixed up information about the risk neutral and the risk natural (true) proba- bility of moving up the tree. You know it can only be one of the two cases.
Case 1: q = 0.7, p = 0.3
Case 2: q = 0.3, p = 0.7
6 Only Case 1 or Case 2 is correct, but you do not know which one. However, you know that a 2-year zero coupon bond costs P0 (2) = 91.31.
1. Use the information provided to find the risk neutral probability of moving up the tree, and compute the tree corresponding to a 3-year zero coupon bond.
2. An investor buys the 2-year zero coupon bond at time i = 0. What is his/her 1-year expected return on the investment, as of i = 0? What if the trader buys at i = 0 the 3-year zero coupon bond? What is his/her 1-year expected return then?
3. A range bond is structured security, which can be described as follows: It is like a standard coupon bond, but it pays the coupon at some given time t if the reference interest rate at time t − 1 is within a given interval (the range). Otherwise, it pays no coupon at that time (it may pay it in the future, if the condition is met). In any case, it will pay the principal at maturity T. Consider a 3-year range bond, with a coupon equal to $10/year. The range bond pays the coupon at time i if the (continuously compounded) interest rate at time i − 1 is within the interval [0.025, 0.05]
(a) Compute the value of the range bond at time i = 0.
(b) You are conducting a long-term risk analysis of this bond. Draw a histogram of the value of the bond at time i = 2 and compute the 8% Value-at-Risk (Var) at time i = 2. For simplicity, in this computation, simply compare the value of the bond at time i = 2 with the value of the bond at time i = 0 (i.e. forget about the coupons). Note: VaR is measured by assessing the amount of potential loss which can happen with a given probability within a given time frame. In this particular problem, you have to figure out what is the largest potential drop in the value of the asset by i = 2 if you exclude the worst 8% of states. (c) You can compute the 8% VaR by using either p or q above. Draw the histogram for the other case too and compare them. Explain which one you should use for the risk analysis and why. (d) Do you think that the value of the range bond should be higher or lower than a standard coupon bond with the same maturity and $10/year coupons? When would you prefer one over the other?
