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ECO 466/FIN 521: Fixed Income Models and Applications

Fall 2014 Final Exam (with Solution)


1. You have 2 hours to complete this exam.
2. There are four independent problems for a total of 100 points. Point are not allocated equally to the
problems. Read the full exam before starting.
3. This exam is closed book and lecture notes, and must represent your own work. No communication,
whether external or with other students taking the exam, is permitted. Calculators are allowed.
4. Please DO NOT use pencils.

True, False or Uncertain (20 points)

Are the following statements true, false, or uncertain? Explain briefly. A correct answer with no explanation (or
incorrect explanation) will receive little credit.
1. (4 points) If a 30-year Treasury bond issued twenty years ago and a 10-year Treasury note issued today
(so that they have the same final maturity) have different prices, then there is an arbitrage opportunity.
(Assume no call options or other unusual embedded features.)
False.
The complete answer should include the following two factors. I gave full grades as long as you mention
one of them.
1). Different coupon structure leads to different price: floating/fixed leg, high/low coupon;
2). Liquidity issues affect bond prices as well. In reality, illiquid bond yields are determined by demand
and supply. Even if theres aritrage, traders are not able to exploit it given the one-sided market.
2. (4 points) Suppose the expected return from holding zero-coupon bonds is the same, regardless of maturity,
for every one-year holding period. Then the expected return from holding one-year zero-coupon bonds,
and reinvesting them in new one-year bonds when the current bonds mature, is necessarily the same as the
expected return from holding two-year zero-coupon bonds for the same two-year period.
False.
Even if the expectation hypothesis holds, theres still a convexity term when rolling over the short bond.
This argument is true only when interest rate is deterministic.
3. (4 points) If the yield curve is always flat (i.e., at each point in time, the yield of every zero-coupon bond
is the same, regardless of maturity) but the level is changing over time, then it is possible to construct an
arbitrage portfolio using zero-coupon bonds of three different maturities.
True.

Construct the following zero-coupon bond portfolio: 1 unit of P (1 ), n2 units of P (2 ), and n3 units of
P (3 ), such that
1 + n2 2 + n3 3 = 0,
P (1 ) + n2 P (2 ) + n3 P (3 ) = 0.
This portfolio has zero initial cost and zero duration.
According to the assumption, P (, It ) = e It , where It is the contemporaneous yield level. At time t, we
could construct the portfolio by solving n2 , n3 , which apparently depend on It .
Next, we show that there is arbitrage.
dP (, It )
=
P (, It )



2 I2
It +
dt dIt .
2

Simple algebra renders




d [P (1 , It ) + n2 P (2 , It ) + n3 P (3 , It )] = (22 12 )n2 P (2 , It ) + (32 12 )n3 P (3 , It ) dt + 0 dIt .
The drift term in the square bracket depends on the contemporaneous It . If its positive, then we just
constructed a portfolio with arbitrage. If its negative, we could simply flip the sign of position holdings
and get arbitrage.
Note: The above arbitrage goes away in reality, since level shift is just one part of yield dynamics.
4. (4 points) Long-term yields can be lower than short-term yields, even if investors do not demand a risk
premium for exposure to interest rate risk (i.e. the price of risk, , is equal to zero) and their expectation
of the future interest rate level, rt+ , is equal to the current level, rt ?
True.
Given EtQ [rt+ ] = EtP [rt+ ] = rt , short rate has zero drift under Q. Convexity causes long yields to be
lower.
Lets start from a simple example to get some intuition. Assume rate follows a random walk
rt = r0 + Wt .
h t
i
t
1
Then E0Q e 0 rs ds = er0 t+ 2 var( 0 Ws ds) = ey(t)t . So
y(t) < r0 .

In fact, this result is model-independent. Convexity always leads to lower long yields, under the assumptions.
5. (4 points) If you know the process followed by the nominal instantaneous interest rate, rt , then by no
arbitrage arguments, it is possible to determine the price of any nominal fixed income derivative.
True.

Given the process, i.e. both P&Q dynamics, we should be able to price any nominal fixed income
derivative.
I see one student mentions credit spread. Strictly speaking, the argument should be false in the general
setting, since once credit spread, liquidity, incomplete market, frictions are taken into account, the assumptions underlying the pricing PDE are violated. Thesere beyond the scope of the course.
I give full grades as long as your False is based on any of these factors.
Note: Given the ambiguity of the process, I also give full grades to those who say False arguing the
Q process is not given.

An Unrealistic Interest Rate Model (25 points)

Suppose the interest rate follows the process under the historical probability measure, P :
drt = dt + dWtP
and the risk-neutral dynamics of the interest rate are given by:
drt = dWtQ
You conjecture that the continuously compounded yields of zero-coupon bonds take the form:
y(t, T ) = rt +

1
a(T t)
T t

for some function a(T t). (Note: this notation indicates that a() is a function of T t and does not represent
the product of a constant a and (T t).)
1. (5 points) Assuming your conjecture is correct, write down a stochastic differential equation (under the
historical probabilities, P ) followed by the yield y(t, T ), where T is held fixed.
By Itos Lemma,
dy(, rt )


= y + yr + 21 yrr 2 dt + yr dWtP


)
a0 ( )
= + a(
dt + dWtP
2

2. (5 points) Assuming your conjecture is correct, write down a stochastic differential equation (under the
historical probabilities, P ) followed by the price P (t, T ) of a zero-coupon bond with face value $1 to be
paid at T .
Note that P (, r) = exp(y( ). ) = exp(r a( )).


1 2 2
0
dP = P rt + a ( ) + dt P dWtP .
2

3. (10 points) Assuming your conjecture is correct, the risk-neutral process of the price P (t, T ) of a zerocoupon bond can be characterized by two distinct but equally correct stochastic differential equations.
What are they?
3

Similar to last question, under Q, we have




1
dP = P rt + a0 ( ) + 2 2 dt P dWtQ .
2
Moreover, any tradable asset under Q has expected return rt , and hence
dP = P rt dt P dWtQ .

4. (5 points) What should the function a(T t) be? In principle, this part requires solving an ODE; however
the solution can be obtained by making a change of variable = T t and integrating.
According to last question,
a0 ( ) =

2 2
.
2

Given a(0) = 0, simple integration renders


a( ) =

2 3
.
6

TIPS Yield Curve and Pricing (30 points)

Assume today is December 12, 2008 and you observe TIPS prices as shown in the table below.
Security

Maturity

Price

Coupon

Index ratio

1/15/2014

91 7/32

1.18406

1/15/2016

91

1.10231

7/15/2014

90 1/2

1.16067

1/15/2026

85 25/32

1.10231

1. (5 points) Describe how you would use the extended Nelson-Siegel-Svensson (NSS) model, in which the
instantaneous forward rate is given by






s
s
s
s
s
f (s) = 0 + 1 exp
+ 2 exp
+ 3 exp
,
1
1
1
2
2
to calculate the real discount curve and the real yield curve.

1
y( ) =


f (s)ds = 0 +1






1 e /1
1 e /1
1 e /2
/1
/2
+2
e
+3
e
/1
/1
/2
B( ) = ey( ) .

2. (2 points) Now assume that your parameter estimates for the NSS curve are 0 = 6278.3013, 1 =
6278.227, 2 = 6289.189, 3 = 0.18763, 1 = 27056.491, and 2 = 32.190532. Can you see what
the short-term real rate rt is by looking at those parameters?

rt = 0 + 1 = 7.93%
3. (3 points) Using the NSS model, price a 2% coupon TIPS with the maturity date 12/12/2012 and an index
ratio of 1.07817.

y(1) = 7.124%, y(2) = 6.831%, y(3) = 6.549%, y(4) = 6.278%.


i

h 
P = 107.817 2 ey(1) + e2y(2) + e3y(3) + 102e4y(4) = 91.213.
4. Treasury STRIPS (acronym for Separate Trading of Registered Interest and Principal of Securities) allow
investors to hold and trade individual interest and principal components of eligible Treasury securities
as separate zero-coupon securities. Now assume that you decide to make a portfolio out of the stripped
coupon payments from TIPS 1 and 3 in the table. Specifically, you decide to short the next five coupon
payments only of Security 1 and go long the next five coupon payments only of Security 3.
(a) (5 points) Because you are essentially short and long 2% coupons in real terms, the price of the total
position should be zero. True or false? Explain.
False.
The principal in TIPS 1 is bigger than in TIPS 3.
(b) (5 points) What is the nominal price of this position based on the NSS curve estimated above?


P = 2.339 2% ey(1) + e2y(2) + e3y(3) + e4y(4) + e5y(5) = 0.1938.
(c) (5 points) The next coupon payment occurs on January 15, 2009, and you are given the index ratios
for those two securities on that date of 1.16196 for Security 1 and 1.08173 for Security 3. What will
the actual cash flows be at that date? Do you receive money or do you pay?
You pay
2% (116.197 108.173) = 0.16046.

(d) (5 points) Is this portfolio similar to holding inflation risk or is it more like holding insurance against
inflation risk?
We are holding inflation risk. When inflation changes, we suffer.

Pricing Mortgage using a Risk-Neutral Tree (25 points)

Suppose that you estimated the risk neutral tree for interest rates in the table below
i=0

i=1

i=2
r2,uu = 6%

r1,u = 5.5%
r0 = 5%

r2,ud = r2,du = 5%
r1,d = 4.7%
r2,dd = 4.5%

where there is equal risk-neutral probability to move up or down the tree. Assume also for simplicity that each
interval of time represents a year, that is, = 1.
1. (5 points) Compute the value of a non-callable and callable bonds, with principal = $100, maturity i = 3,
and annual coupon rate = 5.25%. Which of the two bonds is more expensive for investors? Why?
Non-callable is expensive. Callable must be cheaper, since the buyers are prone to pre-payment risk.
So callable bonds must be issued at a lower price to penalize for the embedded call option. Otherwise,
investors could be better off buying a non-callable bond.
Non-callable tree:
i=0

i=1

i=2
99.121

99.257
100.129

100.117
100.768
100.619

where each node uses the formula


Vt = e

rt


u
d
Vt+1
+ Vt+1
+ Ct+1 .
2

Callable tree:
i=0

i=1

i=2
99.121

99.201
99.737

100
100
100

where each node uses the formula



 u

d
V
+ Vt+1
Vt = min 100, ert t+1
+ Ct+1 .
2

2. Consider a 2-year mortgage with $10,000 face value, and a continuously compounded mortgage rate of
5.097%.
(a) (3 points) If there is no prepayment, what is the annual payment?

C=

10000
= 5395.52.
+ e25.097%

e5.097%

(b) (2 points) Given the annual payment, compute the principal and interest payment each period (t = 1
and t = 2). Also, compute the value of the mortgage along the tree.
r = er 1, I0 = rP0 = 522.9, CI0 = 4872.6, P1 = 5127.4, I1 = 268.1, CI1 = 5127.4, P2 = 0.
i=0

i=1

5106.776
10009.597
5147.794

where each node uses the formula


Vt = e

rt

u
d
Vt+1
+ Vt+1
+ Ct+1
2

(c) (5 points) Compare the value of the mortgage at each node with the principal outstanding: What is
the option value? When is it optimal to exercise the option?
i=0

i=1

0
9.701
20.396

where each node uses the formula



 u

c
+ cdt+1
ct = max Vt Pt , ert t+1
2
Its optimal to exercise the option at time 1 if r = 4.7%.
7

(d) (5 points) From your results above, compute the value of the mortgage with prepayment: What is the
homeowner really paying?
Vt ct = 9999.897.
3. (5 points) How would you calculate the duration of the mortgage in this exercise?

D=

1
1 V1u V1d
5106.776 5127.397
=
= 0.258.
V0 r1u r1d
9999.897
5.5% 4.7%

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