FIN8340 - Final Exam Fixed Income Securities

Exam time is: 60 hours.

Total points for this exam is: 600 points, corresponding to 60% of your
…nal grade.

0.0.1 Instructions

Read carefully the questions.

Summarize you answers in a Report in the …rst work sheet of the excel
…le. The report in the …rst work sheet should be formatted in such a way
that when I press "print" I will be able to get all of your results, plots, and
explanations. Your grade will be based on the report. It is advisable that
you preview and print the report before you submit your exam for a last
check.
You should execute your work in the work sheets assigned for each prob-
lem in an orderly fashion so that I can check it, if necessary. However, if a
results is not reported in the report, do not assume that I will be able to …nd
it in some place of the workbook, and that you will get credit for it.

If you …nd a question unclear, explain your approach, make any assump-
tion that you need to make, and provide the best answer you can. Given the
structure of the test, and for fairness, I will not reply to any queries.
The workbook contains the data that you need for your work.

0.0.2 Con…dentiality Agreement.

By taking this exam you acknowledge that you have agreed to the terms of
the con…dentiality agreement reproduced below for you convenience.
You agree that the contents of the …nal take home exam are con…dential
and that the disclosure of that information could compromise the integrity
of the student evaluation process.
The exam is available to you solely to test your knowledge of the exam
subject matter. You are expressly prohibited from disclosing, publishing,
reproducing, transmitting, discussing, or accessing any previous exam and

1
any related information including, without limitation, questions, answers,
worksheets, computations, drawings, diagrams, length or number of exam
segments or questions, or any communication, including oral communication
regarding or related to the exam, in whole or in part, in any form or by any
means, oral or written, electronic or mechanical, for any purpose, without
the prior express written permission of the instructor.
Mid term exams and in class labs are in the public domain, and thus
are excluded from con…dentiality. However, while taking the exam, you are
expressly prohibited from any communication, including oral communication,
regarding or related to the mid term exams and in class labs, in whole or in
part, in any form or by any means, oral or written, for any purpose, without
the prior express written permission of the instructor.
The instructor determines, in its sole discretion that you have undertaken
or participated in any action that compromises the integrity and con…den-
tiality of the examination.
Failure to comply with the terms of this agreement before the …nal grade
is issued will be handled through the established procedures of the KSU
University Judiciary Program, which includes either an “informal”resolution
by a faculty resulting in a F grade, or a formal hearing procedure, which may
subject a student to the Code of Conduct’s minimum one semester suspension
requirement.
The term of this Agreement is perpetual. You waive any right to challenge
the validity of this agreement on the grounds that it was transmitted and
entered into electronically.
You agree that entering into the Agreement electronically is equivalent
to signing the Agreement.

2
1 Problem 1
a) Write the price function and plot the price of a 15 year bond, nominal
value 1000, coupon 5.5% with annual payment, as a function of the yield to
maturity. Use a range of yields from 0 to 20% with increments of 2%.
b) Compute the $duration analytically and numerically when the yield is
7%.
Use
i) 1 basis point increment for the numerical approximation
ii) use a smaller increment equal to :0000001. Do you notice any di¤erence
in the two numerical approximations?
c) Explain what does this number measure.
d) Plot the linear approximation of the bond function about the 6% yield.
e) What is the error from the approximation when the yield is 6%.
f) What is the error when the yield is 5.9999%.
g) What is the error when the yield is 12%
e) Comment on e, f , and g.

X
15
55 1000
P (y) = (1+y)t
+ (1+y)15
t=1

1400
y
1200

1000

800

600

400

200

0
0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14 0.16 0.18 0.20
x

P (:07+:0001) P (:07)
:0001
= 8239: 68 =

3
 P (:07+:0000001) P (:07)
:0000001
= 8245:0 =

X
15
t55 15 1000
(1+:07)t+1
+ (1+:07)16
= 8245: 01
t=1

X
15
t55 15 1000
(1+:07)t+1
+ (1+:07)16
= 8245: 01
t=1
Linear approximation

L(y) = P (:06) 8245: 01(y :06)

L(:06) P (:06) = 0:0

L(:059999) P (:059999) = 0:001 15
L(:12) P (:12) = 100: 556

2 Problem 2
Assume that you manage a portfolio that includes several dozens of di¤erent
bonds. The characteristics of the portfolio are

Value Yield Modi…ed Duration Convexity

$103 768 :81 5:5% 7: 438 073 5 70: 949 696
Assume that in the market there are three bonds with the following spec-
i…cations.

1) Bond H1
Coupon 6%, paid annually.
maturity = 20 year ,
par value =100,
yield =5:75% .
2) Bond H2
Coupon 5%, paid annually
maturity =5 year
par value = 100,
yield = 5:25% .

3) Bond H3

4
Coupon 7%, paid annually
maturity =7 year
par value = 100,
yield = 5:65% .

a) Compute the price, $duration and $Convexity of all the bonds.

For H1 we have:
X
20
6 100
Price function H1 (y) = (1+y)t
+ (1+y) 20
t=1
X
20
6 100
Price (1:0575)t
+ (1:0575)20
= 102: 927
t=1

X
20
t(6) 20(100)
$Dur(H1 ) = (1:0575)t+1 (1:0575)21
= 1194: 66
t=1
X
20
t(t+1)6 (20)(21)100
$Convexity(H1 ) = (1:0575)t+2
+ (1:0575)22
= 19516: 237
t=1

For H2 we have:
X
5
5 100
Price function H2 (y) = (1+y)t
+ (1+y)5
t=1
X
5
5 100
Price H2 (:0525) = (1:0525)t
+ (1:0525)5
= 98: 925 07
t=1

X
5
t(5) 5(100)
$Dur(H2 ) = (1:0525)t+1 (1:0525)6
= 427: 012 41
t=1
X
5
t(t+1)5 (5)(6)100
$Convexity(H2 ) = (1:0525)t+2
+ (1:0525)7
= 2354: 732 8
t=1

For H3 we have:
X
7
7 100
Price function H3 (y) = (1+y)t
+ (1+y)7
t=1
X
7
7 100
H3 (:0565) = (1:0565)t
+ (1:0565)7
= 107: 630 87
t=1

5
 X
7
7(100)
t7
$Dur(H3 ) = (1:0565)t (1:0565)8
= 600: 557 21
t=1
X
7
t(t+1)7 (7)(8)100
$Convexity(H3 ) = (1:0565)t+2
+ (1:0565)9
= 4196: 22
t=1
b) Use the …rst bond above to hedge your portfolio to the …rst order
change in y. In other words, form a portfolio that is duration neutral. How
many unit of the bond should you buy or sell? Report the number q.
Since the value of the portfolio is a function of the yield we write P (y)
We denote the change in P (y) as dP (y).

For a small change in the yield we know that dP (y) can be approximated
@P (y)
by @y
dy:
So we write

@P (y)
dP (y) dy = $Dur(P )dy
@y
dH(y) = $Dur(H)dy
dP (y) = $Dur(P )dy

dP (y) + qdH(y) = 0
implies
(q$Dur(H) + $Dur(P ))dy = 0

$Dur(P ) q$Dur(H) = 0
$Dur(P ) + q$Dur(H) = 0
$Dur(P )
q = $Dur(H)
The total dollar duration of the portfolio P (y) is equal to modi…ed dura-
tion times the price of the portfolio, i.e. P (y)M D = $Dur(P )

7: 438 073 5(103 768 :81) = 771840

to …nd q we need

$Dur(P )
q= :
$Dur(H1 )
The quantity q to be SHORTED is then equal to
771840
q= = 646: 075
1194: 66
6
 c)What is the value of your hedged portfolio? Check what happens to
your unhedged portfolio when the yield moves upward of 10 basis points?
What happens when the yields goes up 300 bp’s. Comment.
The …rst order approximation of P (y) = 103768: 81 771840(y :055)
Answer

Around x0
f (x) = f (x0 ) + f 0 (x0 )(x x0 ) + error

Unhedged
P (:055 + :001) P (:055) = 771: 84

P (:055 + :03) P (:055) = 23155: 2

Let’s now form the hedged portfolio. What is the value of the portfolio?
The value is:

P (y) qH1 (y) = P (:055) 646: 075H1 (:0575)

37270: 5

P (:055) 646: 075H1 (:0575) = 37270: 5

Let’s see what happens if the yield goes to up 10 bp’s

The new value of the hedged portfolio is:

P (:055 + 0:001) 646: 075H1 (:0575 + :001)

37264: 2

P (:055 + 0:001) = 102997

103768: 81 771840(:055 + 0:001 :055) = 102997
H1 (:0575 + :001) = 101: 742

646: 075H1 (:0575 + :001) = 65732: 7

P (:055 + 0:001) 646: 075H1 (:0575 + :001) = 37264: 2

102997 65732: 7 = 37264: 3

7
 The new value of the hedged portfolio is:

The loss is 38036: 1 37270: 5 = 765: 6

Let’s see what happens if the yield increases 300 bps

The new value of the hedged portfolio is:

P (:055 + :03) 646: 075H1 (:0575 + :03) =

The new value is

P (:055 + :03) = 80613: 6
H1 (:0575 + :03) = 74: 442 8
P (:055 + :03) 646: 075H1 (:0575 + :03) = 32518: 0
and the loss is
32518: 0 37270: 5 = 4752: 5

d) Use bonds H1 and H2 and H3 above to hedge your portfolio to the

second order changes in y, while keeping the value of portfolio unchanged. In
other words, form a portfolio that is duration neutral and convexity neutral.
This means that you want to …nd 3 quantities q1 ; q2 ; and q3 such that the
duration and convexity of your portfolio are both equal to zero, and the total
investment necessary to hold the position is unchanged. Report the system
that you have set up and the solution, i.e. q1 ; q2 ; and q3 :

Answer

Or we can write the system in the form

0 = q1 H1 (y) + q2 H2 (y) + q3 H3 (y)

0 0 0 0
P (y) = q1 H1 (y) + q2 H2 (y) + q3 H3 (y)
00 00 00 00
P (y) = q1 H1 (y) + q2 H2 (y) + q3 H3 (y)

We can now use the information about our bonds to set the hedge

8
 The total duration of the portfolio P (y) is equal to the number of certi…-
cates times the $duration of each certi…cate.
$Convexity = 103 768 :81(70: 949 696) = 7: 362 37 106
Hence

0 = q1 103 + q2 99 + q3 108
771840 = q1 1195 + q2 427 + q3 601
7362365: 5 = q1 19516 + q2 2355 + q3 4196
2 3 2 32 3
0 102: 926 60 98: 925 07 107: 630 87 q1
4 771840 5 = 4 1194: 66 427: 012 41 600: 557 21 5 4 q2 5
7362366 19516: 237 2354: 732 8 4196: 22 q3

So we have
2 3 1 2 3 2 3
102: 926 60 98: 925 07 107: 630 87 0 237: 960
4 1194: 66 427: 012 41 600: 557 215 4 771840: 5 = 4 7357: 535
19516:
2 3 237 2354: 732 8 4196: 22 7362366: 6989: 97
q1
= 4q2 5
q3

These are the q’s we are looking for.

f) Consider now the hedged portfolio. Compute its value at the time the
hedge is set up. Then check what happens to your hedged portfolio when the
yield moves upward of 10 basis points? What happens when the yields goes
down 300 bp’s. (Hint, do not forget to de…ne a QUADRATIC price function
for the portfolio). Comment.
Answer. As expected the hedged portfolio is worth at the time of the
hedge

P (:055) 237: 960H1 (:0575) 7357: 53H2 (:0525) + 6989: 97H3 (:0565) =
103769

Rede…ne the portfolio quadratic function

P (y) = 103768: 81 771840(y :055) + :5 7362366(y :055)2

Let’s apply a 10 basis points change to the 3 bonds

9
 P (:055+:001) 237: 960H1 (:0575+:001) 7357: 53H2 (:0525+:001)+6989:
97H3 (:0565 + :001) = 102285:

The loss is 103648 103 768 :81 = 120: 81

Let’s apply a 300 basis points change to the 3 bonds

P (:055 + :03) 237: 960H1 (:0575 + :03) 7357: 53H2 (:0525 + :03) + 6989:
97H3 (:0565 + :03) = 62255: 6

Now the loss is

104756 103 768 :81 = 987: 19

3 Problem 3
Nelson and Siegel propose to …t the yield curve with a function of the fol-
lowing form.
! !
1 e 1 e
R(0; ) = 0 + 1 + 2 e

Here ; is the maturity, and is a scaling parameter.

a) Brie‡y, explain the meaning of the parameters 0 ; 1 ; and 2 .
b) Estimate the 0 ; 1 ; and 2 and ; for the U.S. government securities
constant maturities on 1/2/2004, using the data in the data sheet. Convert
to continuos compounding. Report the parameters estimates and the value
of the minimized loss function, i.e. the sum of the squared di¤erences of the
rates.
6:0217% 5:3243% 0:1437% 3:33
loss function = 4:69407E 06
c) Use the curve that you have estimated to price a 15 year U.S. govern-
ment year bond, with annual coupon 5%. and face value equal to 1000. Use
continuos compounding for the discount factor.

10
 Price 1023:5235

d) Estimate the $ sensitivities to changes in 0 ; 1 ; and 2 of a portfolio

made of 1000 certi…cates. Numerically, estimate all sensitivities with an
increment of :0001:
Assume that you expect a 1% decrease of 1 and you have no view with
respect to 0 ; and 2 :
Assume in addition that you want the face value of the portfolio un-
changed, regardless of the strategy you take and that you can use the 1-year,
5-year and 10-year bonds (recall that you have the data for the zeros) to
immunize your portfolio.

Report the system that you need to solve. You don’t need to solve it.

4 Problem 5
Merton (1973) suggests that the payo¤ of a limited liability company’s stock
is akin to that of an option. For instance, consider a …rm with market value
V, and debt with face value K on date T. The value of the equity in the …rm,
S(T ), at maturity of the debt, T, is the price of a hypothetical option on the
…rm value.
a) What type options is it? What is its payo¤ function?

b) Draw the payo¤ function ST (VT ) assuming that the strike price K,
which in this case represents the value of the …rms’debt, is equal to 8M

c) Consider the fundamental balance sheet identity. What type of options

does the value of debt resembles? What is the payo¤ function of the bond
B? Draw it. Comment on the economic meaning of the two pictures.

B = VT ST = VT M ax(VT K; 0)
VT if VT < 6
=
6 if x > 6

The two pictures show that the equity payo¤ is similar to that of a call
option. It start to pay only after the debt has been fully repaid. On the

11
other side, debt resembles short position in a put contract. If the value of
the of the …rm is below those of debt, bond holders only get the value of the
…rm. If it is higher than that of the bond, bond holders get the full principal
back.
d) Let S be the stock value, VT the value of the …rm asset, N (d) the
normal standard probability of a VT being less or equal to d. The other
parameters are the years to maturity T of the bond B, the risk free rate r;
and the strike price K and the volatility of equity S . The stock of this …rm
is currently traded at $3 and there are 2; 000; 000 common stock certi…cates
held by investors. The bond and the stock are the only entries in the right
hand side of the …rm’s balance sheet.
The parameters are as follows:
Bond F aceV alue = 8
Risk F ree Rate = 0:05
Y ears to M aturity = 1
Stock V olatility = 0:60

Using the Merton model answer the following question:

d) What is the value of the Firm V computed with the model?
e) What is the value of Firm Volatility V computed with the model?

Equity V alue (V ) 13:5954

F irm V olatility V 0:2677

f) What is the probability of default?

Probability of Default = 0.0210
g) What is the Corporate Bond Value?
B = S = Ke rT N (d2 ) + VT [1 N (d1 )]
Corporate Bond Value =7.5954

h) What is the value of the risk free bond?

rT
B = Ke

Risk Free Bond Value =7.6098

In addition de…ne and provide the estimate of the following quantities

i) What is the Expected Credit Loss ECL?

12
 ECL = BF B
Expected Credit Loss =0.0145

j) What is the Loss Given Default LGD?

LGD = 1 ECL
N (d2 )
Loss Given Default =0.6897

k) What is the recovery rate?

RR = K KLDG or 1 LDG K
Recovery Rate = 0.9138

l) Brie‡y comment on whether these results make sense to you.

5 Short questions
5.1 Question 1 - 25 points
Provide a de…nition of yield to maturity and show how the de…nition that
you provided applies to the case of a bond with 10 year maturity, semiannual
payment, coupon 9%, and 100 par value, that is traded at 93: 768 9.

Answer

It is the rate of discount the makes the present value of the future bond
cash ‡ows equal to the price of the bond.
Answer y is the solution to
X
20
4:5 100
93: 768 9 = (1+y=2)t
+ (1+:y=2) 20
t=1

y=2 = :05
y = 10%

13
5.2 Question 2 - 25 points
You have been hired by an investment bank. The CFO of your new client
company says that he has invented a bond with special characteristics that
will make it very successful in the market. He wants to call it “The Happy
New Year Bond R ”. This bond has a par value of 100, the maturity is 50
years. The bond is to be ‡oated on the …rst trading day of January 2008.
The reason he thought about the name is that he wants the coupon payment
to be 5 dollars on July 1 of and 10 dollars on January 1 of each year. Assume
that the yield curve is ‡at at 15%. How can you (easily) compute the price
of “The Happy New Year Bond R ”? How much is it?

Answer.
This bond is just the combination of two bonds with par value equal to
50. One pays $5 dollar coupon semiannually on July and January, the other
pays $5 annually, on January.

X
50
5 50
(1+:15)t
+ (1+:15)50
= 33: 348 7
t=1
X
100
5 50
(1+:15=2)t
+ (1+:15=2)100
= 66: 654 6
t=1

33: 348 7 + 66: 654 6 = 100: 003

5.3

5.4 Question 3 - 25 points

a) What are the stylized fact of interest rates?
Consider the following model for the dynamics of the interest rate.

drt = dt + dWt
a) Which of the stylized facts does it …t? Do you see any problem with
this model?

Consider now this other model for the dynamics of the interest rate.

14
 p
drt = ( rt )dt + rt dWt
Can this be considered an improvement over the previous one? Why?
b) What is the interpretation of ; ; and ?

Answer

Interest rate changes randomly. It is not mean reverting. It can become

negative.
is the speed of mean reversion. is the level at which the rate tends
to revert. is the level of volatility

5.5 Question 4 - 25 points

Consider two securities (nominal $100). One year pure discount bond selling
at $95
and a two year 8% bond selling at $99

a) Compute the one-year spot rate

b) What is the zero coupon rate for the 2 year time horizon?
c) How is this method of extracting zero rates called?
100
a) 95 = 1+R(0;1)
1 + R(0; 1) = 100
95
= 1: 052 63
R(0; 1) = 5:263%
8 108
b) 99 = 1+R(0;1) + (1+R(0;2)) 2

Use the R(0; 1) that you compute in a)

8 108
99 = 1: 052 63
+ (1+R(0;2))2

Solve for R(0; 2)

(1 + R(0; 2))2 = 1: 181 62
R(0; 2) = 1: 181 621=2 1 = 8: 702 35%
c) Bootstrapping

15