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Risk-Neutral Rates & Bond Valuation

This homework assignment contains 4 questions regarding bond pricing and mortgage calculations. Students are asked to: 1) Find risk-neutral probabilities for a 6-month interest rate process and price various zero-coupon bonds. 2) Price a 1.5-year collared floating rate note using the risk-neutral tree from question 1. 3) Complete calculations to derive spot rates, forward rates, and value bonds using bootstrapping and a binomial interest rate tree. 4) Construct an amortization schedule for a 30-year fixed rate mortgage and calculate the mortgage balance and scheduled payment at specific points in time.

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Yuhao Gu
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472 views2 pages

Risk-Neutral Rates & Bond Valuation

This homework assignment contains 4 questions regarding bond pricing and mortgage calculations. Students are asked to: 1) Find risk-neutral probabilities for a 6-month interest rate process and price various zero-coupon bonds. 2) Price a 1.5-year collared floating rate note using the risk-neutral tree from question 1. 3) Complete calculations to derive spot rates, forward rates, and value bonds using bootstrapping and a binomial interest rate tree. 4) Construct an amortization schedule for a 30-year fixed rate mortgage and calculate the mortgage balance and scheduled payment at specific points in time.

Uploaded by

Yuhao Gu
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Homework Assignment #5

Due: December 10, Tuesday, submit online by 6pm

1. Assume that the true 6-month rate process starts at 5% and then increases or decreases
by 100 basis points every 6 months. The probability of each increase or decrease is 50%.
The prices of 6-month, 1-year, and 1.5-year zeros are 97.5610, 95.0908, and 92.5069.
Find the risk-neutral probabilities for the six-month rate process over the next year (i.e.,
two steps for a total of three dates, including today). Assume, as in the note, that the
risk-neutral probability of an up move from date 1 to date 2 is the same from both date
1 states. As a check to your work, write down the price trees for the 6-month, 1-year,
and 1.5-year zeros.

2. Collared floater is a floating-rate note that has both a floor and cap on the interest rate.
Consider a 1.5-year collared floater that makes payment every six months according to
the rule:
a. If 𝑟𝑖 < 3.5%, the interest payment of the collar floater on date 𝑖 + 1 is
3.5%
𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 × .
2
b. If 3.5% ≤ 𝑟𝑖 ≤ 6.5%, the interest payment of the collar floater on date 𝑖 + 1 is
𝑟𝑖
𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 × .
2
c. If 𝑟𝑖 > 6.5%, the interest payment of the collar floater on date 𝑖 + 1 is
6.5%
𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 × .
2
In addition, at maturity, the collared floater returns the $100 principal amount.
Using the risk-neutral tree derived for Question 1, price $100 face amount of the
collared floater.

3. (Note that sub-questions (a) to (c) were asked in assignment #2. You can either use the
solution from assignment #2 directly or re-do the calculation for completeness.) The
current on-the-run yields for the Ramsey Corporation are as follows:

Maturity (years) Yield to Maturity (%) Market Value


1 2.5 100
2 2.6 100
3 2.7 100

Assume that each bond is an annual-pay bond and trading at par. Answer the questions

Assignment 5 Page 1
below.
a. Using the bootstrapping methodology, complete the following table:

Year Spot Rate (%) One-Year Forward Rate (%)


1
2
3

b. Using the spot rates, what would be the value of a three-year 3.5% coupon option-
free bond of this issuer?
c. Using the one-year forward rates, what would be the value of a three-year 3.5%
coupon option-free bond of this issuer?
d. Using the same binomial interest rate model as describe in the lecture note. (That is,
at date t, if the interest rate at the lowest node is 𝑟𝑡 , then the interest rate one node
above is 𝑟𝑡 𝑒 2𝜎 , two nodes above is 𝑟𝑡 𝑒 4𝜎 , …, where σ is the assumed standard
deviation of one-year interest rate.) If σ is assumed to be 10%, what is the lower
one-year spot rate one year from now? What is the one-year spot rate two years
from now? Draw the complete binomial interest rate tree.
e. Determine the value of a three-year 3.5% coupon option-free bond for this issuer using
the binomial interest-rate tree.
f. Determine the value of a three-year 3.5% coupon bond that is callable at par (100)
after one year.
g. Determine the value of a three-year3.5% coupon bond that is puttable at par (100).

4. Consider the following fixed-rate, level-payment mortgage:


maturity = 360 months
amount borrowed = $100,000
annual mortgage rate = 10%.
(a) Construct an amortization schedule for the first 10 months.
(b) What will the mortgage balance be at the end of the 360 th month assuming no
prepayments?
(c) Without constructing an amortization schedule, what is the mortgage balance at the
end of month 270 assuming no prepayments?
(d) Without constructing an amortization schedule, what is the scheduled principal
payment at the end of month 270 assuming no prepayments?

Assignment 5 Page 2

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