EF4327
Fixed Income Securities
Group Assignment II - Dr. Yingxiang Li
Due date: April 13, 2025, 11:59 p.m.
INSTRUCTIONS
1. The assignment is to be done using the same group as for the first assign-
ment.
2. You need to answer all questions on a single pdf file and upload the file
on Canvas.
3. Indicate your names and your SIS IDs on the first page of the pdf file.
4. Indicate precisely how you solved each question and show intermediate
steps in the calculations.
5. Overly lengthy solutions will receive low grades.
6. Only the content of the pdf file will be graded. Excel files or other material
will not be considered.
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Exercise 1:
You have estimated the risk neutral interest rate tree for the continuously compounded
interest rate as in the table above. There is equal risk neutral probability to move up or
down the tree and each interval time represents 6 months, that is, ∆ = 0.5.
1. Compute the discount factors for all maturities.
2. Compute the price of a security that pays $100 at time i = 2 if the continuously
compounded interest rate at that time is less than 5.00% and zero otherwise.
3. Compute the price of a 1.5-year floor, paying semi-annually, with strike rate rK =
4.50%, and notional N = 300.
Exercise 2:
You have estimated the risk neutral interest rate tree for the continuously compounded
interest rate as in the table above. There is equal risk neutral probability to move up or
down the tree and each interval time represents 1 year, that is, ∆ = 1.
1. a) Compute the value of a non-callable bond with par value N = 150, maturity
i = 3, and annual coupon rate of 5.50%.
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b) Compute the value of a similar bond that is callable at par value starting i = 1.
c) Which of the two bonds is more expensive for investors? Why?
d) Does the value of the embedded option increase or decrease with the level of
interest rate? Give the intuition.
2. Consider a 2-year mortgage with annual payment, $70, 000 face value, and a contin-
uously compounded mortgage rate of 5.23%.
a) If there is no prepayment, what is the annual payment?
b) Given the annual payment, compute the principal and interest payment each
period (i.e. i = 1 and i = 2). Also, compute the value of the mortgage without
prepayment option along the tree.
c) 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?
N.B.: You cannot exercise at i = 0.
d) Compute the value of the mortgage with prepayment. What is the homeowner
really paying?
e) How would you calculate the duration of the mortgage? Give its value.
Exercise 3:
Suppose you are an investor who invested in callable bonds. In particular, your bond
portfolio is long in 4.5%, 10-year AAA rated corporate coupon bonds (par = 400 million),
which will become callable in exactly three years.
The discount factors are the following:
T Z(t,T) T Z(t,T) T Z(t,T) T Z(t,T)
0.5 0.9738 3 0.8598 5.5 0.7574 8 0.6646
1 0.9484 3.5 0.8385 6 0.7380 8.5 0.6473
1.5 0.9250 4 0.8178 6.5 0.7190 9 0.6303
2 0.9031 4.5 0.7973 7 0.7005 9.5 0.6137
2.5 0.8811 5 0.7772 7.5 0.6823 10 0.5975
1. Assume σ = 17.77%, and use the discount curve to fit a simple BDT tree with semi-
annual steps up to T = 10. You should report the interest rate tree and explain the
methodology used to construct it.
N.B.: You can use the file BDT BinomialT ree M acro available on Canvas.
2. Using the tree, compute the value of the portfolio of bonds.
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3. Compute the spot rate duration and the spot rate convexity of the portfolio.
The spot rate convexity can be computed as
1 D1,u − D1,d
C0 = − ,
V0 r1,u − r1,d
where D1,u and D1,d are the spot rate durations computed in time/nodes (1, u) and
(1, d), respectively.
