MGT 6769 - Fixed Income Securities

Assignment 3 Prof. Hsu

This assignment must be submitted by the end of class on Wednesday, March 29th ,
2017. The assignment questions are to be completed in groups of up to three people. You
must show the details of your work in Excel spreadsheets. Please HIGHLIGHT your final
answers. The assignment will be marked based on (1) how you arrive at the solution, (2) is
the solution correct or does it make sense? (3) the presentation of your results. Remember,
you must present your work in a clear and concise manner. Make sure your spreadsheets
are tidy, and clearly labeled. Your group members can be different from assignment 1. This
assignment consists of two parts: A and B.

PART (A) Forwards

1. Forwards, Dollar Duration, and Risk Management - 15 points
Assume you wish to take a long position in a forward contract with a 2 year maturity.
However, this forward contract is not for delivery of a zero-coupon bond on the maturity
of the forward contract. On the maturity of the forward contract, this forward contract
delivers a four-year coupon bond with annual coupon payments of $90.00 and a face
value of $1000.00.
The current annualized forward rates with continuous compounding are the follow-
ing:

F0 (0, 1) = 3% F0 (1, 2) = 7% F0 (2, 3) = 8% F0 (3, 4) = 9%

F0 (4, 5) = 13% F0 (5, 6) = 11%

(a) Based on the above forward rates, determine the appropriate price that the long
position should pay for this four-year coupon bearing bond. As in all forward
contracts, the delivery price will not be paid by the long party until the maturity
date of the forward contract - when the security is delivered. In this question, the
maturity date the forward contract is in 2 years from now.
(b) What is the dollar duration for this particular forward contract which delivers a
coupon bearing bond?
(c) Now assume you have a balance sheet that contains only a single security. This
single security is a six-year zero with face value of $4050.75. The balance sheet
has no liabilities. Without selling this six-year zero, how many forward contracts
would you go long or short to obtain a delta of zero for your net equity. (Your
hedge instrument is the forward contract which delivers the four-year conpond
bearing bond).

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PART (B) Swaps
1. Pricing the roller coaster SWAP contract - 15 points
Today is 31st-Jan-2002. Consider a 10-year roller coaster SWAP. The floating leg is
indexed to the 6-month T-bill. The fixed leg payment is annually. A real estate con-
struction company wants to enter into this roller coaster SWAP contract by receiving
the floating leg and pays the fixed leg. The notional amount on the fixed leg is $50
million dollars. However, the notional amount on the floating leg will vary seasonally
through the 10-year period. During the summer time, the company expects to depend
on a large cash flow. Therefore the notional amount on the floating leg for the summer
is three times the size of the notional contract for the winter. Make any other assump-
tions, if necessary. However, use your common sense. Unreasonable assumptions will
not be accepted. Zero-rates data are available on FRED II or WRDS websites. You
need to extrapolate or estimate the term structure first.

(a) Assume that the fixed annual leg payment is 5% and that this roller coaster SWAP
contract is traded at par. What is the notional amount on the floating leg of this
SWAP contract for the summer?
(b) If the notional amount on the floating leg for the summer is $25 million, what is
the rate for the fixed leg payment? Assume that this roller coaster SWAP contract
is traded at par.
(c) Let’s assume that you have entered into this SWAP contract and the fixed leg
payment rate is 5% (i.e. from part a). Recall that today is 31st-Jan-2002 and
this SWAP contract is traded at par. Now, a year has gone by and the date is
31st-Jan-2003. What is the price of this roller SWAP contract?

2. Hedging with SWAP contracts - 20 points

Today’s date is 6/21/2001. You want to hedge the following portfolio (duration-
convexity hedging)
Portfolio that we want to hedge (PF)
Price YTM Duration MD Convexity
$32,863,500 5.143% 7.11 6.76 85.329

Hedging instruments: You are able to invest in any of the following SWAP contracts
that are traded at par
Notional Value Payment Frequency of fixed leg Floating Rate index Maturity
SWAP A $20,000 Semi-annual 3-month T-bill 2
SWAP B $50,000 annual 6-month T-bill 7
SWAP C $75,000 annual 6-month T-bill 15

(a) Compute the market rates for the fixed leg of these SWAP contracts. This is the
payment rate for the fixed leg such that each SWAP contract is traded at par.
Hint: prices of these contracts DO NOT equal to zero.

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(b) Compute the yield-to-maturity, modified duration, and convexity of these SWAP
contracts.
(c) Construct hedging portfolios consisting of these SWAP contracts in order to im-
munize the target portfolio (PF) against the first ($duration) and second order
($convexity) changes in the yield-to-maturity. Assume a parallel shift in the in-
terest rates curve. Hint: there are more than one possible combinations of A,B,C
such that you can achieve your hedging goal. Report all of them. If you have to
choose one of them, which one would you choose, and why? Be very concise with
your answer.