ADM3351A Assignment 2 (32 points total) Due 11:59pm on November 21st, 2023

Weight this assignment is the second of two assignments for the semester. The
assignment is worth 12.5% of your final mark in the course.

Instructions

• Submit this assignment as a single PDF file. Do not submit several photos.
• You can type or handwrite your solution. Either option should be compiled into a
single PDF file.
o For handwritten assignments, scan your pages and combine them into a
single PDF file.
• Feel free to resubmit your assignment before the deadline. Only the last
submitted file will be graded.

Specific assignment instructions:

Show your step-by-step work for part marks. Write down the equations you are using.
For problems that you will be using a financial calculator, write down your inputs for
partial marks. Keep at least 4 decimal digits in all your calculation and answers unless
specified otherwise. Make sure your work is legible.

Penalty for late submissions: Students who submit their assignments after the due date
will lose 5 points for each calendar day post due date.
Problem 1 (10 points): Assume the term structure of interest rates is flat and consider a
1-factor model with a factor equal to that interest rate. Assume also that the current
interest rate is 10%. You currently own 1000 of 20-year 14% coupon bonds.

a) (2 points) If you want to hedge your portfolio with 20-year 6% coupon bonds,
how many bonds do you need to sell?
b) (2 points) By how much will the value of your hedged portfolio change if the
interest rate increases by 0.4%, from 10% to 10.4%?
c) (2 points) You just found a risk-free-security trading on the market, a perpetuity
with $100 face value and 15% annual coupon rate (paid semi-annually). How
many of such perpetuities do you need to sell to hedge your original portfolio?
d) (2 points) By how much will the value of your newly hedged portfolio change if
the interest rate decreases by 0.4% from 10% to 9.6%?
e) (2 points) What can you conclude about hedges from the occurrence in question
d?

Problem 2 (10 points): Assume the term structure of interest rates is flat and consider a
1-factor model with a factor equal to that interest rate. Assume also the current interest
rate is 10%. Your portfolio consists of $200,000 investment in 6-year zero-coupon bonds
and $300,000 investment in 9-year zero-coupon bonds

a) (2 points) Find the Duration of your portfolio.

b) (2 points) If you want to hedge your portfolio with 13-year zero-coupon bonds,
what will be the total dollar value of the 13-year bonds that you will sell?
c) (2 points) If you want to hedge your portfolio with perpetuities that pay semi-
annual payments, what will be the total dollar value of the perpetuity that you will
sell?
d) (4 points) If you want to hedge your portfolio with the 13-year zero-coupon
bonds along with 7-year zero-coupon bonds, what dollar value of each bond will
you buy or sell?
Problem 3 (12 points)
You have the following information:
Use zero coupon, $1,000 Face Value bonds compounded semi-annually. Consider the
following forward rates:

5.3%

4.5%

4% 3.7%

3.5%

3.3%

Consider 1-year and 1.5-year spot rates of 𝑟̂(1) = 4.3% and 𝑟̂(1.5) = 4.7%

a) (8 points) Solve the binomial tree.

b) (2 points) Using the data from the tree you have completed, find the price of a 1-
year call option with strike price X=$985 on an 18-month zero-coupon bond with
face value of $1,000.
c) (2 points) Using the data from the tree you have completed, find the price of a 1-
year put option with strike price X=$985 on an 18-month zero-coupon bond with
face value of $1,000.