FM405E - Fixed Income Securities and Credit Markets 2021/22

The London School of Economics

Problem Set 4
Interest rate derivatives II

Assume that the discretely compounded one-year rate, or the “short-term rate”, evolves over
time as described by the following tree:

uuu: r = 7.5%
q2

uu: r = 7%
q1

u: r = 6% uud: r = 6%
q0

r = 5% ud: r = 5%

d: r = 4% udd: r = 4.5%

dd: r = 4%

ddd: r = 3%

t=0 t=1 t=2 t=3

Assume three securities are available for trading: (i) a zero coupon bond expiring in two years,
quoting for 0.91000; (ii) a zero coupon bond expiring in three years, quoting for 0.86500; (iii) a
derivative, called the “uuu Arrow-Debreu security”, paying $1 at time 3 in the state “uuu” of
the previous diagram, where the short-term rate equals 7.5% (and pays 0 in other state in the
final period), quoting for 0.10000. Answer the following questions, using numerical accuracy up
to five decimals:

8
 i (15 points) Assume that the risk-neutral probabilities of upward movements in the short-term
rate change over time and take three values, q0 , q1 and q2 , but are independent of the state
of nature, as illustrated in the previous diagram. Use all available market data to calibrate
these probabilities.

ii (20 points) Use the previously calibrated probabilities to price a caplet contingent on the
rates prevailing at time t = 3, paying off at time t = 4, with strike rate equal to 5%, and
notional value equal to $100.

iii (20 points) Consider a forward rate agreement, whereby at time t = 0, two counterparties
agree that at time t = 4, they will exchange with each other the variable short-term rate
prevailing at time t = 3, against a fixed interest rate equal to K. Use the previously calibrated
probabilities to determine the level of K that makes the value of this agreement equal to zero
at time t = 0. How is this value of K referred to, and what is the price of a four year bond
implied by it?

iv (5 points) Determine the value of the forward rate agreement in Part (iii), from the perspective
of the party paying a fixed interest rate K = 6%.