Hw nongraded ans - FINA4120 Assignment Answer PDF

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Non-graded Homework Solution On the forward contract delivery date (June 8 , 2017 ), you can buy the one-year 7% (semi-annual coupon payments) bond for 98. The implied forward yield-to-maturity solves: 23 103.98.1 /2 (1 /2)Y Y  , and Y=8% 20 - year bond: 101 - 110 = -9. 16-year bond 101*.884 - 9...

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Non-graded Homework Solution 1.

On the forward contract delivery date (June 8 , 2017), you can buy the one-year 7% (semi-annual coupon payments) bond for 98.3. The implied forward yield-to-maturity solves:

3.5 103.5   98.3 , and Y=8.813% 1  Y / 2 (1  Y / 2)2 2.

20-year bond: 101 - 110.677 = -9.677 16-year bond 101*.884 - 97.140 = -7.856 The 16-year bond is the cheaper to deliver. You lose money in either case, but given that you have to deliver something it is the smallest loss.

3.

I and III

4.

Go long the September 16 contract and the December 16 contract to lock in a 6-month lending rate using two consecutive three-month contracts. Since you have $200m to invest, buy 200 of the Sept. contract. The return locked in on the Sept. contract is 5.85%, so in December you will have $200(1+.0585(90)/360) = $202.93 million to invest, so buy 203 of the Dec. contracts.

5.

If yield changes on the bond and the contracts are each 1 basis point, the bond value will change by $10 million .0001 8 = $8000. The contract will result in a cash flow of $100,000 .0001 6 = $60. Therefore, you should sell 8000/60 = 133 contracts. You sell because you need profits on the contract to offset losses as a bond issuer if interest rates increase.

6.

a. Company A has a relative advantage at borrowing floating, so they should borrow floating on the market. B should borrow fixed from the market. A mutually advantageous swap (one of many possible) would be for A to pay B LIBOR, and B to pay A a fixed 9.75%:

To Market From Counterparty To Counterparty NET

A LIBOR + 1 (LIBOR) 9.75% 10.75%

B 10% (9.75%) LIBOR LIBOR+.25%

b. Both A and B save .25% relative to borrowing at their preferred maturity. 7.

a. Daiwa should enter the swap is the floating rate payor, to offset the risk on the money they receive from M-T that rates fall. b. The net spread is 7.3 - 7 + LIBOR +4 - LIBOR - 1.5 = 2.8%

8.

a. The benefit from being an intermediary is the spread they receive from the fixed rate coming in versus the fixed rate going out (8.55 – 8.5). The floating rates in and out cancel, so they expect to profit from the spread. Year 1

Counterparty 1

Citibank

Counterparty 2

. . . . . Year 4

Counterparty 1

Citibank

Year 5

Counterparty 1

Citibank

Counterparty 2

b. The risk is due to the maturity mismatch of these two swaps. In year 5 they have an obligation to pay a fixed rate and receive a floating rate, but no offsetting cash flows from another counterparty. If the floating rate falls below the fixed rate, they are exposed to losses. Note that these losses are not only in the future. As interest rates change, the NPV of their two obligations can change differentially, having an immediate effect. c. Since they make a loss if interest rates fall, they can hedge this risk by taking a long position in the Eurodollar futures market. The loss on the swap would be offset by the gain on the futures if rates fell. Conversely, if rates rise the loss on the futures is offset by the gain from the swap. Since the exposure is in year 5, and each contract covers a 3 month period, the best they could do would be to use a set of contracts expiring in4 years, 4.25 years, 4.5 years, and 4.75 years. (The match is not perfect because the swap is based on semiannual payments, but these maturities offer good protection.) You were not asked for this information, but because each contract is for a face value of $1 million, they would need 500 of each contract. 9.

c c c 1    1 2 3 (1.05) (1.06) (1.075) (1.075)3  1  1 1 c 1 0.80496  2  3  (1.075)   (1.05) (1.06) c  7.367%

10. F=12%, X=13%, r=11.5%, σ=12%, T=1.25, t=0.25.

ln(0.12 / 0.13) 0.12  1.25 / 2   0.5295 0.12  1.25 2

d1 

d2  d1  0.12  1.25  0.6637 c  0.25 1,000 e

0.1151.5

 0.12N   0.5295  0.13N   0.6637 

 0.5973 11. Methods for private sector securitizations include obtaining a letter of credit or guarantee from a bank or insurance company, and over-collateralization. Of course a government guarantee is good if you can get one. Credit enhancement is important in this market because it frees the ultimate investors from having to verify the credit quality of the individual loans backing the pools. 12. There is a partial hedge, but it is far from perfect. That is, it is true that having a higher yield on IO when rates falls partly offsets the loss in value from prepayments. However, the increase in prepayment rates is likely to more than offset the higher yield. In the extreme case, if all principal is prepaid, the IO receives nothing, independent of the promised rate. 13. You are better off with the PO. Mortgages will be prepaid quickly when rates fall, which reduces the value of IOs since it cancels promised interest. With the PO it means that the money is repaid sooner, which is beneficial to an investor. 14. Due to the embedded call option in most mortgage securities, the effective duration can be very short if interest rates have fallen. For instance, a mortgage with a fixed rate of 12% might have an effective duration of less than a year if rates were to fall to 6%. In contrast, the effective duration of a non-callable 10 year fixed rate corporate bond should be approximately equal to its modified duration since there is little doubt that the payments will arrive on the dates initially specified....