FINA 556 – Structured Products and Exotic Options

Homework One

Course instructor: Prof. Y.K. Kwok

1. Consider a Treasury bond with a face value of $10,000, a coupon of 8% and several years
to maturity. Currently this bond is selling for $9,260, and the previous coupon has just
been paid. What is the forward price for delivery of this bond in 1 year? Assume that
interest rates for 1 year out are flat at 9%.

Hint: Find the sum of the present value of the cash flows: delivery price and coupons,
and equate that to the current market price of the bond.

2. Suppose that the spot rate curve is flat at 6% with continuous compounding and a three-
year defaultable bond with a coupon of 5% (paid semiannually) and par 100.00 sells for
90.00. How would an asset swap on the bond be structured? What is the asset swap
spread that would be calculated in this situation?

Hint: It is necessary to compute the time-0 value of the annuity stream paying $1 per
annum (6 semi-annual payments during the 3-year life of the asset swap).

3. A company enters into a total return swap where it receives the return on a corporate
bond paying a coupon of 5% and pays LIBOR. Explain the difference between this and
a regular swap where 5% is exchanged for LIBOR. What are the potential risks faced by
the total return payer? Also, explain some of the major differences between a total return
swap and an asset swap.

4. Company X is based in the United Kingdom and would like to borrow $50 million at a
fixed rate of interest for 5 years in US funds. Since the company is not well known in
the United Kingdom, this has proved to be impossible. However, the company has been
quoted 12% per annum on fixed-rate five-year sterling funds. Company Y is based in
the United States and would like to borrow the equivalent of $50 million in sterling for 5
years at a fixed rate of interest. It has been unable to get a quote but has been offered
US dollars at 10.5% per annum. Five-year government bonds currently yield 9.5% per
annum in the United States and 10.5% in the United Kingdom. Suggest an appropriate
currency swap that will net the financial intermediary 0.5% per annum.

5. “A long forward contract subject to credit risk is a combination of a short position in a

Hint: Loss due to counterparty’s default occurs only when the derivative is in-the-
money.

6. An investor purchases a 10-year AA corporate bond that is puttable to the issuer at year
5. The puttable bond yields 7.00% pa (versus the comparable yield on conventional ten
year non-puttable 10-year AA corporate bond of 7.5% pa). How do we monetize the
puttable right using a swaption? Describe the nature of payoff of the swaption. What
would be the option premium charged on the swaption per annum in order that it is more
advantageous for the investor to own the puttable bond (which has a lower yield than
that of its non-puttable counterpart)?

7. Assume that the following market conditions exist:

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 • 5-year AA corporate bonds with a one time call at the end of third year are trading
at 8.3% pa
• 5-year AA corporate non-callable bonds are trading at 7.50% pa
• Receiver swaption at 7.50% pa is priced at a 180bps premium, where the dealer can
require the investor to pay 7.5% pa and receive US$ LIBOR for Year 4 and Year 5
• 5-year AA non-callable floating rate bond yielding US$LIBOR
• 3-year and 5-year fixed-floating interest rate swaps, where the floating rate is US$LIBOR

Assume that an investor wishes to create a “synthetic” callable bond (same as the first
bond listed above) using a non-callable bond (either fixed rate or floating rate) and swaps
and / or swaption. Discuss various strategies that can be adopted using the instruments
listed above. Describe the cash flows under different scenarios. Is it more advantageous
to own the “synthetic” callable bond (make your own assumptions about the swap rates
in the interest rate swaps)?

8. A differential swap may involve three currency worlds: interest payments are calculated
based on the floating LIBOR of two currencies but the actual payments are denominated
in a third currency. Show that this type of 3-currency differential swap can be decomposed
into a portfolio of standard type of differential swaps which involve only two currency
worlds.

9. Suppose that the risk-free zero-curve is flat at 6% per annum with continuous compound-
ing. Consider a four-year plain vanilla credit default swap with annual payments on an
underlying risky bond. Suppose that the recovery rate is 20% and the compensation pay-
ment is (1− recovery rate) times notional. The forward probabilities of default of the bond
during the first year, the second year, the third year, and the fourth year are assumed
0.01, 0.015, 0.02 and 0.025, respectively. Assume that the credit premium is paid by the
Protection Seller at the end of each year (if the bond survives), and accrual premium from
the last payment date to the time of default is paid when the bond defaults. If default
does occur, it would take place either in mid-year or the end of the year. What is the
credit default swap spread? What would the credit default spread be if the instrument
were a binary credit default swap?

Hint: The probability of survival until the end of the second year = 100% − (1% +
1.5%) = 97.5%, and the probability of survival until Year 1.5 is 100% − (1.0% +
0.5 × 1.5%) = 98.25%, and similar calculations for other survival probabilities.
There are 4 swap premium payments if the bond survives throughout the life of
the CDS. However, there are 8 possible dates at which the bond may default.

10. Assume that a regular CDS pays (1− recovery rate) of the notional while a binary CDS
pays the full notional (independent of the recovery rate) upon default of the reference
asset. Find the ratio of the corresponding CDS spread for the regular CDS for the two
cases where the recovery rate is either 10% or 50%. Is the CDS spread of a binary CDS
dependent on the recovery rate? Give an explanation to your answer.

11. Suppose that:

(a) The yield on a 5-year risk-free bond is 7%.

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What arbitrage opportunity is there in this situation? What arbitrage opportunity would
there be if the credit default spread were 300 basis points instead of 150 basis points?
Give two reasons why arbitrage opportunities such as those you identify are less than
perfect.