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Class Handout-3 2024

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15 views2 pages

Class Handout-3 2024

Uploaded by

Dheeraj Sharma
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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DEPARTMENT OF HUMANITIES AND SOCIAL SCIENCES

INDIAN INSTITUTE OF TECHNOLOGY KHARAGPUR

PAPER: FIXED INCOME SECURITIES


FIXED INCOME SECURITIES AND INTEREST RATE DERIVATIVES

CLASS HANDOUT-3: SPRING 2024

1. Assume a one-period spot rate follows a binomial process, is currently at S0 = 5%, u = 1.02, d
= 1/1.02, and the probability of the spot rate increasing in one period is q = .5.
a. Show with a binomial tree the spot rates, logarithmic returns, and probabilities after one period,
two periods, and three periods.
b. What are the spot rate’s expected logarithmic return and variance for each period?
c. Define the properties of a binomial distribution.
d. Verify that the u and d formulas yield the u and d values of 1.02 and 1/1.02 given the logarithmic
return’s mean and variance after three periods.

2. Suppose a spot rate has the following probability distribution of possible rates after four months:

Annualized Spot Rate (%) Probability


6.623 0.0625
6.332 0.2500
6.054 0.3750
5.788 0.2500
5.534 0.0625

a. Calculate the spot rate’s expected logarithmic return and variance. Assume the current rate is
6%.
b. Calculate the spot rate’s annualized variance and mean.
c. What are the spot rate’s u and d values for a period of length one month (h = length of the
period in years = 1/12), one week (h = 1/52), and one day (h = 1/360)?
d. Suppose the spot rate’s mean is equal to zero, what are the rate’s u and d values for the periods
of lengths one month, week, and day? Comment on the importance of the mean in calculating u
and d when n is large.

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3. Suppose a spot rate has the following rates over the past 13 quarters:

Quarter Annualized
Spot Rate (%)
y 1.1 5.5
y 1.2 5.0
y 1.3 4.7
y 1.4 4.4
y 2.1 4.7
y 2.2 5.0
y 2.3 5.4
y 2.4 5.0
y 3.1 4.7
y 3.2 4.4
y 3.3 4.7
y 3.4 5.0
y 4.1 5.5

a. Calculate the spot rate’s average logarithmic return and variance.


b. What is the rate’s annualized mean and variance?
c. Calculate the spot rate’s up and down parameters for periods with the
following lengths:
(1) One quarter (h = length in years = 1/4)
(2) One month (h = 1/12)
(3) One week (h = 1/52)
(4) One day (h = 1/360)

4. Given a variability of σ = ℎ𝑉 = 0.10 and current one- and two-period spot rates of y1 = 0.07
and y2 = 0.0804:
a. Generate a one-period binomial interest rate tree using the calibration model.
(Hint: try Sd = .08148).
b. What do the values of the upper and lower spot rates relative to the current spot rate of 7% tell
you about the structure of interest rates?
c. Using the calibrated tree, determine the equilibrium price of a two-period, option-free, 10.5%
coupon bond (F = 100).
d. Does the binomial tree price the 10.5% option-free bond equal to the bond’s equilibrium price?
Comment on this feature of the calibration model.
e. Using the tree, calculate the value of a two-period, 10.5% bond (F = 100) callable in period 1 at
CP = 101.
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