FIN 485 Fixed Income Analysis

Summer 2021

Exercise Problems

1. A 4-year, 5.8% coupon bond is selling at $95.9353,

A. What is the YTM, current yield, and capital gain yield today?

B. Two years have passed since the purchase of the bond, what would the YTM, current yield,
and capital gain yield be then, assuming that the yield is unchanged at the same level as of
today.

Solution:
A. What is the YTM, current yield, and capital gain yield today?

$5.8 $5.8 $5.8 $105.8

$95.94    
1  YTM  1  YTM  1  YTM  1  YTM  4
2 3

To get YTM = 7%
Current Yield = $5.8/$95.94=6.05%
Capital Gain Yield = 7% - 6.05%=0.95%

B. Two years have passed since the purchase of the bond, what would the YTM, current
yield, and capital gain yield be then, assuming that the yield is unchanged at the same
level as of today.
Price at the beginning of year 3:

$5.8 $105.8
$97.83  
1  7%  1  7%  2
Price at the end of year 3:

$105.8
$98.88 
1  7%  1

Current Yield = $5.8/$97.83=5.93%

Capital Gain Yield = ($98.88-$97.83)/$97.83=1.07%
Total Return = 5.93%+1.07% = 7% = current YTM

2. (Spot Rates and Bond YTM)

A 3 year 6% annual coupon bond, given the spot rates of 8%, 9%, and 10% for 1, 2, and 3-year
maturity, what is the YTM for the bond?

Solution:

First use the spot rates to calculate the bond price:

PMT PMT PMT + FV

Price= 1
+ 2
+ 3
(1+ z 1) (1+ z 2) (1+ z 3)
6 6 106
¿ 1
+ 2
+ 3
=90.25
(1+8 %) (1+9 %) (1+ 10 %)
Use this price to compute the YTM:

PMT PMT PMT + FV

Price= + +
( 1+r )1 ( 1+r )2 (1+ r )3
6 6 106
90.25= 1
+ 2
+ 3
¿ get r =9.92 %
(1+r ) (1+r ) (1+r )

3. Given the following term structure for Treasuries:

1 yr 2yrs 3 yrs 4 yrs

4.9% 5.2% 5.4% 6.0%

A. Use the Treasury yield curve for years 1 to 4 to bootstrap the Treasury spot rates up to
4 years (z1, z2, z3 and z4);

B. For a 4-year 6% coupon bond with coupons paid annually,

B1. Compute the price of the bond with the DCF approach given a market interest rate of 5%;
B2. Compute the price of the bond with the spot rates derived;
B3. Stay how an arbitrage can be taken, and how much arbitrage profit available?

Solution:
 • 3A. Use the Treasury yield curve for years 1 to 4 to bootstrap the Treasury spot
rates up to 4 years (z1, z2, z3 and z4), assuming par for all Treasury bond prices:
• Bootstrapping:
• Year 1: The 1-yr bond is a zero coupon bond, and therefore z1 = 4.90%;
5.2 105.2
• Year 2: + =100 to yield z = 5.2078%;
(1+ 4.90 %) (1+ z 2 )2 2
5.4 5.4 105.4
• Year 3: (1+ 4.90 %) + (1+5.2078 %)2 + (1+ z )3 =100 to yield z3 = 5.4208%;
3
6.0 6.0 6.0 106.0
• Year 4: (1+ 4.90 %) + (1+5.2078 %)2 + (1+5.4208 %)3 + (1+ z )4 =100 to yield z4 =
4
6.0749%;

• 3B. For a 4-year 6% coupon bond with coupons paid annually,

•
• 3B1. Compute the price of the bond with the DCF approach given a market
interest rate of 5%;
•
6.0 6.0 6.0 106.0
P= + + + =¿
• (1+5.0 % ) (1+5.0 %) (1+5.0 %) ( 1+5.0 % )4
2 3 103.546

• 3B2. Compute the price of the bond with the spot rates derived;

6.0 6.0 6.0 106.0

P= + + + =¿
• (1+ 4.90 %) (1+5.2078 %) (1+5.4208 %) (1+6.0749 %)4
2 3 100

• 3B3. State how an arbitrage can be taken, and how much arbitrage profit
available?
•
• An arbitrageur can buy the bond that is priced with the spot rates for 100 and
sell the bond priced with the DCF method for 103.546 to realize a profit of 3.546
per 100 par value.

4. Suppose that the Treasury spot rate curve is as follows:

Period Years to Maturity Spot Rate

1 0.5 5.0%
2 1.0 5.4
3 1.5 5.8
4 2.0 6.4
5 2.5 7.0
6 3.0 7.2
7 3.5 7.4
 8 4.0 7.8

Suppose that the market price of a 4-year 6% coupon non-Treasury issue is $91.4085.
Determine whether the zero-volatility spread (z-spread) relative to the Treasury spot
rate curve for this issue is 80 basis points, 90 basis points, or 100 basis points.

Solution:

The Z-spread relative to the Treasury spot rate curve is the spread that when added to all the
Treasury spot rates will produce a present value for the cash flows equal to the market price.
The present value using each of the three spreads in the question – 80, 90, and 100 basis points
– is shown below:

Period Years to Spot Rate Semiannual Cash PV at Assumed Spread (bps)

Maturit (%) Spot Rate (%) Flow 80 90 100
y
0.5 5.0 2.50 $3 $2.9155 $2.9140 $2.9126
1.0 5.4 2.70 3 2.8223 2.8196 2.8168
1.5 5.8 2.90 3 2.7216 2.7176 2.7137
2.0 6.4 3.20 3 2.6042 2.5992 2.5942
2.5 7.0 3.50 3 2.4777 2.4717 2.4658
3.0 7.2 3.60 3 2.3709 2.3641 2.3573
3.5 7.4 3.70 3 2.2645 2.2569 2.2493
4.0 7.8 3.90 103 73.5466 73.2652 72.9849
Total 91.7233 91.4083 91.0947

The last three columns in the table show the assumed spread. One-half of the spread is added to
the column showing the semiannual spot rate. Then the cash flow is discounted using the
semiannual spot rate plus one-half the assumed spread.

As can be seen, when a 90 basis point spread is used, the present value of the cash flow is equal
to the price of the non-Treasury issue, $91.4083. Therefore the Z-spread is 90 basis points.

5. Suppose that the prevailing Treasury spot rate curve is shown as below.

A. What is the value of a 7.4%, 8-year Treasury issue (semi-annual coupon payments),
discounted at the spot rates provided?

B. Suppose that the 7.4%, 8-year Treasury issue is priced in the market base on the on-the-run 8-
year Treasury yield, which is 5.65%. What is the price of this bond discounted at 5.65%?
C. Given the arbitrage-free value found in part A and the price in Part B, what action would a
dealer take and what would the arbitrage profit be if the marker priced the issue at the price
found in part B?

D. What process assures that the market price will not differ materially from the arbitrage-free
value?

Solution:

5A. The arbitrage-free value is $111.3324:

t
Period Years Spot Rate(%) Discount Factor = 1/(1+(spot rate/2))
Cash Flow PV of Cash Flow
1 0.5 3 0.985221675 3.7 3.645320197
2 1 3.3 0.967799145 3.7 3.580856836
3 1.5 3.5053 0.949211113 3.7 3.512081118
4 2 3.9164 0.925361361 3.7 3.423837035
5 2.5 4.4376 0.896078606 3.7 3.315490844
6 3 4.752 0.868582467 3.7 3.213755126
7 3.5 4.9622 0.842351884 3.7 3.116701971
8 4 5.065 0.818667644 3.7 3.029070284
9 4.5 5.1701 0.794773412 3.7 2.940661623
10 5 5.2772 0.770713212 3.7 2.851638885
11 5.5 5.3864 0.746519992 3.7 2.762123971
12 6 5.4976 0.722235611 3.7 2.672271762
13 6.5 5.6108 0.697899595 3.7 2.582228503
14 7 5.6643 0.67638688 3.7 2.502631457
15 7.5 5.7193 0.655125293 3.7 2.423963583
16 8 5.7755 0.634134353 103.7 65.75973237
Sum of PV 111.3323656

5B. The price based on a single discount rate of 5.65% is $111.1395:

Period Year Cash Flow Present Value at

2.825%
1 0.5 $3.7 $3.5983
2 1.0 3.7 3.4995
3 1.5 3.7 3.4033
4 2.0 3.7 3.3098
5 2.5 3.7 3.2189
6 3.0 3.7 3.1305
7 3.5 3.7 3.0445
 8 4.0 3.7 2.9608
9 4.5 3.7 2.8795
10 5.0 3.7 2.8004
11 5.5 3.7 2.7234
12 6.0 3.7 2.6486
13 6.5 3.7 2.5758
14 7.0 3.7 2.5051
15 7.5 3.7 2.4362
16 8.0 103.7 66.4048
Total 111.1395

5C. Dealers would buy the 7.4% 8-year issue for $111.1395, strip it, and sell the Treasury strips
for $111.3324. The arbitrage profit is $0.1929 ($111.3324 - $111.1395). The table below shows
how that arbitrage profit is realized.

Period Year Sell for Present Value at Arbitrage

2.825% Profit
1 0.5 $3.6453 $3.5983 0.0470
2 1.0 3.5809 3.4995 0.0814
3 1.5 3.5121 3.4033 0.1087
4 2.0 3.4238 3.3098 0.1140
5 2.5 3.3155 3.2189 0.0966
6 3.0 3.2138 3.1305 0.0833
7 3.5 3.1167 3.0445 0.0722
8 4.0 3.0291 2.9608 0.0683
9 4.5 2.9407 2.8795 0.0612
10 5.0 2.8516 2.8004 0.0513
11 5.5 2.7621 2.7234 0.0387
12 6.0 2.6723 2.6486 0.0237
13 6.5 2.5822 2.5758 0.0064
14 7.0 2.5026 2.5051 -0.0024
15 7.5 2.4240 2.4362 -0.0123
16 8.0 65.7597 66.4048 -0.6451
Total 111.3324 111.1395 0.1929

5D. The process of bidding up the price of the 7.4%, 8-year Treasury issue by dealers in order to
strip it will increase the price until no material arbitrage profit is available – the arbitrage-free
value of $111.3324.

6. A two-year floating-rate note pays 6-month Libor plus 80 basis points. The floater is priced at
97 per 100 pf par value. Current 6-month Libor is 1.00%. Assume a 30/360 day-count
convention and evenly spaced periods. What is the discount margin for the floater in basis
points?

Solution:
The formula for calculating discount margin is:

( Index+QM )∗FV ( Index+QM )∗FV ( Index+QM )∗FV

+ FV
m m m
PV = + + …+
Index+ DM 1 Index+ DM 2 Index+ DM 4
(1+
m
1+ ) ( m
1+ ) m ( )
( 0.01+0.008 )∗100
2
97= +
0.01+ DM 1
(
1+
2 )
( 0.01+0.008 )∗100 ( 0.01+ 0.008 )∗100 ( 0.01+0.008 )∗100
+100
2 2 2
+ +
0.01+ DM 2 0.01+ DM 3 0.01+ DM 4
( 1+
2 ) ( 1+
2
1+) 2 ( )
DM = 0.0236

7. A 365-day year bank certificate of deposit has an initial principal amount of US$96.5m and a
redemption amount due at maturity of US$100m. The number of days between settlement and
maturity is 350. What is the bond’s equivalent yield?

Solution:

Year FV −PV 365 100−96.5

AOR= ( Days)(
∗
PV
=
350 ) ( )(
∗
96.5
=3.78 %)
8. A one-year zero-coupon bond yields 4.0%. The two- and three-year zero-coupon bonds yield
5.0% and 6.0%, respectively, what is the forward rate for a one-year loan beginning in wo years?

Solution:

From the forward rate model:

[1+ r ( 3 )] 3=[1+r ( 2 ) ]2 [1+ f (1,2)]1

[1+ 0.06]3=[1+ 0.05]2 [1+ f (1,2)]1

f(1,2) = 8.029%
9. The one-year spot rate r(1)=4%, the forward rate for a one-year loan beginning in one year is
6%, and the forward rate for a one year loan beginning in two years is 8%. What is the three-
year spot rate?

Solution:
3 1 1 1
[ 1+r ( 3 ) ] =[ 1+r ( 1 ) ] [ 1+f ( 1,1 ) ] [ 1+ f ( 2,1 ) ]

3 1 1 1
[ 1+r ( 3 ) ] =[ 1+0.04 ] [ 1+ 0.06 ] [ 1+0.08 ]
So r(3) = 5.987%

10. Given the following rates:

Maturity Par Rate (YTM) Spot Rate

1 year 2.50% 2.50%
2 years 2.99% 3.00%
3 years 3.48% 3.50%
4 years 3.95% 4.00%
5 years 4.37%
For a 3-year bond with 6% annual coupon bond,

(A) Compute the five-year spot rate;

(B) What is the forward rate of a one-year loan beginning in three years?

Solution:

0.0437 0.0437 0.0437 0.0437 +100.0437

(A) 1= + + + +
( 1+2.5 % ) (1+3 % ) ( 1+3.5 % ) (1+ 4 % )4 ( 1+ r (5) )5
1 2 3

r(5) = 4.453%

(B) [1+ r ( 3+1 )]3+1=[1+r ( 3 ) ]3 [1+ f (3,1)]1

[1+ 0.04]3 =[1+0.035]2 [1+f (3,1)]1

f(3,1) = 5.514%

More on Forward Rate Model:

11. Consider a 4-yr annual coupon bond with a coupon rate of 6%, and a market price of 98.4566.
A. What is the YTM of the bond if it is held to maturity and interest rate has not been changing?
B. Assuming the spot rates today of 3%, 4%, 5%, 6%, and 7% for r(1) to r(5). Using Equation
(4) from the Book to extrapolate one-period forward rates for 1 to 4 years from today, i.e., work
out f(1,1), f(2,1); f(3,1), and f(4,1);
¿ ¿
(T +T ) T T
 Equation (4): [1+ r ( T ¿ +T ) ] =[1+r ( T ¿ ) ] [1+ f ( T ¿ ,T ) ]

C. If the bond is priced with forward rates computed above, what will be the annualized rate of
return?
D. Compare the annualized rate of return computed with the forward rates and the YTM, why
they are different?

Solutions:
11A. The YTM (= y(4) in the equation) is 6.45%, which is derived from:
6 6 106
99.4566= + +… ..+
 [1+ y ( 4 ) ] [1+ y (4)] 2
[ 1+ y ( 4 ) ]4

The YTM of 6.45% is derived assuming no default, a holding period of 4 years, and a
reinvestment rate of 6.45%.

11B. The forward rates extrapolated from spot rates are f(1,1)=5.0097%, f(2.1)=7.0289%,
f(3,1)=9.0579%, and f(4,1)=11.0952%.
With 3%, 4%, 5%, 6%, and 7% for spot rates r(1) to r(5), using Equation (4):
¿ ¿
(T +T ) T T
[1+ r ( T ¿ +T ) ] =[1+r ( T ¿ ) ] [1+ f ( T ¿ ,T ) ] to derive:
2 1 1
 [1+ r ( 2 ) ] =[1+r ( 1 ) ] [1+ f ( 1,1 ) ]
2 1 1
 [1+ 0.04] =[1+0.03] [1+ f ( 1,1 ) ]
 So f ( 1,1 ) = 5.0097% (one-year rate one year from today)

3 2 1
 [1+ r ( 3 )] =[1+r ( 2 ) ] [1+ f ( 2,1 ) ]
2 1 1
 [1+ 0.05] =[1+0.04 ] [1+ f ( 2,1 ) ]
 So f ( 2,1 ) = 7.0289% (one-year rate two years from today)

4 3 1
 [1+ r ( 4 ) ] =[1+ r ( 3 ) ] [1+ f ( 3,1 ) ]
4 3 1
 [1+ 0.06] =[1+0.05] [1+ f ( 3,1 ) ]
 So f ( 3,1 ) = 9.0579% (two-year rate one year from today)

5 3 1
 [1+ r ( 5 )] =[1+r ( 3 ) ] [1+ f ( 4,1 ) ]
5 3 1
 [1+ 0.07] =[1+ 0.06] [1+ f ( 4,1 ) ]
 So f ( 4,1 ) = 11.0952% (two-year rate one year from today)

11C. Under the forward rates as the expected reinvestment rates results in the following expected
cash flows at the end of year 5:
  With f(1,1) = 5.0097%, f(2,1) = 7.0278%, f(3,1) = 9.00579%, and f(4,1) =
11.0952% derived above:

 Total coupon and reinvestment income
 = 6(1+5.0097%)(1+7.0278%)(1+9.0579%) + 6(1+7.0278%)(1+9.0579%) +
6(1+9.0579%) + 106 = 106.9011

 Therefore, the expected bond return is (106.9011-98.4566)/98.4566=28.8904%,
and the expected annualized rate of return is 6.5504% (derived from solving
4
(1+x) = (1+0.288904)).


11D. The expected rate of return (6.5504%) is not equal to the YTM (6.45%) even if we make the
generally unrealistic assumption that the forward rates are the future spot rates.

Exercise Problems on Interest Rate Risk

12. (Interest Rate Risk)

An investor buys a 4-year, 10% annual coupon bond priced to yield 5.00%. The investor plans to
sell the bond in two years once the second coupon is received. Calculate the purchase price for
the bond and the horizon yield assuming that the coupon reinvestment rate after the bond
purchase and the YTM at the time of sale is 3.00%.

Solution: First the purchase price is 116.7298:

10 10 10 110
1
+ 2
+ 3
+ 4
=116.7298
(1+5 %) (1+ 5 %) (1+5 %) (1+5 %)
(1) At 3%, the future value of reinvested coupons is 20.300

(10x (1+3%) + 10) = 20.300

The sale price of the bond is 113.3943:

10 110
1
+ 2
=113.3943
(1+3 %) (1+ 3 %)
Total return is 20.300 + 113.3943 = 133.6843

If interest rates go down from 5% to 3%, the realized rate of return over the two-year
investment horizon is 6.5647%, higher than the original YTM of 5%:

117.7298 = 133.6943/(1+𝑟)^2 , r = 0.065647

13. An investor buys a 6% annual payment bond with three years to maturity. The bond has a
YTM of 8% and is currently priced at 94.845806 per 100 of par. What is the bond’s Macaulay
duration?

Solution:

Period Cash Flow PV Weight Period*Weight

1 6 5.555556 0.058575 0.058575
2 6 5.144033 0.054236 0.108472
3 106 84.146218 0.887190 2.661570
94.845806 1.000000 2.828617
The Macaulay duration is therefore 2.83.

14. A bond with exactly nine years remaining until maturity offers a 3% coupon rate with annual
coupons. The bond, with a YTM of 5%m, is priced at 85.784357 per 100 par value. What is the
estimated price value of a basis point for the bond?

Solution:

The formula for the price value of a basis point is:

PVBP=¿ ¿
PV 3 3 103
Where: −¿= + +…+ =85.849134 ¿
(1+4.99 %)1 (1+ 4.99 %)2 ( 1+4.99 % )
9

PV 3 3 103
+¿= + +…+ =85.719638 ¿
(1 +5.01% )1 (1 +5.01% )2 ( 1+5.01 %)
9

PVBP=¿ ¿
Alternatively, the PVBP can be derived using modified duration:

ApproxModDur=¿ ¿
PVBP = 7.547*85.784357*0.0001 = 0.06475

15. A bond has an annual modified duration of 7.140 and annual convexity of 66.200. The
bond’s YTM is expected to increase by 50 basis points. What is the expected percentage price
change?

Solution:

The expected price change is close to -3.49%. The convexity adjusted percentage price change
for a bond given a change in the YTM is estimated by:

%ΔPrice = -Modified Duration * ΔYield + 0.5*Convexity*(ΔYield)2

= -7.140*0.005 + 0.5*66.200*(0.005)2
 = -0.034873 or -3.49%

16. The Impact of Credit Migration on Expected Return (from PPP Book)
For a 10-year AAA-rated corporate bond that would have a modified duration of 7.3 at the end of the
year. Using the corporate transition matrix in Exhibit 7, show that the expected return on the bond over
the next year can be approximated by the yield to maturity less 32.55 basis points to account for a
possible credit downgrade even if there is no default.

From/To AAA AA A BBB BB B CCC/CC/ D

C
AAA 90.00 9.00 0.60 0.15 0.10 0.10 0.05 0.00
Credit 0.6 0.90 1.10 1.50 3.40 6.50 9.50
Spread

Solution: First calculate the expected percentage price change using the modified duration for the bond
and the change in the credit spread:

From AAA to AA: -7.3 x (0.90%-0.60%) = -2.19%

From AAA to A: -7.3 x (1.10%-0.60%) = -3.65%

From AAA to BBB: -7.3 x (1.50%-0.60%) = -6.57%

From AAA to BB: -7.3 x (3.40%-0.60%) = -20.44%

From AAA to B: -7.3 x (6.50%-0.60%) = -43.07%

From AAA to CCC, CC, C: -7.3 x (9.50%-0.60%) = -64.97%

Second, calculate the expected percentage change in the bond value over the year using the probabilities
in the corporate transition matrix:

(0.9000x0%) + (0.0900x-2.19%) + (0.0060x-3.65%) + (0.0015x-6.57%) + (0.0010x-20.44%)

+ (0.0010x-43.07%) + (0.0005x-64.97%) = -0.3249%

17. Calibrating a Binomial Tree

Given the following interest rates (spot rates and forward rates are derived from par rates):

Maturity Par Rate (Treasury Yield) Spot Rate Forward Rate

1 2.000% 2.000% 2.000%
2 3.000% 3.015% 4.040%
3 4.000% 4.055% 6.166%
Calibrate a binomial tree for two years.

Solution:
Time 0: The par, spot, and forward rates are all the same for the first period is a binomial tree.
Consequently, Y0=S0=F0=2.0%.

Time 1:

We need to use trial-and-error search to find the two forward rates that produce a value of 100 for the
3%, two-year bond. The lower trial rate need to be lower than the implied forward rate of 4.040%, for
instance, 3.500%. The higher trial rate would be 3.500%*(e 2+0.15) = 4.725%. These lead to a Time 0 value
for the bond of 99.936. Therefore the next stage in the procedure lowers the trial rates. Finally, the
calibrated forward rates are 4.646% and 3.442%. These are the correct rates because the value of the
bond at Time 0 is 100:

 103/1.04646 = 98.427 and 103/1.03443 = 99.572

 [3 + (0.5*98.427 + 0.5*99.572)]/(1+2%) = 100

Time 2:

The initial trial rate for the middle node for Time 2 is the implied forward rate of 6.166%. The rate for the
upper node is 8.323% (=6.166%*(e2+0.15)) and the rate for the lower node is 4.568% (=6.166%/(e 2+0.15)).
These rates for Time 2, and the already calibrated rates for Time 1, lead to a value of 99.898 for the 4%
three-year bon as of Time 0. These are not the arbitrage-free rates – the Time 2 rates need to be lowered
slightly to get the price up to 100.

The calibrated forward rates for Time 2 are 8.167%, 6.050%, and 4.482%. There are the calculations:

104/1.08167 = 96.148

104/1.06050 = 98.068

104/1.04482 = 99.538

4+(0.5*96.148+0.5*98.067)/1.04646 = 96.618

4+(0.5*98.067+0.5*99.539)/1.03442 = 99.382

4+(0.5*96.618+0.5*99.382)/1.0200 = 100.000

The calibrated arbitrage-free interest rate tree will price option-free bond correctly, including prices for
the zero-coupon bonds used to find the spot rates and, to the extent that we have chosen an appropriate
interest rate process and interest rate volatility, it will provide insights into the value of bonds with
embedded options and their risk parameters.

18. Compute the price for a 2-year, 6%, $100 face value bond which is callable after one year, at a call
price of $99.

Assuming that interest rates follow a binomial distribution for movements which could go up by a factor
of u=1.05, or down by a factor of d=0.9524 per year with 60% probability going up and 40% probability
going down. Given the current interest of 7%, what will this 2-year callable bond price be today?

Solution:
Exercise Problem on Callable Convertible Bond Price

19. A 3-year, 10% annual coupon bond has a par value of $1,000 is both callable and convertible.
The bond can be converted into 10 shares of the underlying company’s stock (so the conversion
ratio is 10 or the conversion price is $100. And the conversion value will be 10* stock price). The
bond can also be called by the issuing in years 1 and 2, at a call price of 1,100. Assuming that
the one-period forward rates will remain at 5% for the 3-year period, but the stock price could
change. The current stock price is 92 and could move up by a factor u=1.10, and could go down
by a factor of d=0.9091, based on a binomial process. Given all these information, what is the
price of the bond?

Solution:

Step 1: Based on the binomial process, project stock prices for year 1, 2 and 3:

Year 0 Year 1 Year 2 Year 3

122.45
111.32
101.20 101.20
P=92 92
83.64 83.64
76.03
69.12

Step 2: Use the backward induction method, discount the cash flows from year 3 back to year 2,
and then from year 2 to year 1, then from year 1 to year 0. For each node, decide whether the
call or conversion option or both will be exercised.

20. (Valuation of Credit Risk)

Consider a 3-year floating-rate note that pays LIBOR + 1.5% on an in-arrear basis (e.g., the
coupon payment for time t is based on the LIBOR rate at time t-1).
The bond carries a differential amount of credit risk over the years: for year 1, the annual
default probability is 10.00% (the hazard rate) and the recovery rate 30%; for the years 2 and 3,
the default probability is 5% and the recovery rate 50%.
In the valuation, interest rate volatility would have to be taken into account. The interest rate
volatility is assumed to be 10% in government bond yields over the next few years.
Compute the CVA and price of the bond without the credit risk, and then use them to calculate
the price of this floater, using the binomial interest rate tree in the following exhibit.

Notice the question requires to calculate each of the items to be included in the following table:
Year Expected LGD POD Expected PV PV of the
Exposure Credit Loss Discounting Expected
Factor Loss
1 1.002506
2 0.985093
3 0.955848
CVA=?

Solutions:
Each projected interest payment in the tree is the benchmark rate at the beginning of
the year plus 1.50% times 100. The rate is -0.25% on date 0; the “in-arrears” interest
payment on date 1 is 1.2500 (= [-0.25%+1.5%)x100]). If the rate is 2.4820% on date 2,
the payment at maturity on date 3 is 103.9820 (=[2.4820%+1.50%]x100+100).

The VND for the floater is 104.4152, calculated with the binominal interest rates:
Value in Year 2:
105.2026/1.037026 = 101.4464
104.5315/1.030315 = 101.4559
103.9820/1.024820 = 101.4637

Value in Year 1:
{[(0.5x101.4464)+(0.5x101.4559)]+3.4442}/1.019442 = 102.8949
{[(0.5x101.4559)+(0.5x101.4637)]+3.0918}/1.015918 = 102.9134

Value in year 0:

{[(0.5x102.8949)+(0.5x102.9134)]+1.2500}/0.997500 = 104.4152
Assuming:
Probability of Default of 10% for Year 1 and 5% for years 2 and 3;
Recovery Rate of 30% Year 1 and 50% for Years 2 and 3.

Year Expected LGD POD Expected PV PV of the

Exposure Credit Loss Discounting Expected
Factor Loss
1 104.5619 72.9268 10% 7.2927 1.002506 7.3114
2 104.7235 52.3615 4.5% 2.3563 0.985093 2.3212
3 104.1812 52.2810 4.275% 2.2350 0.955848 2.1363
CVA=11.7689

Items in the table are calculated as below:

Expected Exposure Calculation:

Year 3: [(0.25x105.2026) + (0.5x104.5315) + (0.25x103.9820)] = 104.5619
Year 2: [(0.25x101.4464) + (0.5x101.4559) + (0.25x101.4637)]
+ [(0.50x3.4442) + (0.5x3.0918] = 104.7235
Year 1: [(0.50x102.8949) + (0.5x102.9134] + 1.2500 = 104.1812

POD Calculation:
Year 1: POD=10%, POS=90%
Year 2: POD=5%*(1-10%)=4.5% POS = 90%-4.5%=85.5%
Year 3: POD=5%*(1-10%)*(1-5%)=4.275% POS=85.5%-4.275%=81.225%

LGD Calculation:
Year 1: LGD=104.1812*(1-30%)=72.9268
Year 2: LGD=104.7235*(1-50%)=52.3615
Year 3: LGD=104.5619*(1-50%)=52.2810

Fair value of the Floater assuming no default = 104.4152

CVA = 11.7689
Fair value of the floater with default risk = 104.4152 – 11.7689 = 92.6462