Fixed Income Securities and Analysis – II Sep 2024

Description

Fixed Income Securities and Analysis – II

September 2024 Examination

 

 

1. Following information has been given regarding the binomial tree interest rate. The bond has a par value of $100, three-year floating rate note that pays  a market reference rate (MRR).

t=0	t=1	t=2
2%	5%	8%
	2.5%	6.5%
		3%

 

Find the value of the embedded cap option if it is capped at a rate of 7%.   (10 marks)

Ans 1.

Introduction

Fixed Income Securities are debt instruments that provide investors with regular, fixed interest payments, and return the principal upon maturity. They are crucial in financial markets for both issuers, seeking to raise capital, and investors, who desire a stable income stream. The valuation and analysis of these securities are complex due to the multitude of factors influencing interest rates, such as economic conditions, monetary policy, and market sentiment. The binomial tree model is a widely used method for valuing fixed income securities, particularly those

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2. TechWave Solutions is evaluating different financing options and is particularly interested in understanding the theories of term structure of interest rates to better predict future interest rates and manage its debt portfolio. Explain the three main theories of term structure. Your manager has seen the below information in the news: “The inversion today is flatter than it was during periods in 2023. As of April 25,

2024, the yield on the 3-month Treasury bill was 5.47%. By comparison, the yield was 4.70% for the 10-year U.S. Treasury note, a 0.77% spread. The spread, or yield advantage for 3-month Treasuries over 10-year Treasuries, was as high as 1.88% in May 2023.”

Given the current downward-sloping yield curve, analyze which theory or combination of theories might best explain this shape.  (10 marks)

 

 

 

Ans 2.

Introduction

The term structure of interest rates, often depicted through yield curves, plays a crucial role in financial markets. It reflects the relationship between bond yields and their maturities, offering insights into future interest rate movements and economic expectations. For businesses like TechWave Solutions, understanding this structure is vital for making informed financing decisions and managing debt portfolios effectively. The yield curve can take various shapes—upward sloping, flat, or downward sloping—

 

3a.  Consider the following spot rates:

S1 = 8% S2 = 7% S3 = 6.5% S4 = 6%

Calculate four-years par rate.     (5 marks)

 

Introduction

Spot rates are interest rates applicable to zero-coupon bonds maturing at specific future dates. They play a crucial role in the bond market, particularly in the context of determining par rates. The par rate is the coupon rate at which a bond will trade at its face value. Calculating the par rate over multiple periods, such as four years, requires understanding the relationship between spot rates and the cash flows of a bond. In this scenario, we are tasked with determining the four-

 

 

1. TechWave Solutions is considering different types of bond options for its upcoming financing strategy. Please make a report detailing the difference between the types of the embedded options, i.e., simple options and complex options. (5 marks)

Ans 3b.

Introduction

In the bond market, embedded options are provisions included in bonds that grant either the issuer or the bondholder certain rights or flexibility. These options can significantly affect the risk and return characteristics of a bond, making them a crucial consideration for any financing strategy. TechWave Solutions, in planning its upcoming financing strategy, must understand the differences between simple and complex embedded options to make informed decisions. This report outlines the distinctions between these two categories of embedded options, highlighting their