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FINA0804/3323 Fixed Income Securities

Dr. Huiyan Qiu

Homework Assignment #3
Due: October 24, Monday, drop in TAs box by 6PM

1. Consider a convertible bond as follows:


par value = $1,000; coupon rate = 9.5%
market price of convertible bond = $1,000
conversion ratio = 37.383
estimated straight value of bond = $510
yield to maturity of straight bond = 18.7%
Assume that the price of the common stock is $23 and that the dividend per share is $0.75
per year.
a. Calculate each of the following (1) conversion value, (2) market conversion price,
(3) conversion premium per share, (4) conversion premium ratio, and (5) premium
over straight value.
b. If the price of the common stock increases from $23 to $46.
1) What will be the approximate return realized from investing in the convertible
bond?
2) What would be the return realized if $23 had been invested in the common
stock?
3) Why would the return on investing in the common stock directly be higher
than investing in the convertible bond?
c. If the price of the common stock declines from $23 to $8.
1) What will be the approximate return realized from investing in the
convertible bond?
2) What would be the return realized if $23 had been invested in the common
stock?
3) Why would the return on investing in the convertible bond be higher than
investing in the common stock directly?
2. An investment banking firm purchases $100 million of a 10-year (fixed-rate) 8% coupon
bond in the secondary market.
(a) The firm issues $50 million of floaters and $50 million of inverse floaters. (The most
popular split of floaters and inverse floaters is 50/50.) If the current short-term
interest rate in the market is 5.75%, and this is paid on the floating-rate debt, how
much coupon interest will be paid on the inverse floaters over the next 6-month
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FINA0804/3323 Fixed Income Securities

Dr. Huiyan Qiu

period? What is the coupon interest rate on the inverse floaters?


(b) Answer the above two questions now assuming that the firm issues $75 million of
floaters and $25 million of inverse floaters.
3. Following is a binomial interest rate tree. All rates given are one year spot rates and riskneutral probability is 50%. Consider a 3-year floating rate note with annual coupon rate
set to equal to the 1-year interest rate plus 1%. What is the price of the 3-year floating
rate note? Assume $1,000 par value.

4. Following table provides the information on the effective annual spot rates.
Maturity

0.5

1.5

2.5

3.5

4.5

5.5

Spot Rate
(%)

3.53 3.44 3.25 3.69 3.78 3.89 3.90 3.98 4.10 4.12 4.20 4.25

a. What are the six-month forward rates (effective annual number) for each period?
Use excel to draw the spot rate curve and the forward curve.
b. What is the price of a forward contract in which a 3-year 6% coupon bond will be
delivered in year 3? Assume coupon is paid semiannually with $3 per payment and
assume $100 par value.
c. Suppose one year later, all spot rates increase by 10 basis points, what is the market
value of the above forward contract then?
5. Suppose that bond ABC is the underlying asset for a futures contract with settlement six
months from now. You know the following about bond ABC and the futures contract: (1)
In the cash market ABC is selling for $80 (par value is $100); (2) ABC pays $8 in coupon
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FINA0804/3323 Fixed Income Securities

Dr. Huiyan Qiu

interest per year in two semiannual payments of $4, and the next semiannual payment
is due exactly six months from now; and (3) the current six-month interest rate at which
funds can be loaned or borrowed is 6% (annual number).
a. What is the theoretical futures price?
b. What action would you take if the futures price is $83?
c. What action would you take if the futures price is $76?
d. Suppose that the borrowing rate and lending rate are not equal. Instead, suppose
that the current six-month borrowing rate is 8% and the six-month lending rate is 6%.
What is the boundary for the theoretical futures price?
e. Suppose that bond ABC pays interest quarterly instead of semiannually. If you know
that you can reinvest any funds you receive three months from now at 1% for three
months, what would the theoretical futures price for six-month settlement be?

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