CHAPTER 18 INTEREST RATE DERIVATIVES

1. Write down the problem we must solve in order to value a puttable bond. The puttable bond satises 2V V V + 1 w2 2 + (u w) rV = 0, 2 t r r with V (r, T ) = 1, and
+ V (r, tc ) = V (r, tc ) + Kc ,

across coupon dates. If the bond can be sold back for an amount P (t) then we have the constraint on the bonds value V (r, t) P (t), together with continuity of V /r. 2. Derive a relationship between a oorlet and a call option on a zero-coupon bond. A oorlet has the following cashow max(rf rL , 0). This is received at time ti but the rate rL is set at ti1 , and = ti ti1 . This cashow is exactly the same as the cashow max(rf rL , 0) 1 + rL received at time ti1 . We can rewrite this cashow as max But 1 + rf 1 + rL 1 + rf 1, 0 . 1 + rL

102

INTEREST RATE DERIVATIVES

is the price at time ti1 of a bond paying 1 + rf at time ti . We can conclude that a oorlet is equivalent to a call option expiring at time ti1 on a bond maturing at time ti . 3. How would a collar be valued practically? What is the explicit solution for a single payment? A collar is equivalent to long a cap and short a oor. Market practice gives the explicit value of a caplet as er
(t i t)

F (t, ti1 , ti )N(d1 ) rc N(d2 ) ,

where F (t, ti1 , ti ) is the forward rate today between ti1 and ti , r is the yield to maturity for a maturity of ti t, log(F /rc ) + 1 2 (ti ti1 ) d1 = and d2 = d1 ti ti1 . 2 ti ti1 is the volatility of the (three-month) interest rate. Similarly, the explicit value of a oorlet is er where log(F /rf ) + 1 2 (ti ti1 ) and d2 = d1 ti ti1 . d1 = 2 ti ti1 The explicit solution for a single collar payment is therefore er
(t i t) (t i t)

F (t, ti1 , ti )N(d1 ) + rf N(d2 ) ,

F (t, ti1 , ti )N(d1 ) rc N(d2 )

(t i t)

er = er = er
(t

F (t, ti1 , ti )N(d1 ) + rf N(d2 )

i t)

F (t, ti1 , ti )N(d1 ) rc N(d2 )

+ F (t, ti1 , ti )N(d1 ) rf N(d2 )

(t i t)

F (t, ti1 , ti )(N(d1 )

+ N(d1 )) rc N(d2 ) rf N(d2 ) . 4. When an index amortizating rate swap has a lockout period for the rst year, we must solve V 2V V + 1 w2 2 + (u w) rV = 0, 2 t r r with jump condition V (r, P , ti ) = V (r, g(r, i)P , ti+ ) + (r rf )P ,

INSTRUCTORS MANUAL 103

where g(r, i) = 1 if ti < 1, and with nal condition V (r, P , T ) = (r rf )P . In this case, reduce the order of the problem using a similarity reduction of the form V (r, P , t) = P H (r, t). We set V (r, P , t) = P H (r, t), then H V =P , t t V H =P , r r and 2V 2H =P 2 . r 2 r Substituting into the partial differential equation for V , we nd H 2H H + 1 w2 2 + (u w) rH = 0. 2 t r r The jump condition becomes H (r, ti ) = g(r, i)H (r, ti+ ) + (r rf ), and the nal condition becomes H (r, T ) = r rf . 5. Find the approximate value of a cashow for a oorlet on the one month LIBOR, when we use the Vasicek model. The yield curve is given, for small maturities, by log Z r + 1 (u w)(T t) + . . . as t T . 2 T t For the Vasicek model with one month Libor, we nd rL r + 1 ( r)(1/12). 2 A oorlet cashow therefore has approximate value max(rf rL , 0) max rf r 1 ( r), 0 . 24