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MSc Financial Risk and Investment Analysis
Interest Rates Sensitive Instruments � Course Work # 1
Week V � 17 October 2016
� Answer all questions in this exercise set.
� The deadline for submitting your work is 4pm, Monday 17th October 2016.
� Submit a printed copy of your document with a one-page snapshot of your Excel worksheet(s) and answers to any theoretical questions at the school office by the deadline.
� Upload the Excel file on the module�s Study Direct site by the deadline.
� Late submissions will be treated according to university regulations.
� Please note that this is NOT a group exercise.
Section A
1. Bond Pricer:
(a) Construct an Excel spread-sheet that uses the input variables below:
� Trade Date
� Spot Rate Curve
� Coupon Rate
� Coupon Frequency (semi-annual or annual) � Maturity (up to 10 years)
� Price
to compute the following:
(i) the Yield to Maturity (YtM),
(ii) the Current Yield, and
(iii) the Accrued Interest as of any date between the Trade Date and the next Coupon Date.
You may use the built-in Excel function to calculate the Yield to Maturity.
[ 3.5 marks ] /Turn over
762N1 Interest Rates Sensitive Instruments Course Work # 1 (b) Verify the accuracy of the yield to maturity computed in (a) by recalculating the bond
2. (a)
� You may assume a spot rate curve of your choice by downloading a curve from Reuters (or Bloomberg) or assuming realistic values. Hint: It would be easier to use a curve with data points every 6 months, i.e., 6m, 1y, 1.5y, 2y, …, 10y.
� Marks will also be awarded for the implementation style.
Build another sheet to plot the relationships between the following variables:
price as a sum of discounted cash-flows.
Notes:
[ 1 mark ] � Price vs Maturity
� Price vs Coupon Rate
� Price vs Yield to Maturity
[ 2 marks ] (b) Describe in your own words, by providing at least one reason on why you agree with the observed behaviour of the bond price against each of the above variables.
[ 1 mark ] Section B
3. Fixed income securities are affected by various types of risks such as: interest rate risk, yield curve risk, call & reinvestment risk, credit/default risk, liquidity risk, inflation risk, volatility risk, event risk and sovereign risk.
Pick any three types of risks from the above list and for each of those:
(a) describe the risk and discuss how it affects fixed income securities; and
[ 3 marks ] (b) discuss the case of at least one financial institution (such as hedge-funds, banks, brokers etc) that suffered huge losses or went bankrupt due to factors that can be attributed to that specific risk type.
Note 1: Essay Guidelines
[ 4.5 marks ] Your essay should clearly demonstrate analytical, critical and evaluative skills. Evidence is expected of a reasonable background of reading and research, without which above average grades are unlikely. All references should be acknowledged (see Library handout on reference styles; Harvard approach is strongly recommended). Good standards of written English and presentation are expected and marks will be deducted if such standards are not met.
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762N1
Interest Rates Sensitive Instruments Course Work # 1
� You don�t have to include a separate introduction and conclusion.
� Clearly describe how each of the chosen risks affect bond prices/yields.
� You may want to use historical market data, tables, formulae and/or charts to support your answer. For instance, you can show how volumes are low for instruments with high bid-ask spread (liquidity risk); or you can draw the price-yield curve to demonstrate their inverse relationship (interest rate risk).
� Few popular examples of institutions that traded fixed-income securites and became bankrupt or suffered heavy losses are: LTCM, Lehman brothers, Orange County, Daiwa banks, Kidder Peabody, Dexia Bank, Cuyahoga County (Ohio), Merrill Lynch. Please note that this list is not exhaustive and you are free to pick an institution of your choice.
� Support your examples with timelines and facts.
� Try to avoid using the same financial institution as an example for more than one risk
type unless their losses can be strongly attributed to each of those risk types.
� Briefly describe the Fixed-Income trading strategies, employed by the financial institu- tions, that led to such losses. For example, you could discuss about the convergence trades that LTCM put on or the leveraged investment that Orange County did.
Note 2: Word Indication
The essay should be typed on A4 paper, Times New Roman, 12 point font, aligning text to both left and right margins, 1.5 spacing and should be no more than 1,000 words, excluding the reference page(s), bibliography and appendices (if applicable).
Marks will be deducted for excessively short or lengthy essays. Separate word counts should be displayed on the opening cover the coursework. Please keep a copy of the essay for your own records.