Consider again the risk neutral tree for interest rates in Table 12.11, where there is equal risk
(a) Compute the tree for an American swaption with maturity i = 3 and strike rate c = 5.25%.
(b) Consider now a callable bond with maturity i - 3, principal = 100, and annual coupon rate = 5.25%.
(c) An investor is long the callable bond priced in the previous exercise, and is worried about prepayment risk. Can you suggest how the investor can employ an American swaption to hedge against prepayment risk? Assume the investor is not worried about interest rate risk.
(d) Assume that the investor in the callable bond is instead worried about interest rate risk. Can you suggest a hedging strategy that would cover the investor against changes in the interest rates?
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity. Coupons are usually referred to in terms of the coupon rate (the sum of coupons paid in a...
Step by Step Answer: