DAUPHINE UNIVERSITY MARCH 2022

MASTER 203 - M2 - Fixed Income II

Hafid AGOUZOUL

Duration 2 hours - Lecture notes and calculators NOT allowed.

We will use the following notations:

ˆ F (t, Ts , Te ) := Forward fixed at time t for the period [Ts , Te ]

ˆ S(t, Ts , Te ) := Swap rate at time t for a swap spanning over the period [Ts , Te ]
∫t
ˆ rt := Short rate at time t; βt := exp( 0 rs ds) the bank account numeraire and Qβ the
probability measure associated to it.

ˆ B(t, T ) := Price at t of a Zero-Coupon bond with maturity T and QT the probability

measure associated to it.

ˆ F F X(t, T ) := The forward FX observed at time t for an exchange at maturity T .

Please start with Exercise 0 - we will use its results in the other sections

Exercise 0. Preliminary results - Black Model

Black model is a version of the Black-Scholes model adapted to deal with forward underlying
assets (in practice, it could be forward equity price, forward IBOR or forward wap rate). The
goal of this exercise is to derive analytical formula for pricing options on a forward asset using
Black model.

Let’s assume that a forward process Xt follows the SDE diffusion (under some probability
measure Q):

dXt
= σL ∗ dWtQ
Xt
with initial value X0 > 0.

(1) Derive the value of XT

(2) Derive the value of EQ (XT − K)+ where K is a positive number. From now on, we will
denote this value by BSC (X0 , K, T, σL )

(3) We assume that K = X0 . Derive the exact formula of BSC (X0 , X0 , T, σL ) and propose
an approximation for it.

Assuming now that Xt follows the ”Normal Black” SDE diffusion (under some probability
measure Q):

dXt = σN ∗ dWtQ

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(4) Derive the value of XT

(5) Derive the value of EQ (XT − K)+ where K is a positive number. From now on, we will
denote this value by N BSC (X0 , K, T, σN )

(6) We assume that K = X0 . Derive the exact formula of N BSC (X0 , X0 , T, σN ) and propose
an approximation for it.

(7) Through comparing results from questions (3) and (6), derive the relationship between σN
and σL for an ATM option.

Exercise 1. Around FX

We consider a FX currency pair FOR/DOM.

(1) Recall the definition (not the formula) of the FX forward F F X(0, T ) observed today for
maturity T ?

(2) Derive using non-arbitrage arguments the formula that gives the FX Forward as a function
of the FX Spot, the domestic and foreign rates.

(3) We assume that the 1y DOM rate is Rd and 1y FOR rate is Rf .

3-1 Briefly remind the definition of FX swap points.

3-2 Derive the formula for the 1Y Swap points as a function of the rates?
3-3 Under which condition, the pair would be considered trading at a discount?

(4) We would like to offer one our clients a hedge in 1Y against the increase of the FX beyond
a level K under the following 3 scenarios:

4-1 Forward format: What would be the price of such product?

4-2 Call option: What would be the price of such product asssuming the FFX
follows a Black model with a volatility σL ?
4-3 Up and out Call option: We sell the client a call option that will be active
as long as the FX is below a certain barrier level B > K. If the FX expires
above B, the client will not get anything. What would be the price of such
product asssuming the FFX follows a Black model with a volatility σL ?
4-4 How do the above prices compare to each other?

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 Exercise 2. Around IR Forwards

(1) We would like to derive the price of the following product: we receive at T +δ the following
payout: δ ∗ F (T, T, T + δ) (i.e. fixed at the beginning of the period and paid at the end of
the period).

1-1 We define the forward Zero-Coupon B(t, T, T + δ) as the value at time t, of

the amount to pay at T to get one unit (e.g. 1$) at T + δ.

Using non-arbitrage arguments, prove that:

1 B(t, T )
=
B(t, T, T + δ) B(t, T + δ)

then deduce that:

( )
1 1
F (t, T, T + δ) = −1
δ B(t, T, T + δ)

1-2 Show that the process F (., T, T + δ) is a martingale under QT +δ . Deduce

today’s price for the considered product.
1-3 We assume that the forward rates are positive. Explain why the diffusion of
the process F (., T, T + δ) can be written as

dF (t, T, T + δ)
= σt ∗ dWtQ
T +δ

F (t, T, T + δ)

with σt being a volatility function.

(2) In this question, we assume that the forward rate follows the SDE:

dF (t, T, T + δ)
= σ ∗ dWtQ
T +δ

F (t, T, T + δ)

2-1 We now consider the Caplet that pays at T + δ the following payoff: δ ∗
[F (T, T, T + δ) − K]+ for a pre-defined K.
Using previous results, write today’s Caplet price as an expectation under Qβ
and then under QT +δ .
2-2 Using results from Exercise 0, derive a closed form formula for the price of
that Caplet.

(3) We now consider the following Libor-In-Arrears (L.I.A) that pays at T the following payoff:
δ ∗ F (T, T, T + δ) (i.e. fixed and paid at the same time).

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3-1 Prove that under QT +δ , today’s price of this product can be written as:
T+δ
δ ∗ B(0, T + δ) ∗ F (0, T, T + δ) + δ 2 ∗ B(0, T + δ) ∗ EQ (F 2 (T, T, T + δ)).

Compare this result to question [1-2] and comment.

T+δ
3-2 In what follows, we will try to derive a model-free value for the term EQ (F 2 (T, T, T +
δ)).

3-2-1 Prove that ∀F ∈ R, the following equality holds:

∫
F 2 = 2 ∗ (F − K)+ dK
R

3-2-2 Deduce a pricing formula for the considered Libor-In-Arrears.

Comment the result.

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 Exercise 3. Part I: Swap and Swaptions

We consider a vanilla swap exchanging fixed rate against Libor. The swap starts at T0 and ends
at Tn with the following schedule (T0 , T1 , ..., Ti , Ti+1 , ..., Tn ). We assume that ∀i, Ti+1 − Ti = δ.

K K K

T0 T1 TN-1 TN

F(T0,T0,T1) F(TN-2,TN-2,TN-1) F( F(TN-1,TN-1,TN)

(1)
1-1 Express the value of the floating leg and the fixed leg using the (B(t, Ti ))i and
then deduce the swap par-rate: S(t, T0 , Tn )
1-2 Explain why the swap rate is a martingale under QLV L measure.
Going forward, we assume that δ = 1 and that the swap rate follows the SDE:

dS(t, T0 , Tn )
= σ ∗ dWtQ
LV L

S(t, T0 , Tn )

(2) Let us now consider a physical payer swaption written on the previous swap with strike
K and maturity Tex = T0

2-1 Briefly remind the definition of such swaption

2-2 What’s the payoff of such swaption seen from Tex ?
2-3 Deduce the price expressed in terms of expectation under QTex and then under
QLV L .
2-4 Derive a closed form formula for the swaption price.

Exercise 3. Part II: HJM Framework - Ho-Lee model

We place ourselves in a HJM framework. The target of this exercise is to value vanilla rate
options in a Ho-Lee model.
We assume that:

dB(t, T )
= rt dt + Γ(t, T )dWt
B(t, T )
where (Wt ) is a brownian motion under Qβ et Γ(t, T ) is a deterministic function.

(3) Derive the value of B(t, T ) under Qβ .

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(4) We define B(t, T1 , T2 ) the forward Zero-Coupon as the value at time t, of the amount to
pay at T1 to get one unit (e.g. 1$) at T2 .

4-1 Using non-arbitrage arguments, prove that:

B(t, T2 )
B(t, T1 , T2 ) =
B(t, T1 )

4-2 Explain why B(t, T1 , T2 ) is a martingale under QT1

4-3 Derive the formula of B(t, T1 , T2 ) under Qβ .
4-4 Derive the formula of B(t, T1 , T2 ) under QT1 .
4-5 What is the diffusion of B(t, T1 , T2 ) under QT1 .

(5) For the rest of this exercise, we place ourselves under the Ho-Lee model which is part of
the HJM family of models. In this model, Γ(t, T ) = σ ∗ (T − t) where σ is a constant.

5-1 We consider a caplet with strike K that pays at T2 : (T2 − T1 ) ∗ (F (T1 , T1 , T2 ) −

K)+ . Derive a closed form formula for today’s price of the above caplet using
σ.
5-2 We consider a receiver swaption with strike K with expiry Tex written on
a swap starting at Tex = T0 and ending at TN , with a frequency of δi (the
difference between 2 payments on the fixed leg).

5-2-1 Show that the payoff of such swaption seen from T0 can be written
as:

∑
N
( ai B(T0 , Ti ) − B(T0 , T0 ))+
i=1

with
{
ai = δi ∗ Kfor i=1,...,N-1
aN = 1 + δN ∗ K
5-2-2 What’s the price of such swaption under QT0 measure?
∑ B(t,Ti )
5-2-3 We denote Ht = N i=1 ai B(t,T0 )

Write the diffusion of Ht under the QT0 measure.

5-2-4 Assume that we approximate all the B(t, Ti ) in the diffusion of
Ht by their forward value B(0,T i)
B(0,t) , what’s the new formula of the
Ht diffusion?
5-2-5 Using the previous approximation, derive a formula for the swap-
tion pricing under the Ho-Lee model.

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