Question 1

Evaluate the following statements:

(a) If the future spot rates are expected to be lower than the current forward rates for thesame maturities, bonds are most likely to be overvalued, according to the expectationshypothesis.(5 marks)

(b) Z-spread is the spread over the Treasury spot curve that a bond would trade at if it hadno embedded option.(5 marks)

(c) If the binomial tree is correctly calibrated, it should give the same value for an option-free bond as using the spot curve (par curve) used to calibrate the tree.(5 marks)

(d) If a firm?s credit rating remains stable over time, the correlation its default probabilityover the business cycle would be reduced.(5 marks)

(e) Zero coupon bonds (ZCB) have duration equals to its maturity. Hence, ZCB?s pricesensitivity to interest rate change is the same regardless of the interest rates level. (5 marks)

Question 2 Contingent Immunisation Strategy is to invest in a bond such that: ? Its duration (Macaulay) matches the investment horizon, and ? Its present value matches the present value of the target value. Given the current available return is 6%. The required terminal value (the target liability) is$2,054.46 over a 10-year investment horizon (based on yearly compounding). Construct a bond that would immunise this target liability. Compute and verify your strategyindeed immunised the liability when the market interest rates are 3%, 6% and 9%.(20 marks) See attachment for formulas to be used

Question 3 The structure of a collateralised debt obligation (CDO) is $800 million. It consists of 4tranches:

Tranche A	60% of the structure	Coupon: Treasury Rate + 200 bps
Tranche B	20% of the structure	Coupon: LIBOR + 50 bps
Tranche C	20% of the structure	Coupon: Fixed Rate 9%
Equity Tranche	10% of the structure	-

The collateral under the structure consists of bonds with 10 years maturity and coupon 8%.

Assuming there is no default in the collateral pool and ignoring all other fees and expenses,illustrate how to calculate the bond-equivalent yield and effective yield of the equity tranche,given the 10-year Treasury rate is 4% and the LIBOR is 6.5%. (The coupons in the collateraland tranches are all semi-annually paid) (20 marks)

Question 4 Describe what securitisation is and the benefits of it. (10 marks)

Question 5

See attachments