Question

Suppose that the risk-free yield curve is flat at $8 \%$ (with continuous compounding). The payoff from a derivative occurs in 4 years. It is equal to the 5 -year rate minus the 2 -year rate at this time, applied to a principal of $$\$ 100$$ with both rates being continuously compounded. (The payoff can be positive or negative.) Calculate the value of the derivative. Assume that the volatility for all rates is $25 \%$. What difference does it make if the payoff occurs in 5 years instead of 4 years? Assume all rates are perfectly correlated.

   Suppose that the risk-free yield curve is flat at $8 \%$ (with continuous compounding). The payoff from a derivative occurs in 4 years. It is equal to the 5 -year rate minus the 2 -year rate at this time, applied to a principal of $$\$ 100$$ with both rates being continuously compounded. (The payoff can be positive or negative.) Calculate the value of the derivative. Assume that the volatility for all rates is $25 \%$. What difference does it make if the payoff occurs in 5 years instead of 4 years? Assume all rates are perfectly correlated.
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Options, Futures, and Other Derivatives
Options, Futures, and Other Derivatives
John C. Hull 10th Edition
Chapter 30, Problem 11 ↓

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Given that the payoff is based on the difference between the 5-year rate and the 2-year rate, we're essentially dealing with a bet on the shape of the yield curve in the future. Since all rates are perfectly correlated and have the same volatility, we can simplify  Show more…

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Suppose that the risk-free yield curve is flat at $8 \%$ (with continuous compounding). The payoff from a derivative occurs in 4 years. It is equal to the 5 -year rate minus the 2 -year rate at this time, applied to a principal of $$\$ 100$$ with both rates being continuously compounded. (The payoff can be positive or negative.) Calculate the value of the derivative. Assume that the volatility for all rates is $25 \%$. What difference does it make if the payoff occurs in 5 years instead of 4 years? Assume all rates are perfectly correlated.
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