CT8 2017 September Q9

[Priyanshi Bhansali]

Here, in the second and the third bit, the marks allotted are quite a lot for finding interest on a zero coupon bond and then subtracting risk free rate from it. So, it this the right procedure for it, or is the solution different.

Following the above steps, the interest on zero coupon bonds is 5.258% (continuously compounded) and the credit spread is 3.25%.

Is that the correct solution?

(Screenshots of the question attached)

 

[Steve Hales]

Hi
The required approach is exactly as you've described it.
Well done
Steve

 

[Priyanshi Bhansali]

Hi
The required approach is exactly as you've described it.
Well done
Steve

Thank you for the reply.
Also, in Q6 (which asks for the expression of a derivative in a Black Scholes market in terms of an expectation under the risk neutral measure), part (i), since we aren't given the specifics of the derivative will it be appropriate to use the formula for price of a derivative under the risk neutral measure and indicate St (in the payoff) follows geometric Brownian motion?

 

[Steve Hales]

Almost. The general risk-neutral pricing formula doesn't require the underlying to follow geometric Brownian motion, it's just convenient when it does so that we can actually calculate the expectation.