Page 1 You need to take two bond issuers, A who is regarded as riskless and B who is more risky. You can chose A and B. You may wish to take two sovereigns (eg Germany and Greece, or the USA and Brazil) or two corporates (one AA or AAA rated, one sub-investment grade). What you need is that both issuers have several plain vanilla, fixed rate bonds in issue, issued in the same currency, whose prices you know on one particular date. I want you to do the following 1. Estimate the term structure of interest rates for both issuers. 2. Estimate the difference in forward rates between the two issuers (the spread). 3. Comment on the spread. Discuss the reliability and accuracy of the methods you have used to estimate the spread. Discuss whether the spread reflects the way that the short term spread between the two issuers is likely to evolve in the future. 4. Design and evaluate a trading strategy that is based on a specific (and plausible) view about the evolution of the spread. Your write up should be no more than 3000 words. You should state where you got your data from and explain your computations in sufficient detail that I could, if I wanted to, replicate your recipe and come to the same answer. As you will observe, you have a lot of flexibility in deciding what markets you want to look at and how many bonds you take for each issuer. For the exercise to work, you will need at least four bonds for each issuer, and you will need to make sure that the longest dated bonds have similar maturities for each issuer. If you are unsure about whether the issuers you have chosen are suitable, please feel free to consult me, saying why you are interested and what your worries are. The basic objective is to show that you can use take the techniques you will have learnt on this module to prices in the market and use them to draw interesting conclusions about the markets view of risks, or about trading strategies. The way I will mark your assignment is as follows: technical aspects (computation of term structures): is your methodology clear? have you applied it correctly? are your term structures consistent with the bond prices you have? (50%) realism: given the liquidity of the market and the precision of the price data you have, do you understand how precise your numbers are? are you making effective use of all the information you have? are you aware of factors that may be distorting your conclusions? (25%) interpretation: are you using the data from the term structure in an effective way to get insight into the spread between the two markets? Are your conclusions plausible and interesting? (25%) The deadline for the assignment is Wednesday 14 November. The basic material you will need will come in the first four weeks of term (Lecture 1-4), so you can start quite soon, and you may well choose to hand in well before the deadline. You will not have covered credit risk that comes in the last couple of weeks, but that should not matter. Having thought about some of the issues by doing the assignment will actually help you when we come to learn more formally about credit risk.
You need to take two bond issuers
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