ECONOMIC

ACT 2020, MIDTERM #1 AND FINANCIAL APPLICATIONS FEBRUARY 8, 2007 HAL W. PEDERSEN

You have 70 minutes to complete this exam. \\Then the invigilator instructs you to stop writing you must do so immediately. If you do not abide by this instruction you will be penalised. All invigilators have full authority to disqualify your paper if, in their judgement, you are found to have violated the code of academic honesty. Each question is worth 10 points. Provide sufficient reasoning to back up your answer but do not write more than necessary. This exam consists of 8 questions. Answer each question on a separate page of the exam book. Write your name and student number on each exam book that you use to answer the questions. Good luck!

Question 1. Bill and Jim enter into a binding contract involving the exchange of an asset in nine months time. The current market price of the asset is $100. The continuously compounded interest rate is r = 0.045. The contract calls for Jim to sell the asset to Bill at that time at a price G that is set today. The price G is set so that a fair valuation of the contract requires Jim to pay Bill $2.20 today. If the price of the asset in nine months time is $98 what is Jim's total profit or loss at the time the asset is sold? Question 2. John has just purchased a home for $200,000. The insurance policy will
cover any losses due to fire subject to a deductible of $10,000. The one-year premium on the insurance policy is $3,000 which is due at the start of the policy year.

(1) [5 points] Let NI denote the market value of John's home at the end of the policy
year.1 Draw a chart of the net value of John's home and insurance policy versus AI at the end of the policy year. Assume r = 0 for simplicity. (2) [3 points] Explain in what sense there is a put option implicit in this transaction, possibly drawing an appropriate chart. (3) [2 points] Explain in what sense there is a call option implicit in this transaction, . possibly drawing an appropriate chart.

llf there is a devastating fire the market value of John's home could be close to zero. If there is no fire and the real estate market soars then the market value of John's home could be more than John's purchase price of $200,000.

ACT 2020 - r.I1DTERM

#1

and has an investment horizon of six months. The current market price of one share of XYZ Corporation is $25. Your client is considering writing one European call option on XYZ Corp. that expires in six months. The market price of an at-the-money European call option expiring in six months is $2.35. The market price of a European call with a strike price of $27.50 expiring in six months is $1.35. (1) [3 points] Draw a chart showing the total profit at the end of six months from holding one share of XYZ Corporation and writing one at-the-money European call option expiring in six months as a function of the XYZ Corporation share price in six months time. (Your chart should provide numerical values identifying the key parts of the chart as was done in class.) (2) [4 points] Draw a chart showing the total profit at the end of six months from holding one share of XYZ Corporation and writing one European call with a strike price of $27.50 expiring in six months as a function of the XYZ Corporation share price in six months time. (Your chart should provide numerical values identifying the key parts of the chart as was done in class.) (3) [3 points] What is the greatest possible total return at the end of six months from holding one share of XYZ Corporation and writing one European call with a strike price of $27.50 expiring in six months?

Question 3. Your client currently owns one share of XYZ Corporation

Question 4. Assume that you open a 100 share short position in Jiffy Inc. common
stock at the bid-ask price of $32.00 - $32.50. When you close your position the bid-ask prices are $32.50 - $33.00. If you pay a commission rate of 0.5%, calculate your profit or loss on the short investment?

product that guarantees the return of 85% of the investor's capital at the end of 5 years. The continuously compounded interest rate is r = 0.05. The index underlying the structured product is currently at 1200 (i. e. So = 1200). The current market price of one at-the-money European call on the underlying index expiring in 5 years is $350. (1) [5 points] Assuming that the Federated Bank of Canada charges the investor nothing for this contract (i.e. the haircut is zero), compute the participation rate for the structured product. (2) [5 points] Assume that the Federated Bank of Canada tells the investor that after their fee is applied the investor's total return for the five year investment horizon has the profile R = -0.15 + 0.9875 (R1NDEJ+. As in class, RINDEX denotes the total return on the underlying index for the five-year period. What has the investor been charged for this product as a percentage of their initial investment?

Question 5. The Federated Bank of Canada is offering a structured

ACT 2020 - MIDTERM

#1

Question 6. The continuously compounded interest rate is r = 0.08. The market price of a European put option on a market index that expires in 4 months is $93.39348. The current level of the market index is 1100 and the strike level on the put option is 1200. What is the price of a European call option on a market index that expires in 4 months with a strike level of 1200?

Suppose the 6-month $1,200-strike S&R index put option trades at a bid of $72.97 and at an ask of $74.44. Suppose you can enter into an S&R index forward contract for $1,260. The 6-month effective interest rate is 5%. Draw, in the same diagram, the profit for a short put and a long forward position. At what price is the profit of the put option the same as the profit of the forward contract? If the index level is higher than the threshold you calculated, which instrument (put or forward) makes more money? .

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Suppose the stock price is $40 and the effective annual interest rate is 8%. Draw payoff and profit diagrams for the following options: a. 35-strike put with a premium of $1.53. b. 40-strike put with a premium of $3.26. c. 45-strike put with a premium of $5.75.

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(b) We need to solve (remember that we rece~ve the proceeds from the sale of the put option, and can earn interest on them): $72.97 x (l + 0.05) = Sr - $1,260 ~ Sr = $1,336.62

Our profit from the sold put option is capped at the initial premium, plus interest, that we receive. Therefore, to the right of the threshold, we earn more profit with the long forward contract.

In order to be able to draw profit diagrams,

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we need to find the future values of the put premia.

a) b) c)

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Intuitively, whenever the 35-strike put option pays off (i.e., has a payoff bigger than zero), the 40-strike and the 35-strike options also payoff. However, there are some instances in which the 40-strike option pays off and the 35-strike options does not. Similarly, there are some instances in which the 45-strike option pays off, and neither the 40-strike nor the 35-strike payoff. Therefore, the 45-strike offers more potential than the 40- and 35-strike, and the 40-strike offers more potential than the 35-strike. We pay for these additional payoff possibilities by initially paying a higher premium. It makes sense that the premium is increasing in the strike price.