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FinalExam-FINE 4140 Answers Show all your work to receive full credit for the problems!

All calculations should be done with 4 decimals!


Cristina Danciulescu Tulane University Date: December 10th, 2012 Total points: 160
Problem 1. (12 points) A company enters into a short futures contract to sell 5,000 bushels of wheat for 450 cents per bushel. The initial margin is $3,000 and the maintenance margin is $2,000. a. What price change would lead to a margin call? b. Under what circumstances could $1,500 be withdrawn from the margin account? a. There is a margin call if $3,000-$2,000=$1,000 is lost on the contract. This will 1,000 = 20 cents from 450 cents to 470 happen if the price of wheat futures rises by 5 ,000 cents per bushel. ,500 b. $1500 can be withdrawn if the futures price falls by 1 = 30 cents to 420 cents 5,000 per bushel. Problem 2. (12 points) The two-month interest rates in Switzerland and the United States are 2% and 5% per annum, respectively, with continuous compounding. The spot price of the Swiss franc is $0.8000. The futures price for a contract deliverable in two months is $0.8100. What arbitrage opportunities does this create? (For this problem you do not need to calculate the prots obtained from the arbitrage opportunities.) 1

The theoretical futures price is $0.8000 e(0.050.02) 12 = 0.8040. The actual futures price is too high ($0.8100 > $0.8040). This suggests that an arbitrageur should buy Swiss francs and short Swiss francs futures. Problem 3. (12 points) It is January 30. You are managing a bond portfolio worth $6 million. The duration of the portfolio in six months will be 8.2 years. The September Treasury bond futures price is currently 108-15, and the cheapest-to-deliver bond will have a duration of 7.6 years in September. How should you hedge against changes in interest rates over the next six months? The value of a contract is 108 15 1, 000 = $108, 468.75 (i.e it is $108.46875 per 32 $100 face value and the futures contract is for $100,000 face value). The number of 6,000,000 8.2 = 59.7 Rounding to the nearest whole contracts that should be shorted is 108 ,468.75 7.6 number, 60 contracts should be shorted. The position should be closed out at the end of July. Problem 4. (26 points) Companies A and B face the following interest rates (adjusted for the dierential impact of taxes): US dollars (oating rate) Canadian dollars (xed rate) LIBOR+0.5% 5.0% LIBOR+1.0% 6.5%

Company A Company B

Assume that A wants to borrow U.S. dollars at a oating rate of interest and B wants to borrow Canadian dollars at a xed rate of interest. A nancial institution is planning to arrange a swap and requires a 50-basis-point spread. Design a swap which is equally attractive to both A and B and nets a 50-basis-point spread for the nancial institution. What rates of interest will A and B end up paying? Suppose that LIBOR=4%, then the opportunity cost table looks as follows US dollars (oating rate) Canadian dollars (xed rate) 4.5 5.0 = 0.9 = 1.11 5.0 4.5 5.0 6.5 = 0.76 = 1.3 6.5 5.0

Company A Company B

Figure 1: Problem 4

The table shows that company A has a comparative advantage in the Canadian dollar xed-rate market and company B has a comparative advantage in the U.S. dollar oating-rate market. (This may be because of their tax positions.) However, company A wants to borrow in the U.S. dollar oating-rate market and company B wants to borrow in the Canadian dollar xed-rate market. This gives rise to the swap opportunity. The dierential between the U.S. dollar oating rates is 0.5% per annum, and the dierential between the Canadian dollar xed rates is 1.5% per annum. The dierence between the dierentials is 1% per annum. The total potential gain to all parties from the swap is therefore 1% per annum, or 100 basis points. If the nancial intermediary requires 50 basis points, each of A and B can be made 25 basis points better o. Thus a swap can be designed so that it provides A with U.S. dollars at LIBOR+0.25% per annum, and B with Canadian dollars at 6.25% per annum. The swap is shown in Figure 1.

Principal payments ow in the opposite direction to the arrows at the start of the life of the swap and in the same direction as the arrows at the end of the life of the swap. The nancial institution would be exposed to some foreign exchange risk which could be hedged using forward contracts. Problem 5. (20 points) An European call option and put option on a stock both have a strike price of $20 and an expiration date in three months. Both sell for $3. The risk-free interest rate is 10% per annum, the current stock price is $19, and a $1 dividend is expected in one month. 3

a. Identify the arbitrage opportunity open to a trader. b. How much does the trader gain from the arbitrage opportunity? a. If the call is worth $3, put-call parity shows that the put should be worth 3 1 3 + 20 e0.10 12 + e0.1 12 19 = 4.50. This is greater than $3. The put is therefore undervalued relative to the call. The correct arbitrage strategy is to buy the put, buy the stock, and short the call. This costs $19. b. If the stock price in three months is greater than $20, the call is exercised. If it is less than $20, the put is exercised. In either case the arbitrageur sells the stock for $20 and collects the $1 dividend in one month. The present value of the gain to the 1 3 arbitrageur is 3 19 + 3 + 20 e0.10 12 + e0.1 12 = $1.50 at t0 (today) (or $1.536 at T (in three months)). Problem 6. (26 points) Three put options on a stock have the same expiration date and strike prices of $55, $60, and $65. The market prices are $3, $5, and $8, respectively. a. Explain how a buttery spread can be created with the respective put options. b. Construct tables showing the payo and prot from the buttery strategy. c. For what range of stock prices would the buttery spread lead to a loss? a. A buttery spread is created by buying the $55 put, buying the $65 put and selling two of the $60 puts. This costs 3 + 8 2 5 = $1 initially. b. The following tables shows the prot and payo from the strategy. Table 1: Prot from the buttery spread. Prot from Prot from Prot from rst long second long short puts putl put ST $55 ($55 ST ) $3 ($65 ST ) $8 2($60 ST ) + $10 $55 < ST $60 -$3 ($65 ST ) $8 2($60 ST ) + $10 $60 < ST $65 -$3 ($65 ST ) $8 $10 ST $65 -$3 -$8 $10 Stock price range Total prot -$1 ST $56 $64 ST -$1

c. The buttery spread leads to a loss when the nal stock price is greater than $64 (or $65) or less than $56 ( $55).

Table 2: Payo from the buttery spread. Stock price range ST $55 $55 < ST $60 $60 < ST $65 ST $65 Payo from Payo from Payo from Total rst long second long short puts payo put put $55 ST $65 ST 2($60 ST ) $0 $0 $65 ST 2($60 ST ) ST $55 $0 $65 ST $0 $65 ST $0 $0 $0 $0

Problem 7. (26 points) A stock price is currently $40. Over each of the next two three-month periods it is expected to go up by 10% or down by 10%. The risk-free interest rate is 12% per annum with continuous compounding. a. What is the value of a six-month European put option with a strike price of $42? b. What is the value of a six-month American put option with a strike price of $42? a. A tree describing the behavior of the stock price is shown in Figure 2. The up 100 10 10 and down movements are u = 100 + 100 = 1.1 and d = 100 100 100 = 0.9. This implies that S0 u = 1.1 $40 = $44, S0 d = 0.9 $40 = $36, S0 uu = 1.1 1.1 $40 = $48.400, S0 ud = 1.1 1.9 $40 = $39.600, S0 dd = 0.9 0.9 $40 = $32.400.
12 The risk-neutral probability of an up move, p, is given by p = e 1.1 = 0.6523. This 0.9 implies that 1 p = 0.3477. We then calculate fuu = max(42 48.400, 0) = $0, fud = max(42 39.600, 0) = $2.400, fdd = max(42 32.400, 0) = $9.600 The value of the European put option is given by f = e2rt [p2 fuu + 2p(1 p)fud + (1 3 p)2 fdd ] = e20.12 12 [(0.6523)2 0 + 2 0.6523 0.3477 2.400 + (0.3477)2 9.600] = $2.118. This can also be calculated by working back through the tree as shown in Figure 2. The second number at each node is the value of the European option. b. To obtain the value of the American option we need to calculate the following values: 3 fu = ert [pfuu + (1 p)fud ] = e0.12 12 [0.6523 0 + 0.3477 2.4] = $0.810 and fd = 3 ert [pfud + (1 p)fdd ] = e0.12 12 [0.6523 2.400 + 0.3477 9.600] = $4.759. Early exercise at node B implies that max(42 44, 0.810) = $0.810. Early exercise at node C implies that max(42 36, 4.759) = $6.000. 3 In this case f = ert [pfu +(1 p)fd ] = e0.12 12 [0.6523 0.810+0.3477 6.000] = $2.537. Early exercise at node A implies max(42 40, 2.537) = $2.537. Therefore the value of the American option today is $2.537. This is greater than the value of the European option because it is optimal to exercise early at node C. The value of the American option is shown as the third number at each node on the tree. 0.12 3 0.90

Figure 2: Tree to evaluate European and American put options in Problem 7. At each node, upper number is the stock price, the next number is the European put price, and the nal number is the American put price.

Problem 8. (26 points) Consider an American call option on a stock. The stock price is $50, the time to maturity is 15 months, the risk-free rate of interest is 8% per annum, the exercise price is $55, and the volatility is 25%. Dividends of $1.50 are expected in 4 months and 10 months. a. Show that it can never be optimal to exercise the option on either of the two dividend dates. b. Calculate the price of the option. 4 15 a. We have that D1 = D2 = 1.50, t1 = 12 = 0.3333, t2 = 10 12 = 0.8333, T = 12 = 1.25, r = 0.08, and K = 55. It follows that K [1 er(T t2 ) ] = 55(1 e0.080.4167 ) = 1.80. Hence, D2 < K [1 er(T t2 ) ]. Also, K [1 er(t2 t1 ) ] = 55(1 e0.080.5 ) = 2.16. Hence, D1 < K [1 er(t2 t1 ) ]. It follows that the option should never be exercised early. b. The present value of dividends is 1.5e0.33330.08 + 1.5e0.83330.08 = 2.864. (5) (4) (3) (2) (1)

The option can be valued using the European pricing formula with: S0 = 50 2.864 = 47.136, K = 55, = 0.25, r = 0.08, T = 1.25,
.136 ln( 4755 ) + (0.08 + 0.25 2 )1.25 d1 = = 0.0545, 0.25 1.25 d2 = d1 0.25 1.25 = 0.3340,
2

(6) (7)

N (d1 ) = 0.4783, N (d2 ) = 0.3692 and the call price is 47.136 0.4783 55 e0.081.25 0.3692 = 4.17 or $4.17. (8)

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