First 3 Letters of Last Name:

Finance 100: Corporate Finance

Professor Michael R. Roberts
Quiz 3
November 28, 2007

Name:

Section:

Question Maximum Student Score

1 35

2 35

3 30

Total 100

Instructions:
• Please read each question carefully
• Formula sheets are attached to the back of the quiz
• To receive credit you must: (1) show all work, (2) clearly circle or
box your final answers, and (3) express all numeric answer with at
least 2 decimal places of precisions.
• Good luck

1
1. (35 Points) Suppose that a portfolio manager holds a portfolio that mimics the
S&P 500 Index. The current value of the portfolio as of November 1 is $99.845
million, up 20% since the beginning of the year. The S&P index is currently at
644.00 and the S&P 500 index future maturing at the end of December has a
futures price of 645.00. Assume that “quantity” of each futures contract is 250
times the index.

(a) (5 Points) Should the portfolio manager buy or sell futures contracts to
hedge against further market movements that may occur before the end of
the year?

Solution: He needs to sell futures contracts.

(b) (5 Points) What is the total value of the portfolio the manager can be
ensured of having at years end by entering into the futures contract hedge?

Solution: The manager will lock in a total value of $99.845(645/644) =

$100 million.

(c) (5 Points) How many futures contracts must he buy or sell to hedge his
entire exposure?

Solution: Each contract covers 250(645) = $161,250.

So he needs 100,000,000/161,250 = 620.16 contracts.

2
(d) (10 Points) Suppose that the S&P 500 Index declines to 635 at the end of
December. What is the value of the stock portfolio? What is the profit
or loss on the futures position? What is the combined value of the stock
portfolio and futures position?

Solution: The value of the stock portfolio is: 99.845(635/644) = 98.45

Million. The value of the futures position is: (645-635)(250)(620) = 1.55
Million. The combined value of the stock portfolio and the futures position
is $100 Million.

3
(e) (10 Points) Suppose that the S&P 500 Index increases to 655 at the end
of December. What is the value of the stock portfolio? What is the profit
or loss on the futures position? What is the combined value of the stock
portfolio and futures position?

Solution: The value of the stock portfolio is: 99.845(655/644) = 101.55

Million. The value of the futures position is: (645-655)(250)(620) = -1.55
Million. The combined value of the stock portfolio and the futures position
is $100 Million.

4
2. (35 Points) The following questions are independent of one another.

(a) (10 Points) Consider two European call option contracts (call them A and
B) on the same stock and both maturity in one year from today. Assume
that contract A has a strike price of $90 and sells for $5, while contract
B has a strike price of $110 and sells for $15. Is there an arbitrage op-
portunity? If so, explain how you would take advantage of it by clearly
describing the transactions that you would take today and how these trans-
action would lead to risk-free profit.

Solution: You want to buy option A and sell option B because the higher
the strike price, the lower the price of the call options, all else equal.
The initial transaction will generate $10 today. If the stock price is below
$90, you don’t exercise option A and the owner of option B won’t exercise
either. If the stock price is between $90 and $110 dollars, you will exercise
option A, making the difference between the stock price and the $90. The
owner of option B won’t exercise their option. If the stock price is greater
than $110, you will exercise your option and so will the owner of option
B. But for each dollar that you lose on option B, you make on option A
(plus the $20 difference in strikes).

5
(b) (5 Points) True or False: A call option and a put option on the same stock,
with the same maturity, and the same strike price will have the same prices
(or premiums).

Solution: False. This can be seen from put-call-parity.

(c) (5 Points) True or False: The owner of a European put option has the
option, but not the obligation, to sell the underlying asset for a prespecified
price on the contract maturity date.

Solution: True.

(d) (5 Points) True or False: The difference between a forward contract and a
futures contract is the payoff at maturity.

Solution: False.

(e) (5 Points) True or False: The NPV rule and the internal rate of return
(IRR) rule lead to the same conclusions when the cash flows alternate
between positive and negative each period.

Solution: False.

(f) (5 Points) True or False: When determining the relevant cash flows for the
NPV rule, one should ignore all sunk costs.

Solution: True.

6
3. (30 Points) The following questions are independent of one another.

(a) (15 Points) Derive the formula for the forward price on a stock using the
replicating portfolio approach used in class. Take care to show all of the
cash flows, their timing, and the corresponding transactions. I suggest you
use a table as we have done in class.

Solution:

Time

Transaction 0 T

Buy Forward 0 ST − F

Buy Stock −S0 e−dT ST

Borrow (Short Bond) F e−rT −F

Replicating Portfolio F e−rT − S0 e−dT ST − F

No arbitrage implies:

F e−rT − S0 e−dT = 0 =⇒ F = S0 e(r−d)T

7
(b) (15 Points) Derive the put-call parity relationship using the replicating
portfolio approach used in class. Take care to show all of the cash flows,
their timing, and the corresponding transactions. I suggest you use a table
as we have done in class.

Solution:

ST < K ST ≥ K

Transaction 0 Maturity

Buy Call -C 0 ST − K

Buy Stock −S0 e−dT ST ST

Borrow (Short Bond) Ke−rT −K −K

Buy Put −P K − ST 0

Replicating Portfolio −P + Ke−rT − S0 e−dT 0 ST − K

No arbitrage implies:

−C = −P + Ke−rT − S0 e−dT