LBS Institute of Management, Delhi

Post Graduate Diploma in Management (PGDM): 2012-14 Trimester-IV Course: Financial Derivatives Due Date: Sept 7, 2013

Assignment Q1.

Suppose that US $ and British spot and forward exchange rates are as follows: Spot 90-day forward 180-day forward 2.0080 2.0056 2.0018

What opportunities are open to an arbitrageur in the following situations? a. A 180-day European call option to buy 1 for $1.97 costs 2 cents. b. A 90-day European put option to sell 1 for $2.04 costs 2 cents.

Q2.
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. What price change would lead to a margin call? Under what circumstances could $1,500 be withdrawn from the margin account?

Q3.
The standard deviation of monthly changes in the spot price of live cattle (in cents per pound) is 1.2. The standard deviation of monthly changes in the futures price of live cattle for closest contract is 1.4. The correlation between the futures price changes and the spot price changes is 0.7. It is now October 15. A beef producer is committed to purchasing 200,000 pounds of live cattle on November 15. The producer wants to use the December live-cattle futures contracts to hedge its risk. Each contract is for the delivery of 40,000 pounds of cattle. What strategy should the beef producer follow?

Q4.
A stock is expected to pay a dividend of $1 per share in 2 months and in 5 months. The stock price is $50, and the risk-free interest rate is 8% per annum with continuous compounding for all maturities. An investor has just taken a short position in 6-month forward contract on the stock. a. What are the forward price and the initial value of the forward contract? b. Three months later, the price of the stock is $48 and the risk free interest rate is still 8% per annum. What are the forward price and the value of the short position in the forward contract?

Q5.
Consider a 6-month forward contract on an asset that is expected to provide income equal to 2% of the asset price once during a 6-month period. The risk free rate of interest (with continuous compounding) is 10% per annum. Calculate the forward price.

Q6.
The two-month interest rates in Switzerland and 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?

Q7.
The spot price of silver is $9 per ounce. The storage costs are $0.24 per ounce per year payable quarterly in advance. Assuming that interest rates are 10% per annum for all maturities, calculate the futures price of silver for delivery in nine months.

Q8.
The price of a European call that expires in six months and has a strike price of $30 is $2. The underlying stock price is $29, and a dividend of $0.50 is expected in two months and again in five months. The term structure is flat, with all risk-free interest rates being 10%. What is the price of a European put option that expires in six months and has a strike price of $30? Explain carefully the arbitrage opportunities if the European put price is $3.

Q9.
The price of an American call on a non-dividend paying stock is $4. The stock price is $31, the strike price is $30, and the expiration date is in three months. The risk-free interest rate is 8%. Derive upper and lower bounds for the price of an American put on the same stock with the same strike price and expiration date. Also explain carefully the arbitrage opportunities if the American put price is greater than the calculated upper bound.

Q10.
A stock price is currently $50. It is known that at the end of 6 months it will be either $60 or $42. The risk-free rate of interest with continuous compounding is 12% per annum. Calculate the value of a 6month European call option on the stock with an exercise price of $48. Verify that no-arbitrage arguments and risk-neutral valuation arguments give the same answers.

Q11.
Consider an American put option on a futures contract where both the futures price and the strike price are $50, the risk-free rate is 10% per annum, the volatility is 40% per annum, and the time to maturity is 6 months. (a) Calculate u, d, and p for a two-step tree. (b) Value the option using a two-step tree.

Q12.
A currency is currently worth $0.80 and has a volatility of 12%. The domestic and foreign risk -free interest rates are 6% and 8%, respectively. Use a two-step binomial tree to value (a) a European fourmonth call option with a strike price of $0.79 and (b) an American four-month call option with the same strike price.

Q13.
A stock index currently stands at 300 and has a volatility of 20%. The risk-free interest rate is 8% and the dividend yield in the index is 3%. Use a three-step binomial tree to value a six-month put option on the index with a strike price of 300 if it is (a) European and (b) American?

Q14.
An index currently stands at 1,500. European call and put options with a strike price of 1,400 and time to maturity of six months have a market price of 154.00 and 34.25 respectively. The six-month risk-free rate is 5%. What is the implied dividend yield? Q15. A futures price is currently 60 and its volatility is 30%. The risk-free interest is 8% per annum. Use a twostep binomial tree to (a) (b) (c) (d) (e) calculate the value of a six-month call option on the futures with strike price of 60. If the call were American, would it ever be worth exercising it early? What is the value of a six-month European put option on the futures with strike price of 60? If the put were American, would it ever be worth exercising it early? Verify that the call prices calculated in (a) and the put prices calculated in (c) satisfy put-call relationships.

Q16.
A stock price is currently $50. Assume that the expected return from the stock is 18% and its volatility is 30%. What is the probability distribution for the stock price in 2 years? Calculate the mean and standard deviation of the distribution. Determine the 95% confidence interval.

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