1.

Correct Answer: B

B is correct. The forward contract value will increase during Year 2 as the expected
future spot rate is lower than that implied from the forward rate curve (2.139% and
2.684% respectively).

A is incorrect. The forward contract value will decline in Year 1 as the expected future spot
rates are higher than that implied by the forward curve (1.994% and 1.954% respectively).

C is incorrect. Since the expected and implied spot rates are equal in year 3, the
forward contract value will remain unchanged.

2.

C is correct. Lev can ride down the yield curve when the yield curve is upward sloping which
is the case if the future spot rates expected by investors are realized. If the yield curve does
not change its shape and level, an investor with a two-year investment horizon can buy bonds
with maturity greater than two years. With the passage of time and assuming an upward
sloping yield curve, the bond will be valued at successively lower yields and higher prices as
long as yields do not change. In summary, the bond’s total return will exceed that of a bond
whose maturity is equal to that of the investment horizon.

A is incorrect. Buying a bond with a maturity equal to the investment horizon will earn a
lower return in contrast to buying bonds whose maturity exceeds the investor’s
investment horizon.

B is incorrect. An upward sloping yield curve will allow the trader to generate profit from the
strategy as long as the yields do not change.
3.

B is correct. The yield curve is downward sloping as the four-year spot rate is lower than the
three-year spot rate, which in turn is lower than the two- and one-year spot rates. A
downward sloping yield curve implies that forward rates will decline with the passage of
time. Therefore the one-year rate for a bond to be delivered three years from today will be
lower than the one-year rate for a bond to be delivered two years from today.

A is incorrect. Given that the spot curve is not flat, one-period forward rates will not equal
to the current spot rate but will be lower.

C is incorrect. A downward sloping yield curve will result in expectations for the long-
term rate, r(T*+T), being lower than that of the short-term rate r(T*).
4.

B is correct. The forward model is used to derive the forward rate

f(1,2): f(1,2) = [(1 + 0.025)3/(1 + 0.035)]1/2 – 1 = 0.020036 or 2.00%.

5.

C is correct. White is incorrect with respect to his opinions regarding both of the statements.

The liquidity preference theory can produce an upward sloping yield curve even when
interest rates are declining or flat if the rising liquidity premium is sufficient to offset
declining or flat interest rates. Rising spot rates will be consistent with an upward
sloping yield curve in any case.

Statement 2 reflects the preferred habitat theory which asserts that investors may be willing
to move out of their preferred habitat as long as they have incentive. This incentive may be
in the form of higher returns or reduced risk.

6.

B is correct. Equilibrium models such as the Cox-Ingersoll-Ross (CIR) and Vasicek

models assume that short-term rates are mean reverting. That is, they tend to move in a
bounded range and show a tendency to revert to a long-run value, b.
7.
A is correct. The spot curve represents the term structure for zero-coupon securities. Given the
absence of a coupon on the underlying securities, construction of this curve avoids the complications
associated with the reinvestment rate assumption.

C is incorrect. The par curve represents the yields to maturity on coupon-paying government
bonds. Construction of this curve requires a consideration of the reinvestment rate assumption.

8-A
Hawke is incorrect regarding Statement 2. The shape and level of the spot yield curve is dynamic
because the spot curve depends on the market pricing of option-free zero-coupon bonds.

Hawke is incorrect regarding Statement 3. The yield on zero-coupon bond maturing in T years is
regarded as the most accurate representation of the T-year spot rate. In the absence of default risk, the
T-year spot rate is equal to the yield-to-maturity of a zero-coupon bond.
9-B
The forward rate model will be used to determine the presence of the arbitrage opportunities. If
the return earned on trading the 3-year bond issue exceeds the geometric mean of one-period
forward rates, the trader was able to exploit an arbitrage opportunity.

r(5)  1  r11  f 1,11  f 2,11  f 3,11  f 4,11/ 5 1

r(5)  1  2.0%1  3.8%1  4.6%1  5.1%1  5.9%1/ 5 1  4.27%

According to the forward rate model, the spot rate for a security with a 5-year maturity should be
4.27%. However, the trader’s return (6.0%) is greater than this geometric mean of one-period forward
rates. Therefore, he has successfully exploited an arbitrage opportunity.
10-C
As evident from Exhibit 1, the forward curve is upward sloping. Therefore, Hawke should expect the
five-year spot rate to be higher than the forward rate on a contract to purchase a 4-year zero-coupon
bond one year from today. In other words, f(1, 4) < r (5)

11-B
Given that the yields have declined at all maturity points; the yield curve has experienced a parallel
downward shift. Furthermore, given that the short-term rates have declined more than the long-term
rates, the slope of the yield curve has steepened.

12-B
A decline in yields will increase the value of the bond portfolio.
Change in the value of the portfolio = (- 0.10)(- 0.016) + (- 0.30)(- 0.012) + (- 0.60)(- 0.005) + (-
0.90)(- 0.003) = + 1.09%

The value of the portfolio has increased to $202,180 ($200,000)(1.109).

 13-C is correct. The swap rate represents the interest rate quoted on the fixed rate leg of the swap.

14- C

C is correct. Abdul is valuing the bond on behalf of County House, which is a wholesale bank. These
organizations employ the swap curve to value assets and liabilities because they hedge many items
on their balance sheet with swaps.

A is incorrect. While it is true that swap contracts are non-standardized and customized, this does not
explain why the swap rate will be preferred over Treasury spot rates for valuation.

B is incorrect. The swap and Treasury markets are both active in the US. This factor will not serve to
influence the choice of benchmark.

15- C

I-spread = Bond rate – swap rate of same maturity a s bond = 7.99% - 4.55% = 3.44%

TED spread = LIBOR – T-bill yield of matching matur ity = 3.00% - 1.25% = 1.75%

16-A

A is correct. While the swap spreads provide a convenient way to measure credit and liquidity risk,
a more accurate measure is the Z-spread.

17-B

Discount factor = P(t,T) = P(2,4)

1/P(2,4) = [1 + 0.03][1 + 0.04][1 + 0.05][1 + 0.07] = 1.203493

P(2,4) = 1/1.203493 = 0.8309

18.
Correct Answer: A

Abdul is correct with respect to Conclusion 1 but incorrect with respect to Conclusion 2. The local
and pure expectations theories both assert that the one-period return is equal to the risk-free rate.
Therefore, the one-year holding period return should equal to the 1-year risk-free rate of 3%.

The local expectations theory asserts that the expected return for bonds over longer-time periods
is higher than the risk-free rate due to the existence of a premium.

19-A

A is correct. Given that callable bonds include embedded options, the yield curve is sloping steeply
upwards and the fact that interest rates are volatile, the callable bond’s YTM is a poor estimate of its
expected return. Even though default-free zero-coupon bonds do not include embedded options, the
assumptions concerning yield curve slope and volatility will result in the zero-coupon bond issue’s
YTM being a poor estimate of its expected return.

20-B

Since the forward rates are the assumed reinvestment rates, Mathews’ first step will
involve determining the forward rates.

f (1,1) = 1.082/1.12 – 1 = 4.1429%

f (2,1) = 1.063/1.082 – 1 = 2.1104%
f (3,1) = 1.044/1.063 – 1 = - 1.7764%

Expected cash flow at the end of Year 4 =

5(1 + 0.041429) (1 + 0.021104) (1 – 0.017764) + 5(1 + 0.021104) (1 – 0.017764) + 5(1 – 0.017764)
+ 105 = 120.14859

Expected bond return = (120.14859 – 102.70) /102.70 = 16.9899%

Expected annualized return = (1 + 0.169899)1/4 = 4.00%

21-A

Mathew expects the spot rate curve to be sloping steeply downwards. In this scenario, the forward
rate curve will be below the spot rate curve.

22-A

A is correct. Lester’s comments are accurate with respect to modern term structure models but
inaccurate with respect to equilibrium term structure models. Modern term structure models provide
quantitative descriptions of how interest rates evolve and attempt to capture the statistical properties
of interest rate movements.

The CIR model cannot be calibrated to market data because it has a finite number of parameters and
therefore it is not possible to specify the parameter values in such a way that model prices coincide
with observed market prices.
23-C
C is correct. Mathews is inaccurate regarding Feature 3. The standard deviation makes volatility
proportional to the square root of the short-term rate which allows for volatility to increase with the
level of interest rates. It also avoids the possibility of non-positive interest rates.

Mathews is accurate regarding Feature 1. The CIR model is a single factor model. The short-
term interest rate can determine the entire term structure.

Mathews is accurate regarding Feature 2. The deterministic or drift term of the model ensures
the mean reversion of interest rates towards a long-run value.

24-A

A is correct. Lester’s conclusion concerning the CIR model is appropriate. Because the model
requires the short-term rate to follow a certain process, which features mean reversion to a long-
term value (deterministic part) and a random normal distribution with a mean of 1 and standard
deviation of 0 (stochastic term), the estimated yield curve may not match the observed yield curve.

25-A

A is correct. Discounting cash flows at their relevant spot rates is inappropriate for bonds
with embedded options such as the Joyce Borde Inc. issue. This is because the framework
assumes constant interest rates and is inappropriate for valuing bonds with embedded
options. Changes in interest rates will impact the size and timing of cash flows of this bond
category.

B and C are incorrect. The binomial model is appropriate for valuing zero-coupon issues such as
Vox Limited while the Monte Carlo method is suitable for valuing bonds with embedded options
whose cash flows are path dependent. The Monte Carlo method is suitable because it allows for
changing interest rates by making a volatility assumption. In this way, the model incorporates
impact of changing interest rates on the size and timing of cash flows.
 26-C

C is correct. Keeping in mind that the bond is valued at par at maturity, the value of the bond
is $100 at Time 3. The value of the bond issue at Node 1-2 is derived using the value of the
bond at nodes 2-2 and 2-3 (see the table below for the aforementioned nodes).
Value of bond issue at Node 2-2 = 0.5 × (100/1.0521 5 + 100/1.05215) = 95.04348
Value of bond issue at Node 2-3 = 0.5 × (100/1.0410 2 + 100/1.04102) = 96.05963

Value of bond issue at Node 1-2 = 0.5 × (95.04348/1 .03752 + 96.05963/1.03752) = 92.0961

Time 0 Time 1 Time 2 Time 3

Node 1 Node 1-1 Node 2-1 Node 3-1
Node 1-2 Node 2-2 Node 3-2
Node 2-3 Node 3-3
Node 3-4

27-A

A is correct. The Monte Carlo simulation model is well calibrated if it is arbitrage-free. A

model is rendered arbitrage-free if it generates a value for the benchmark bond, which is
equal to its market price. In order to ensure the Monte Carlo model generates arbitrage-
free values for benchmark bonds and fits the current spot rate curve, a constant will need
to be added to all short-term rates on all paths.

B is incorrect. Increasing the number of paths will only serve to enhance the statistical
accuracy of the value estimate. However, this does not mean that the model value of the
security is closer to its fundamental value or in other words, the model is well-calibrated.

C is incorrect. Stripping and reconstitution allows dealers to separate or recombine the

bond’s individual cash flows such that trading activities will eliminate any arbitrage
profits. However, the process does not ensure that the Monte Carlo simulation model is
well calibrated.

28-A

A is correct. In order to determine which trade offers the maximum potential for arbitrage
profits, the issue’s market price is compared to its arbitrage-free value.
Arbitrage-free value of the issue (PV) =
103.6299 FV = 100
I/Y = 4%
PMT = 5
N=4

The arbitrage profit realized if the issue is purchased in NYSE, at a price of 103.6214, and
sold at its arbitrage-free price of 103.6299 is equal to 0.0085 per 100 par (103.6299 –
103.6214). The trader can maximize arbitrage profits by executing this trade.

B is incorrect. The arbitrage profit realized if the issue is purchased in ASE, at a price of
103.6245, and sold at its arbitrage-free price is equal to 0.0054 per 100 par (103.6299 –
103.6245). The realized profit is lower than if the trade is undertaken in NYSE.
 C is incorrect. The arbitrage profit realized if the issue is purchased at its arbitrage-free
price and sold in LSE a price of 103.6311 is equal to 0.0012 per 100 par (103.6311 –
103.6299). The trader realizes the lowest arbitrage profit in this trade.

29-B

B is correct. To determine the arbitrage-free valuation of a bond with embedded options,

individual cash flows are discounted at forward rates implied from the benchmark spot rate
curve. Implied forward rates are most suitable for this purpose because they account for
volatility, which is necessary given that the size and timing of the cash flows generated by
bonds with embedded options are sensitive to interest rate volatility.

A is incorrect. Benchmark spot rates cannot be directly used to discount cash flows of a
bond with embedded options. The reason for this is that the rates do not incorporate a
volatility assumption.

C is incorrect. Discounting the early coupons on a bond at the security’s yield-to-maturity

will give too much discounting and an upward sloping yield curve and too little discounting
for a downward sloping yield curve making the yield to maturity inappropriate as a discount
rate. Furthermore, using this rate involves making the unrealistic assumption that all cash
flows are reinvested at the yield-to-maturity, which is unrealistic given interest rate volatility
and its impact on the size and timing of cash flows.
30-A

A is correct. The law of one price applies to the price of a product trading in more than one
market and specifies that the prices of otherwise two identical products trading in different
markets should be the same. However, this law is not relevant to the generation of implied
forward rates from the benchmark spot rate curve.

Both options B and C are incorrect. Implied forward rates generated from the benchmark
spot rate curve need to be consistent with 1) an assumed level of interest rate volatility, 2)
an interest rate model that governs the random process of interest rates, and 3) the current
benchmark yield curve.
31-A

The process of bootstrapping is used to generate spot rates from the benchmark par yield
curve. This process employs linear interpolation to generate the relevant rates.

32-B

B is correct. Lone believes that the law of one price is being violated; this is because
the three issues are believed to be mispriced.

When assets are mispriced, there exists an opportunity for arbitrage profits. Therefore, assets
are no longer valued under the principal of no arbitrage which otherwise validates arbitrage-
free valuation. This principal is based on the law of one price and therefore arbitrage
opportunities arise as a result of a violation of the law of one price.

A is incorrect. The non-negativity of interest rates is a property of the lognormal model of

interest rates, which provides structure to the randomness of interest rates in a binomial
interest rate tree.

C is incorrect. The existence of arbitrage opportunities will increase the demand of mispriced
securities. Prices will adjust until opportunities disappear. Therefore, the existence of such
opportunities is never permanent.

33-C

To determine the amount of mispricing, it is first necessary to determine the arbitrage-

free value. This value is derived using spot rates which are calculated using the par yields
provided in Exhibit 2.
5 105
100 = 1.03  1  z2 2 ; z2  5.051%
7 7 107
100 = 1.03  1.050512  1  z3 3 ; z3  7.198%
Arbitrage-free value = 7  7  107  99.9999 or 100.00
2 3

1.03 1.05051 1.07198

Therefore, the Sliver Inc. issue is mispriced by $5 per 100 of par value.
34-C
C is correct. Using spot rates to discount the cash flows for callable bonds ignores one
key aspect of these securities – that is, cash flows ar e dependent on the path of interest
rates. Changes in future interest rates will affect the likelihood that the option will be
exercised which, in turn, will impact the cash flows.

A is incorrect. The process of discounting cash flows using spot rates considers the time
value of money and so this is not a valid argument.

B is incorrect. Mean reversion in interest rates is a concept which is specifically

considered for Monte Carlo simulation. It is unlikely to constitute a limitation of Lone’s
preliminary analysis.

35-B

B is correct. The process of calibration allows for the resulting bond values to be
arbitrage-free or, in other words, equal to the current observable market price.

A is incorrect. Incorporating mean reversion in Monte Carlo simulation ensures that

interest rates never get too high or too low.

36-A
The value of the Gary-Tills issue at each of the three nodes is presented below:

100.000 100.000
Node 1-1:
0.5  0.5
1.07984 1.07984  92.684
100.000 100.000
Node 1-2:
0.5  0.5
1.06463 1.06463  93.929
92.684 93.929
Node 1-0:

0.5 1.03  0.5 1.03  90.589

The value of the issue is calculated incorrect at Node 1-0.

37-A

Three months after initiation, the current value of the original 6 x 9 FRA is determined using
the 90- and 180-day LIBOR rates. The following steps will be followed to determine the
current value of the FRA:

Step 1: Calculate the new FRA rate of a contract which initiates today and expires at the
same time as the original FRA. The relevant rates to use are the 90- and 180-day LIBOR.

FRA (90, 180 – 90, 90) = {[1 + (0.0438 × 180/360)]/ [1 + (0.0425 × 90/360)] – 1} ÷
(90/360 = 0.044626 or 4.46%

Step 2: Calculate the current value of the FRA as the difference between the initial FRA
price and the FRA price determined in step 2 discounted at the provided rate of 5.60% over a
period of 180 days.
 Value of the FRA = {[(4.46% - 4.50%) × 90/360] × SE K 50,000,000}/[1 + (0.056
× 180/360)] = - SEK 6,534.5333 ≈ - SEK 4,549

Because the FRA rate has declined, the value of the FRA will be negative to Macro Limited.

38-C

Because the original FRA contract is a 6 x 9 FRA, the relevant rates to use are the 180-
and 270-day LIBOR for determining the potential for arbitrage profits. The FRA rate using
the hypothetical market LIBOR rates is calculated as follows:

FRA (0, 180, 90) = {1 + (0.0568 × 270/360)]/[1 + (0 .056 × 180/360)] –

1}/(90/360) = 0.05681 or 5.68%

Comparing the initial FRA rate of 4.50% to the market rate of 5.68%, the original contract would
have been underpriced if the hypothetical rates actually existed at time 0
 39-C

C is correct. Unlike a fixed-rate swap, a floating rate swap in general is not priced because a
single coupon rate is not designated to the swap. At each reset date, the coupon rate will be re-
established according to the LIBOR prevailing at the time. The same holds true for a floating
rate bond which is used to price the swap; the coupon rate is reset at each reset date.

A is incorrect. The statement holds true for fixed-for-fixed currency swaps in which the
coupon rates on fixed-rate bonds are selected to match the fixed swap rates resulting in future
net cash flows equaling zero.

B is incorrect. The value of the swap is equal to par on each reset date.

40-B

The notional principal paid by Macro Limited at contract initiation is equal to

SEK 54,347,826.09 (£5,000,000/0.092).

Using the rates provided in the exhibit, the SEK present value factors are determined
as follows:

SEK Spot Present Value

Days to Interest Rates Factors
Maturity (%)
180 3.0 0.98522
360 3.5 0.96618
540 4.1 0.94206

The annualized SEK swap fixed rate is determined as follows:

rFIX,SEK = 1  0.9426 
360  3.968%
0.98522  0.96618  0.94206 180

Annual swap fixed payment = SEK 54,347,826.09 × 0.0 3968 × 180/360 = SEK
1,078,260.87 or ≈ SEK 1.09 million

41-A
At the initiation of the swap, Macro Limited will receive £5 million from and pay
SEK 54,347,826.09 (£5,000,000/0.092) to the swap counterparty.

42-A

A is correct. Based on the formula for calculating forward iron ore prices (see below), an
increase in the risk-free rate, ‘r’, will increase forward prices relative to spot prices.

B is incorrect. Carry benefits, represented by the symbol γ0 in the formula, decrease

the burden of carrying the underlying instrument through time and so an increase in
carry benefits will decrease the forward price relative to the spot price.

C is incorrect. Expectations of the future underlying price have no bearing on the forward
price. Therefore, an expectation that the underlying will increase in value has no impact on
the forward price.

Forward price formula: F0(T) = (S0 + θ0 – γ0)(1 + r)T

43- C
The formula used to calculate the no-arbitrage forward price at contract initiation is as follows:

F0,T  S0 1 rT

F 0, T   AUD1,0001  5%7 12 AUD1,028.8698AUD1,029

44- C
Since the actual forward price is AUD 1,500 while the forward price determined as part of the no-
arbitrage formula (solution to Part 1) is AUD 1,029, the forward contract is overpriced. Thus Cohen
should undertake a short position in the wheat forward contract. Using the spot price of wheat and the
forward price (AUD 1,500), the rate of return will be:

AUD1,500  
1 0.50
AUD1,000

The risk –free return for seven months is 50%. The annualized return is 100.4% which is calculated as
follows:
1.512 7 1 1.003875

45- A
 Since Cohen already holds a corporate bond investment in Test Manufacturing, he will undertake a
short position in a forward contract in which the underlying is the manufacturer’s corporate bond.
The formula to calculate the value of a corporate bond forward contract at time T is:

Vt 0,T   Bt C (T Y )  PV CI,t,T  F0,T  1rTt

200 days into the forward contract, the first coupon date (181 days) has already passed. The second
and third coupon payments are 165 days (365 – 200) and 347 days (547 – 200), respectively, away.

85
The present value of the second coupon payment is AUD 83.14578 =  365200

1.05 365

85
The present value of the third coupon payment is AUD 81.14739 =  547200 

1.05 365
Since the forward contract will expire a day after the third coupon payment, the time to maturity is
348 days [(547 + 1) – 200].
1,075.45 = AUD
Thus, Vt 0,T  AUD1,250.50  83.14578  81.14739  548200 365

1.05
59.63858831 or AUD 59.64

Since Cohen already holds the corporate bonds, he is short the forward contract, thus the value of the
forward contract to Cohen is - AUD 59.64 and the value to the manufacturer is + AUD 59.64

46-:B
The duration of an FRA agreement beginning in 2 months time covering a loan to be taken out in
eight months time is 6 months (8 – 2 months) or 180 days (30 days × 6).

Since Test Manufacturing would like to protect against increase in borrowing costs, it should
undertake a long position in an FRA agreement. The formula to calculate the initial FRA rate is:
hm
1 L0 h  m
360 360
FRA(0, h, m)  1
h m
1 L0 h
360

FRA (0,30,180) =

1  14%  240
360

1
360
= 0.159671 or 15.97%
60 180



1 7.50%  360

47-
B
The formula to calculate the value of the FRA on day g is:
m
1  FRA(0, h, m)
1 360
Vg 0, h, m  hg  hmg
1  Lg h  g  1  Lg h  m  g 
360 360

180
1 1 15.971
1 360
   AUD0.99366538 AUD0.99297011 AUD0.00069527
30 210
1 7.65% 1 15.00% 
360 360

Based on the AUD 2.5 million notional principal (AUD 5 million × 50%), the value of
the forward contract after 30 days is approximately AUD 1,738 (AUD 2,500,000 ×
0.00069527).

48 A
Since Howell’s clients already own Australian investments Howell will need to undertake a
short position in a forward contract that will allow her to sell AUD for USD. However prior
to determining the value of the forward contract after one month, it is necessary to
determine the forward price at the initiation of the contract. Using continuous compounding,
the formula used to calculate the initial forward price of a forward currency contract is:
49 A

Rogers is accurate regarding Statement 1 and inaccurate regarding Statement 2. The

probability used in the expectations approach is determined objectively and is not based
on an investor’s personal views regarding risk preferences. The expectations approach
discounts all cash flows using an estimated risk-free interest rate.

50- B

B is correct. Knight is incorrect regarding his analysis of how option values are derived
when the expectations approach is used within the binomial model framework to
determine call option values at each node. The formula for deriving call option value at
each node using the expectations approach is:
+ -

c = PV[πc + (1 – π)c ]

This formula demonstrates that the call option value at Time 0 is equal to the present value of
the cash flows or call option payoffs at Time 1 using a risk-neutral probability (π).

C is incorrect. The statement summarizes how option values are estimated when the
no-arbitrage approach is used within a binomial model framework.

51- B

B is correct. The formula for deriving the call option value at Time 0 using the
expectations approach is:

c = PV[π2c++ + 2π(1 – π)c+– + (1 – π)2c– – ]

π = (1 + r – d)/(u – d) = (1 + 0.10 – 0.65)/(1.50 – 0.65) = 0.5294
c++ = Max(0, Su2 – X) = Max[0, $180 – $80] = $100.00
c+- = Max(0, Sud – X) = Max[0, ($80 × 1.50 × 0.65) – $ 80] =
$0 c-- = Max(0, Sd2 – X) = Max [0, ($80 × 0.65 2) – $80] = $0
c = 1/(1.10)2[(0.52942 × $100) + 2(0.5294)(1 – 0.5294)($0) + (1 – 0.5294) 2($0) =
$23.1623
5. $23.16
.
52- C

C is correct. An American call option will give the option holder the right to exercise early,
purchase the underlying before it goes ex-dividend, and capture the dividend payment. Note
that the call option is only in the money at Node 2 and therefore the value of the call option at
Node 3 is ignored.

The present value of the dividend payment at Time 0 is $4.5455 ($5/1.10). The value of the
stock without dividends at Node 2 is $113.1818 [($80 – $4.5455) × 1.50]. The exercise
value of the call option including dividends at Node 2 is $38.1818 [Max 0, ($113.1818 +
$5) – $80] ≈ $38.18.

53-C

The carry benefit is equal to the foreign currency risk-free rate, which in this case is the
US$ risk-free rate of 0.50%.

54-C

C is correct. The term N(d2) is interpreted as the probability that the call option expires in
the money and is calculated as N(d2) = 1 – N(-d 2). Therefore, the probability that the ¥ call
option will expire in the money is 51.70% [(1 – 0.4 830) × 100].

.
55- A
In order to determine the intrinsic value of the call option, the following steps need to be followed:

Step 1: Determine u & d.

u = 1.45 (1+ 45%)
d = 0.75 (1 – 25%)

Step 2: Determine S+ and S-.

S+ = €65 (1.45) = €94.25
S- = €65 (0.75) = €48.75

Step 3: Determine c+ and c- (values of the option at

expiration) c+ = Max(0,94.25 – 70) = €24.25
c- = Max(0,48.75 – 70) = €0

Step 4: Determine the risk-neutral probability.

1.05  0.75
π=  0.428571  0.4286
1.45  0.75
1 – π = 0.5714

Step 5: Determine the price of the call today (c).

= 0.428624.25 0.57140  9.89619  9.90
1.05
56- C
At €13, the call is overpriced (relative to €9.90). Thus, the calls will need to be sold. The number of
calls which need to be sold for 1 unit of the underlying stock (n) is determined by the following
formula:
cc  24.25  0
n    0.532967  0.5330

S S  94.25  48.75
Reginald should purchase 533 (0.5330 × 1,000) units of Jasper Inc.’s stocks and sell 1,000 calls.
The outlay/net cash flow is:

Sell 1,000 calls at €13 +13,000

Buy 533 units of Jasper Inc.’s stocks at €65 –34,6 50
Net cash flow –21,645

The initial outlay is €21,645. The value of the inv estment at expiration will
be If ST = 94.25
533(94.25) – 1,000(24.25) = €25,985.25
If ST = 48.75
533(48.75) – 1,000(0) = €25,983.75

The rate of return is thus 20.05% = (25,985.25/21,645 – 1)

.
57-: B
Based on Ramirez’s expectations regarding the acceptance of E&E Agriculture and the projected drop
in stock price, Ramirez should purchase a put option on Jasper Inc.’s stock holdings. This will protect
the stock investment from a fall in stock price and give Ramirez the flexibility to benefit from an
increase in stock price (by letting the option expire).

Buying a call option is not the best course of action as it will provide a limited payoff if stock prices
rise above the exercise price (ST – X), whereas the put option will provide unlimite d payoff.
Additionally, the call will not provide adequate protection if the stock price falls below the exercise
price.

Selling a call option is not the best course of action because if the stock price falls below the exercise,
the counterparty will not exercise the option leaving Ramirez (as the option writer) with the option
premium as profit (which will be insufficient to cover the loss on the stock investment). If price rises
above the exercise price, the counterparty will exercise the call and Ramirez will be responsible for
paying the difference between the stock price and exercise price.

58- A
Assumption 1: The Black-Scholes-Merton model assumes that the risk-free rate is not random and
is constant. Thus assumption 1 is partially incorrect.

Assumption 2: The basic model does not take into account the cash flows generate by the underlying
asset but the model can be modified by adjusting the spot price of the underlying asset. Assumption 2
is accurate.

59-B
Volatility is the only variable in the option pricing model which cannot be directly observed and
easily obtained. Thus Ramirez is correct with respect to this statement.

The benefit of using the historical method to estimate volatility is that is based on factual data (what
happened in the past). However in order to get the estimate, a large amount of data is required. This
means some of the data needs to be obtained by going far back into the past. The drawback of doing
so is that the data loses its relevance and the volatility estimate becomes less reliable. Thus Ramirez
has inaccurately pointed out the ability of this method to produce reliable estimates.

The drawback of using the implied volatility method to estimate volatility is that it assumes that the
market correctly prices the options, which makes it difficult to identify mispriced options. Thus the
drawback of the implied volatility method has been accurately illustrated.

.
60- B
The formula to calculate the put option value using the put-call-forward parity is:

p0  c0 X  F0,T /1 rT

P0 = 70.50 + [70 – 100.89]/(1.05) 1.5 = 41.789949 ≈ €41.79

The current put price is €65.45. Relative to the pr ice of the put obtained from the put-call-forward
parity, the put is overpriced. The appropriate (arbitrage) strategy is to sell the put and purchase the
synthetic put. To buy the synthetic put it is necessary go long the call, short the forward contract
and hold a bond with a face value of X – F (0,T). The p ayoff from the transaction at the start of the
contract is:

Sell put + 65.45

Buy call (70.50)
Buy Bond – (70 – 100.89)/(1.05) 1.5
€23.66