MFIN6003 Derivative Securities Dr.

Huiyan Qiu

Answers to practice questions on TVM and no-arbitrage principle

Question 1
1 + EAR = (1 + 5%/2)2 = 1.0506
a) 1 + APR = 1 + EAR = 1.0506 → The equivalent APR with annual compounding is
5.06%.
b) (1 + APR/12)12 = 1 + EAR = 1.0506 → The equivalent APR with monthly compounding
is 4.95%.
c) eAPR = 1 + EAR = 1.0506 → The equivalent APR with continuous compounding is
4.94%.

Question 2
EAR = 1100/1000 – 1 = 10%
a) 1+APR = 1 + EAR = 1.10 → With annual compounding, the percentage return is 10%
per annum.
b) (1 + APR/2)2 = 1 + EAR = 1.10 → With semi-annual compounding, the percentage
return is 9.76% per annum.
c) (1 + APR/12)12 = 1 + EAR = 1.10 → With monthly compounding, the percentage
return is 9.57% per annum.
d) eAPR = 1 + EAR = 1.10 → With continuous compounding, the percentage return is
9.53% per annum.

Question 3
Since the stock is making continuous dividend payment with rate of 1%, after 5 years’
accumulation, 100 shares becomes 100 · e0.01×5 shares. Therefore, your investment worth
HK$50 × 100 · e0.01×5 = HK$5,256.36 after 5 years.

Question 4
With continuous compounding, the present value to deposit today is:
€15,000 = x · e0.08×3
x = €11,799.42

Question 5
a) Investors could borrow money from Bank One and deposit in Bank Enn to exploit the
interest rate differences.
b) Bank One would experience a surge in the demand for loans, while Bank Enn would
receive a surge in deposit.

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MFIN6003 Derivative Securities Dr. Huiyan Qiu

c) Bank One interest rate would rise, while Bank Enn interest rate would fall. The two
interest rates offered by banks would approach to the same number.

Question 6
Applying the Forward pricing formula derived on slide 1-45, the 6-month arbitrage-free
forward price is $35e0.025 = $35.89.

Question 7
a) The price per share of the ETF is $28 × 2 + $40 + $14 × 3 = $138 in a normal market.
b) If the ETF is currently trading for $120, the ETF is undervalued. We can buy ETF at
$120 and short sell two shares of HP, one share of S, and three shares of F. The
future cash flows are offsetting but we get the arbitrage profit of $18 now.
c) If the ETF is currently trading for $150, the ETF is overvalued. We should sell ETF and
buy two shares of HP, one share of S and three shares of F. The future cash flows are
offsetting but we get the arbitrage profit of $12 now.

Question 8
a) The payoff of a portfolio consisting of one share of security A and one share of
security B is 125.
b) The market price of such portfolio is $65.67 + $49.88 = $115.55. The expected return
is $125/$115.55 – 1 = 8.18%.
c) The cash flows of security C can be replicated by two shares of security A and four
shares of security B. Therefore, the no-arbitrage price of security C is $65.67 × 2 +
$49.88 × 4 = $330.86. If the security C is selling for $350 per share, short-sell one
share of security C, buy two shares of A and four shares of B. Ignoring the transaction
cost, the time-0 cash flow is $19.14 and one year later, the cash flows are zero in
either weak economy or strong economy. Thus, arbitrage.