MFIN6003 Derivative Securities Dr.

Huiyan Qiu

TVM and No-Arbitrage Principle: practice questions and problems

Work on the following problems to check your knowledge on the time value of money and
no-arbitrage principle.

1. An interest rate is quoted as 5% per annum with semiannual compounding. To result in

the same effective rate, what should be the annual percentage rate with (a) annual
compounding, (b) monthly compounding, and (c) continuous compounding? [This is the
in-class exercise contained in the first lecture note.]

2. An investor receives $1,100 in one year in return for an investment of $1,000 now.
Calculate the percentage return per annum with: (a) Annual Compounding, (b)
Semiannual Compounding, (c) Monthly Compounding, and (d) Continuous
Compounding.

3. Five years ago, you purchased 100 shares of stock which pays share dividend with
continuous compounding rate of 1%. The current stock price is HK$50 per share. What is
the value of your stock investment? [This question is related to continuous
compounding of dividend which will be covered in session three.]

4. If you need €15,000 in three years, how much will you need to deposit today if you can
earn 8 percent per year compounded continuously?

5. Suppose Bank One offers a risk-free interest rate of 5.5% on both savings and loans, and
Bank Enn offers a risk-free interest rate of 6% on both savings and loans. The interest
rates offered by the two banks have same compounding frequency.
a. What arbitrage opportunity is available?
b. Which bank would experience a surge in the demand for loans? Which bank would
receive a surge in deposit?
c. What would you expect to happen to the interest rates the two banks are offering?

6. Suppose the stock price is $35 and the continuously compounded interest rate is 5%.
Assuming dividends are zero, what is the 6-month arbitrage-free forward price?

7. An Exchange-Traded Fund (ETF) is a security that represents a portfolio of individual

stocks. Consider an ETF for which each share represents a portfolio of two shares of
Hewlett-Packard (HP), one share of Sears, Roebuck (S), and three shares of Ford Motor
(F). Suppose the current stock prices of each individual stock are as shown here:

Stock HP S F
Price $28 $40 $14

a. What is the price per share of the ETF in a normal market?

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MFIN6003 Derivative Securities Dr. Huiyan Qiu

b. If the ETF currently trades for $120, what arbitrage opportunity is available? What
trades would you make?
c. If the ETF currently trades for $150, what arbitrage opportunity is available? What
trades would you make?

8. The table here shows the no-arbitrage prices of two securities.

Cash Flow in One Year

Price Today Weak Economy Strong Economy

Security A 65.67 50 100

Security B 49.88 75 25

a. What are the payoffs of a portfolio of one share of security A and one share of
security B?
b. What is the market price of this portfolio? What expected return will you earn from
holding this portfolio?
c. Suppose security C has a payoff of $400 when the economy is weak and $300 when
the economy is strong. What is the no-arbitrage price of security C? If the security C
is currently selling for $350 per share, how to arbitrage?