BaaaBEseetoeN BUS 337 FINANCIAL INSTRUMENTS Solutions to Suggested Homework Problems frm Hull th ed) Problems 121,128 210,211,227 33,311, 3 61,67, 6.10 75,7, 712,717, 722,728,725 83,84, 88, 811,814,815, 816,819,820 317,319 122, 125, 12.6, 127, 12.15, 12.16, 12.26, 12.42, 12.44 138, 13:19, 1320, 13.26, 13.25 165, 166, 168, 1613, 173,175,197, 1710, 19.11, 17.13 219CHAPTER 1 1.21. The arbitrageur could borrow money to buy 100 ounces of gold today and short futures contracts on 100 ounces ounces of gold for delivery in one year, This means that gold is purchased for $500 per ounce and sold for $700 per ounce. The return (40% per annum) is far greater than the 10% cost ofthe borrowed funds. This is such ‘ profitable opportunity that the erbitrageur should buy as many ounces of gold as possible and short futures contracts on the same number of ounces. Unfortunately arbitrage opportunities as profitable as this rarely arise in practice 41.28. (a) The trader buys 1 180-day call option and takes a short position in a 180 day forward contract. If Sr isthe terminal spot rate, the profit from the call option is max (Sr ~1.57, 0)~ 0.02 ‘The profit from the short forward contract is 1.6018 ~ Sp ‘The profit from the strategy is therefore ‘max (Sz ~1.87, 0) — 0.02 +1.6018 - Sp smax Sr ~ 187, 0)+1.8818 ~ Sy ee 1S818—Sp when Sp < 187 OO” when Sr > 1.57 ‘This shows chat the prot is always postive, The time value of money has been ignored in thwe calculation. However, when iti taken into account the strategy Stl Hey to be profitable inal circumstances, (We would require an extremely high interest rte for S0.0118 interest to be required on en outlay of $0.02 over a 180-day period.) (@) The trader buys S0-day put options and takes along poston in 890 day forward contrct. If Sp isthe terminal spot rate, the prof from the put option is ‘max (1.64 ~ Sr, 0) ~ 0.020 ‘The profit from the long forward contract is Sr ~ 1.6056, ‘The profit from this strategy i therefore max (1.64 ~ Sp, 0) = 0.020-+ Sy ~ 1.6056 ‘max (1.64 ~ Sy, 0) + Sp ~ 1.6256 This is Sp—16256 when Sp > 1.66 001s when Sp <1.64 ‘The profit is therefore always positive. Again, the time value of money has been ‘ignored but is unlikely to affect the overall profitability of the strategy. (We would require interest rates to be extremely high for 80.0144 interest to be required on an outlay of $0.02 over a 90-day period.)2.10. 2.11. 2.27. CHAPTER 2 There will be a margin call when $1,000 has been lost from the margin account, This will occur when the price of silver increases by 1000/5000 = $0.20. The price of silver ‘must therefore rise to $5.40 per ounce for there to be a margin call. Ifthe margin call is not met, the position is closed out. ‘These options make the contract less attractive to the party with the long position and more attractive to the party with the short position. They therefore tend to reduce the futures price. The mining company can estimate its production on a month-by-month basi. Tt ean then short futures contracts to lock in the price received for the gold. For example, if ‘8000 ounces are expected to be produced in November 1999 and December 1999, the price received for this production can be hedged by shorting a total of 30 December 1999 contracts.CHAPTER 3 3.8. The forward price is pareeriereey B.11, (a) The forward price, Fa, is given by equation (3.6) as Fy = 400%) = 44.21 or $44.21. The initial value of the forward contract is zero. (b) The delivery price K in the contract is $44.21. The value of the contract, f, after six months is given by equation (3.9) as: f= 45 — 44.2120 1205 2.95 i.e, it is $2.95. The forward price is given by: 45°18 = 47.31 3.16. The theoretical futures price is 0,65e°-1957(0.08-003) _ g.6554 ‘The actual futures price is too high. This suggests that an arbitrageur should borrow USS. dollars, buy Swiss francs, and short Swiss franc futures.‘3.17. The present value of the storage costs for nine months are 0.176 0.06 + 0.06e7°25%°4 +. 0,062"08%01 ‘or 80.176, The futures price is from equation (3.15) given by Fy where Fo = (9.000 + 0.176)e°9%075 = 9,89 ive, it is $9.89 per ounce. ‘3.19. In total the gain or loss under a futures contract is equal to the gain or loss under the corresponding forward contract. However the timing of the cash flows is different. When the time value of money is taken into account a futures contract may prove to be more valuable or less valuable than a forward contract. Of course the company does not know in advance which will work out better. The long forward contract provides 1 perfect hedge. The long futures contract provides a slightly imperfect hedge. (a) In this case, the forward contract leads to a slightly better outcome. The company takes a loss on its hedge. If a forward contract is used, the whole of the loss is realized at the end. If futures contract is used, the loss is realized day by day throughout the contract. On a present value basis the former is preferable. (b) In this case the futures contract leads to a slightly better outcome. The company makes a gain on the hedge. Ifa forward contract is used, the gain is realized at the end. Ifa futures contract is used, the gain is realized day by day throughout the life of the contract. On a present value basis the latter is preferable. (c) In this case the futures contract leads to a slightly better outcome. This is because it gives rise to positive cash flows early and negative cash flows later. (@) In this case the forward contract leads to a slightly better outcome. This is because, when a futures contract is used, the early cash flows are negative and the later cash flows are positive.6.10. CHAPTER 6 ‘When a trader buys an option, she must pay cash up front. There is no possibility of future linbilities and therefore no need for a margin account. When a trader sells an option, there are potential future liabilities. To protect against the risk of a default, margins are required. (a) The option contract becomes one to by 500 x 1.1 = 550 shares with an exercise price 40/1.1 = 36.36. (b) There is no effect. The terms of an options contract are not normally adjusted for cash dividends. (c) The option contract becomes one to buy 500 x 4 = 2,000 shares with an exercise price of 40/4 = $10, (2) March, April, June and September (b) July, August, September, December (c) August, September, December, March Longer dated options may also trade.CHAPTER 7 The lower bound is 28 — 25¢~0.08%0.3353 _ $3.66 7.11. The lower bound is 65e79 1907x005 _ 59 — $6.45 The present value of the strike price is 60e~°9%93%01 the dividend is 0.80e-°-°8892%0.12 0.79. Since = $57.65. The present value of 5 <64-87.65-0.79 the condition in equation (7.5) is violated. An arbitrageur should buy the option and short the stock. Regardless of what happens a profit will materialize. If the stock Price declines below $60, the arbitrageur loses the $5 spent on the option but gains at least 64 — 57.65 — 0.79 = $5.56 in present value terms from the short position. If the stock price is above $60 at the expiration of the option, the arbitrageur gains in present value terms exactly 5.56 — 5.00 = $0.56. 7.17. From equation (7.4) So-X X ‘This shows that the value is always either zero or postive at the expiration of the opton fa te absence of arbitrage posbties mut be postive or zero today. Ths ‘means that ate-220 - a £05(e, +6) (cowvex) 7.25. (a) Suppose V is the value of the company and D is the face value of the debt. The ‘alue of the managers sition is ane Year is smax(V ~ D, 0) ‘This is the payoff from a call option on V with strike price D. (b) The debt holders get nin(¥, D) D~ max(D-V,0) Since max(D ~ ¥, 0) i the payof from a put option on V with strike price D, the Sebihaldes have fa eect tude rk be oan (worth B at muta with cera) fects put onions te vale ofr copay wih se pice 15) The manager cad inerene the value of sor ber potion by cresing the value ‘Pate call option sna). I folows that the nager sald attempt to invoice both Sad the vlaiiy of V. Tone why icreasing the vlaity of Vs bencical imagine at Bagpene wh here eng chngen nV HV inter, the manage ene Tethe Al tent of the ange EV detsease, auch ofthe Govaside s Sorc by the company’s lenders,CHAPTER 8 8.8. A butterfly spread involves a position in options with three different strike prices (X1, X2, and Xa). An investor should purchase a butterfly spread when itis considered that the price of the underlying stock is likely to stay close to the central strike price, Xp. 8.4, An investor can create @ butterfly spread by buying call options with strike prices of $15 and $20, and selling two call options with strike prices of $17}. The initial investment is 4+ 1—2x2= $1. The following table shows the variation of profit with the final stock price: ‘Stock Price Profit Sr Sr <5 7 15 < Sp < 17h Sr~ 15} 1} 20 + ‘A bull spread using calls provides a profit pattern with the same general shape as & bull spread using puts (see Figures 8.2 and 8.3 in the text). Define p; and ci as the prices of put and call with strike price Xi and pz and e2 as the prices of a put and call with strike price X2. From put-cll parity ptSaa+Xier™ ptSaatkeT Hence 1 = 2 ~ (Xa ~ Xie? nom ‘This chows that the initial investment when the spread is created from puts is less than the initial investment when it is created from calls by an amount (X2—Xi)e~"?. In fact as mentioned in the text the initial investment when the bull spread is crested from puts is negative, while the initial investment when itis created from calls is positive. ‘The profit when calls are used to create the bull spread is higher than when puts are used by (Xp ~X,)(1-—e-"?). This elects the fact that thecal strategy involves an additional risk-free investment of (X2 — Xi)e~"? over the put strategy. This earns interest of (X2 — X1)(1 - e7"7),8.11. 8.14. 8.15. Define c1, ¢2, and ¢2 as the prices of calls with strike prices Xi, X2 and Xs. Define Pi, Pa and py as the prices of puts with strike prices Xi, Xp and X3. With the usual notation ate T=n4+S atXeT =p +S + X3e777 = py tS Hence e105 — Dea + (Xy + Xg—2Xa)e“7 = Pr + Po — 2p Since Xz — X1 = Xa — Xa, it follows that Xi + Xs — 2X = 0 and et c5— 22 =P + Ps — 2p ‘The cost of a butterfly spread created using European calls is therefore exactly the same as the cost of a butterfly spread created using European puts. Possible strategies are: Strangle Straddie Strip Strap Reverse calendar spread Reverse butterfly spread ‘The strategies all provide positive profits when there are large stock price moves. A strangle is less expensive than a straddle, but requires a bigger move in the stock price in order to provide a positive profit. Strips and straps are more expensive than straddles but provide bigger profits in certain circumstances. A strip will provide a bigger profit when there is a large downward stock price move. A strap will provide a bigger profit when there is a large upward stock price move. In the case of strangles, straddles, strips and straps, the profit increases as the size of the stock price movement increases. By contrast in a reverse calendar spread and a reverse butterfly spread there is a maximum potential profit regardless of the size of the stock price movement. ‘Suppose that the delivery price is K and the delivery date is T. The forward contract is created by buying a European call and selling a European put when both options have strike price K’ and exercise date T. It is easy to see that this portfolio provides a payoff of Sr — K under all circumstances where Sr is the stock price at time T. Suppose that F is the forward price. If K = F, the forward contract thet is created hhas zero value. This shows that the price of a call equals the price of a put when the strike price is K.8.16. The bull spread involves buying a European call with strike price X, and selling a European call with strike price Xz. The bear spread involves buying a European put with strike price Xz and selling a European put with strike price X1. The payoff from a box spread is shown in the following table: Stock Price Bull Call Bear Put Range Spread Spread Total Sih Gh 0. Gh X< Xr 65 0 -1 60 < Sr < 65 65- Sp 64- Sp 55 < Sp < 60 Sr~ 35 Sr— 56 Src 0 =1 ‘The butterfly spread leads to a loss when the final stock price is greater then $64 or Jess than $56.(6:19 The verintion ofan investor's prot oss with the terminal stock price for each ofthe four seston | Variation ef invatorsproit/loes with termizal tock price, SrCHAPTER 9 9.2. In the no-arbitrage approach, we set up a riskless portfolio consisting of a position in the option and a position in the stock. By setting the return on the portfolio equal to the risk-free interest rate, we are able to value the option. When we use risk-neutral valuation, we first choose probabilities for the branches of the tree so that the expected return on the stock equals the risk-free interest rate. We then value the option by calculating its expected payoff and discounting this expected payoff at the risk-free interest rate. 0.90 10 — 0.90 ‘The tree for stock price movements is shown in Figure 9.1. We can work back from the end of the tree to the beginning as indicated in the diagram to give the value of the option as $9.61. The option value can also be calculated directly from Equation = 0.7041 (9.8): e72*0.08x0.5(9, 7941? x 21 +2 x 0.7041 x 0.2959 x 0 + 0.2959" x 0) = 9.61 21 200 Be CALL Put 52063 100 99 9.6104 ie ° 4 ° 81 o 644 9.6. Figure 9.2 shows how we can value the put option using the same tree as in Figure 9.1. The value of the option is $1.92. The option value can also be calculated directly from Equation (9.8): 7 2*0.5x0.08(9,7041? x 0+ 2 x 0.7041 x 0.2959 x 1 + 0.2959? x 19] = 1.92 ‘The stock price plus the put price is 100 + 1.92 = 101.92. The present value of the strike price plus the call price is 100e~°° + 9.61 = verifying that put-call parity holds. (01.92. These are the same, 24 110 7 100 i 1.9203) 607818.10. At the end of three months the value of the option is either $5 (if the stock price is $35) or $0 (if the stock price is $45). Consider a portfolio consisting of: —A shares +1 option (Note: The delta, A, of put option is negative. We have constructed the portfolio so that it is +1 option and —A shares rather than —1 option and +A shares so that the initial investment is positive.) ‘The value of the portfolio is either ~35 +5 or ~454. If: ie, A=-05 the value of the portfolio is certain to be 22.5. For this value of A the portfolio is therefore riskless. The current value of the portfolio is —40A +f where f is the value of the option. Since the portfolio must earn the risk-free rate of interest (40 x 0.5 + f) x 1.02 = 22.5 Hence f= 2.06 i.e, the value of the option is $2.06. ‘This can also be calculated using risk-neutral valuation. Suppose that p is the prob- ability of an upward stock price movement in a risk-neutral world. We must have 45p+35(1 ~ p) = 40x 1.02 p=058 ‘The expected value of the option in a risk-neutral world is: 0x 0.5845 x 0.42 = 2.10 This has a present value of 2.10 102 This is consistent with the no-arbitrage answer. 069.35. (a) A tree describing the bebavicr of the stock price is shown in the diagram below. ‘isleneutral ty of ax up move, p, is given by Welly d=0.4 ae 7= 09 Calculating the expected payoff and discounting, we obtain the valve of the option as [24 x2 x 0.6523 x OS4TT+ 9.6 x O.34TT}en“°29 = 2.118, ‘The value of the ion ie 2118. ‘This can also be calculated . back Whe Her tues the Gngram Te send master tech toad fhe value of the option. ‘hows ar the third sumber at each node on the value of the European option because it 48.400 01000 49.000 2.118 21537 32.400 9600 91600 Problems 9.15 Tree to evaluate European and American put options “Ax each aode, upper aumber is the s:ock price, next number is the European put price; final mumber is American put priceCHAPTER 10 10.1. Imagine that you have to forecast the future temperature from a) the current tem- perature, b) the history of the temperature and c) a knowledge of seasonal averages fand seasonal trends. if temperature followed @ Matkov process, the history of the temperature would be irrelevant. ‘To answer the second part of the question you might like to consider the following scenario for the first week in May: (() Monday to Thursday are warm days; Friday is a very cold day. (ji) Monday to Friday are all very cold days. What is your forecast for the weekend? If you are more pessimistic in the ease of the second scenario, temperatures do not follow a Markov process. 10.8. In: AS = uSAt+ oSeVAt ‘the expected increase in the stock price and the variability of the stock price are constant when both are expressed as a proportion (or as a percentage) of the stock price In: AS = pdt +oevit the expected increase in the stock price and the variability of the stock price are constant in absolute terms, For example if the expected growth rate is $5 per annum when the stock price is $25, it is also $5 per annum when itis $100. If the standard deviation of weekly stock price movements is $1 when the price is $25, itis also $1 ‘when the price is $100. Is AS = uSAt+oeVit the expected increase in the stock price is a constant proportion of the stock price while the variability is constant in absolute terms. I AS =pAt+oSevBt the expected increase in the stock price is constant in absolute terms while the vari- ability of the proportional stock price change is constant, The model: AS =uSAt+ oSeVBt is the most appropriate one since it is most realistic to assume that the expected percentage return and the variability of the percentage refurn in a short interval is ‘constant.10.9. The drift rate is a(6~r). Tous, when the interest rate is above b the drift rate is negative and, when the interest rate is below 8, the drift rate is postive. The interest rate is therefore continually pulled towards the level . The rate at which it ie pulled ‘toward this level is a. A volatility equal toc is superimposed upon the “pull” or the ari Suppose a = 0.4, 6= 0.1 and c= 0.15 and the current interest rate is 20% per annum. ‘The interest rate is pulled towards the level of 10% per annum. This can be regarded as along run average. The current drift is ~4% per annum so that the expected rate ‘at the end of one year is about 16% per annum. (Infact it is slightly greater than this, because asthe interest rate decreases, the “pul” decreases.) Superimpated upon the drift i a volatility of 15% per annum. 10.12 With the not & ~ oudst, oVBI) Ia hire $= 50,1 = 018, 0 = 030 and At 1/865 000TH, ence 85. gases oomrs 030 x VER) = #04, 00157) 5 ~ 460% oma, 50 08157) hati AS ~ 6(0.02, 0.785) Ja) The expected stock price atthe end ofthe nextday is therefore 60.022 8) The standard deviation of the stock price at the end ofthe next day is 0.785 95% confidence Limite for the stock price tthe ead ofthe exe dy are HF2C: soon 2 «0.785 and $0.02242% 0.785 48.45 and 51.50CHAPTER 11 11.21. With the notation in the text Di=Dr=1, %=0.25, t=050, T=0.6667, r=01 and X=65 At ty: xfer 1*0.1657) — 1.97 Hence Dec xpos] Also: Ais X [Lert] = G51 — €°9 #02) = 1.60 Hence: Di B 8 = 308 Title of le woe psa (BAe raed ops en 5,000 x 0.6 ~ 450, Hence, in addition to the 5,000 traded options. a short position in £2,550 is necessary 40 tal the portfolio is both vega and delta neutral. [Lat uy be the position in the first traded option and w; be the position in the second traded option. "We require Surly 41.6,000 = 1.5u; + 0.502 Zechize¢ 4.4,000 = 0.80; + 0.6.5 ‘The solution to these equations can easily be seen to be w) = 3,200, uy = 2,400. The ‘whole portfolio then bas a deta of ~450-43,200 x 0.6 + 2,400 x 0.2 = 1,710 ‘Therefore the portfolio can be made delta, gamma and vega neutral by taking 2 long positon ia 3200 ofthe frst traded option, « long pontion in 2.400 ofthe second Eraded option and a short position in £1,710.CHAPTER 16 16.5. A binomial tree cannot be used in the way described in this chapter. This is an example of what is known as e history-dependent option. The payoff depends on the path followed by the stock price as well as its final value. The option cannot be valued by starting at the end of the tree and working backward since the payoff at the binomial tree approach that can be used to handle options where the payoff depends fon the average value of the stock price. Suppose a dividend equal to D is paid during a certain time interval. If $ is the stock price at the beginning of the time interval, it will be either Su—D or Sd—D at the end of the time interval. At the end of the next time interval, it will be one of (Su—D)u, (Su D)d, (Sd— D)u and (Sd - D)d. Since (Su — D)d does not equal (Sd—D)u the tree does not recombine. If S is equal to the stock price less the present value of future dividends, this problem is avoided ‘When the dividend yield is constant une a=} Por a elr-nat ‘Making the dividend yield, g, a function of time makes a, and therefore p, a function of time. However, it does not affect u or d. It follows that if q is a function of time wwe can use the same tree by making the probabilities a function of time. The interest, rate r can also be # function of time as described in Section 16.4.16.18. In this ease S = 20, X = 18, r = 0.15, ¢ = 0.40, T = 1, and At = 0.25. The ‘parameters for the tree are um eVBE = 00VTB 1 2914 _ 1.0382 - 0.8187 _ 2214 — 08187 ‘The tree produced by DerivaGem for the American option is shown in Figure 16.7. ‘The estimated value of the American option is $1.29. ‘As shown in Figure 16.8, the same tree can be used to value a Europesn put option ‘with the same parameters. The estimated value of the European option is $1.14. The option parameters are $= 20, X = 18, r= 0.15, ¢ = 0.40 and T= 1 1 (20/18) + 0.15 + 0.40°/: 0.40 a 0.8384 N(-é:) = 0.2009; N(—da) = 0.3306 The true European put price is therefore 18e- x 0.3306 — 20 x 0.2000 = 1.10 ‘The control variate estimate of the American put price is therefore 1.29-+1.10—1.14 = $1.25.Crown eto por stap, 4 1.0382 THT] eae 7 EATS OTT TT rca) TOTES am Noe Tne ‘oaco 0.2800 ascoe rst 0000 Figure 16.7 Tree to evaluate American option for Problem 16.13 Grote ete paren a+ 10382 ET Prnabay aap mov, p= 05481 wenn Se enon a a aa ExHo) . na a eI a 3 Tem rea Pa Te Ta ay sa aa ae a eee Tne ‘ome 02sto 0500007800 19000 Figure 16.8 Tree to evaluate European option in Problem 16.1317.3. 17.5. ant. 17.10. ql. 17.18 CHAPTER 17 Jumps tend to make both tails of the stock price distribution fatter than those of the lognormal distribution. This means that we obtain the classic volatility smile shown in Figure 17.1 of the text. The volatility smile is more pronounced for three-month options than six-month options because, as pointed out in the text, the impact of jumps tends to disappear as we look further ahead. ‘These biases are the same because of put-call parity. Suppose that Pus and Cie are the Black-Scholes prices of a Buropean put and call, and that Prokt and Cmxe are the put and call prices based in the market. Put-call parity must always be true. Hence with the usual notation Cet XETT = et S cate + XEWT = Page +S so that oa ~ Gmkt = Pos — Prakt showing that the bias for the call price is the same as the bias for the put price. When the call is in the money the put is out of the money and vice versa. This explains why the biases for in-the-money call options are usually the same as the biases for out-of-the-money put options. ‘There are a number of problems in testing an option pricing model empirically. These include the problem of obtaining synchronous data on stock prices and option prices, the problem of estimating the dividends that will be paid on the stock during the option’s life, the problem of distinguishing between situations where the market is inefficient and situations where the option pricing model is incorrect, and the problems of estimating stock price volatility. ‘The volatilities would have the general form shown in Figure 17.1 in the text. Implied volatilities would be higher for deep-in and deep-out-of-the-money options than for at- the-money options. The volatility differences would be most noticeable for short-life options and gradually disappear as the option life increased. This is because jumps have a relatively greater impact on short maturity options. ‘When the stock price and volatility are negatively correlated, there is a volatility skew similar to that in Figure 17.3 of the text. This tends to become less pronounced as the life of the option increases. A deep-out-of-the-money option has a low value. Decreases in its volatility reduce its value. However, this reduction is small because the value can never go below zero, Increases in its volatility, on the other hand, can lead to significant percentage increases in the value of the option. The option does, therefore, have some of the same attributes as an option on volatility.23.19 In this case o d CHAPTER 23 0.25, At = 1, r = 0.05 and the tree parameters are u = 1.2840, 7788, a = 1.0813, p = 6.5394, and 1 — p = 0.4606. The tree is shown in the figure. The upper number at each node is the stock price. The second number is the discount rate. This is 5% when the convertible is certain to be stock, 7% when it is certain to be debt and a weighted average of the two in other circumstances, The third number at each node is the value of the convertible immediately before the coupon, payment if any. The bond is worth 105 at the end of the final nodes. Tis discount rate at nodes D, E, and F is assumed to be 7% for roll back purposes. At node D the bond should be converted and it is worth 2.5 x 4122 = 144.27 immediately after the coupon payment or 149.27 immediatel e coupon payment. The discount rate St node D for use ia fature ealeulations is therefore 5%. At nodes E and F it should not be converted and is worth 105¢~°®” = 97.90 immediately after the coupon payment or 102.90 immediately before the coupon payment. The discount rate at nodes E and F is 7%. At node C the bond is worth 102,90e~°" = 95.94 immediately after the ‘coupon payment or 100.94 immediately before the coupon payment. the discount rate at this node is 7%. At node B the discount rate is 0.5394 x 5 + 0.4606 x 7 or 5.99% for the purposes of rollback. The value at node B is (0.5394 x 149.27 + 0.4606 x 102.90)e-# 95"? = 120.56 (3240 #3-6 115.56) immediately after th coupon payment. This shows that the bond should not be converted at node B! The value at node B immediately before the coupon payment is 125.56. The discount rate at node A is 0.5394 x 5.92 + 0.4606 x 7 or 6.42%. The value at node A is therefore (0.5394 x 125.56 + 0.4606 x 100.94)e7°°? = 107.12 showing that the value of the convertible is $107.12. The value of a non-convertible bond is 10527 27*9 4 5e°887*? 4 50°97 = 94.19 ‘The value of the conversion option is therefore 107.12 — 94.12 or $13.00.52.92 wens Tow se 108.00 148.27 ©) Jus ee ae ‘becomes 32.1 x 3.6 = 115.86’ The discount rate at node B becomes 5%. The discount rate at node A is 0.5394 x 5 + 0.4606 x 7 or 5.92%. The value of the concertible is (0.5994 x 115.96 + 0.4606 x 100.94)e°° = 102.77 ‘The eall option is therefore worth 107.12 102.77 or $4.35