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1. For American put options on a stock with identical expiry dates, you are given the following prices:

Strike price Put premium

30 2.40

35 6.40

For an American put option on the same stock with the same expiry date and strike price 38, which of the

following statements is correct?

(A) The lowest possible price for the option is 8.80.

(B) The highest possible price for the option is 8.80.

(C) The lowest possible price for the option is 9.20.

(D) The highest possible price for the option is 9.20.

(E) The lowest possible price for the option is 9.40.

2. A company has 100 shares of ABC stock. The current price of ABC stock is 30. ABC stock pays no divi-

dends.

The company would like to hedge its exposure to drops in the stock price by buying European put options

expiring in 6 months with exercise price 28.

European call options on the same stock expiring in 6 months with exercise price 28 are available for 4.10.

The continuously compounded risk-free rate is 5%.

Determine the cost of the hedge.

(A) 73 (B) 85 (C) 99 (D) 126 (E) 141

3. You are given the following prices for a stock:

Time Price

Initial 39

After 1 month 39

After 2 months 37

After 3 months 43

A portfolio of 3-month Asian options, each based on monthly averages of the stock price, consists of the

following:

(i) 100 arithmetic average price call options, strike 36.

(ii) 200 geometric average strike call options.

(iii) 300 arithmetic average price put options, strike 41.

Determine the net payoff of the portfolio after 3 months.

(A) 1433 (B) 1449 (C) 1464 (D) 1500 (E) 1512

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499 Questions continue on the next page . . .

500 PRACTICE EXAMS

4. The price of a 6-month futures contract on widgets is 260.

A 6-month European call option on the futures contract with strike price 256 is priced using Black’s formula.

You are given:

(i) The continuously compounded risk-free rate is 0.04.

(ii) The volatility of the futures contract is 0.25.

Determine the price of the option.

(A) 19.84 (B) 20.16 (C) 20.35 (D) 20.57 (E) 20.74

5. You are given the following binomial tree for continuously compounded interest rates:

0.08

0.06

0.04

0.10

0.06

0.02

Year 0 Year 1 Year 2

The probability of an up move is 0.5.

Calculate the continuously compounded interest rate on a default-free 3-year zero-coupon bond.

(A) 0.0593 (B) 0.0594 (C) 0.0596 (D) 0.0597 (E) 0.0598

6. An asset’s price at time t , X(t ), satisﬁes the stochastic differential equation

dX(t ) =0.5dt +0.9dZ(t )

You are given that X(0) =10.

Determine Pr

¸

X(2) >12

¸

.

(A) 0.16 (B) 0.21 (C) 0.26 (D) 0.29 (E) 0.32

7. For a delta-hedged portfolio, you are given

(i) The stock price is 40.

(ii) The stock’s volatility is 0.2.

(iii) The option’s gamma is 0.02.

Estimate the annual variance of the portfolio if it is rehedged every half-month.

(A) 0.001 (B) 0.017 (C) 0.027 (D) 0.034 (E) 0.054

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PRACTICE EXAM 1 501

8. You own 100 shares of a stock whose current price is 42. You would like to hedge your downside exposure

by buying 6-month European put options with a strike price of 40. You are given:

(i) The Black-Scholes framework is assumed.

(ii) The continuously compounded risk-free rate is 5%.

(iii) The stock pays no dividends.

(iv) The stock’s volatility is 22%.

Determine the cost of the put options.

(A) 121 (B) 123 (C) 125 (D) 127 (E) 129

9. You are given the following weekly stock prices for six consecutive weeks:

50.02 51.11 50.09 48.25 52.06 54.18

Using the method in the McDonald textbook that does not assume expected return is zero, estimate the

annual volatility of the stock.

(A) 0.11 (B) 0.12 (C) 0.29 (D) 0.33 (E) 0.34

10. For European options on a stock having the same expiry and strike price, you are given:

(i) The stock price is 85.

(ii) The strike price is 90.

(iii) The continuously compounded risk free rate is 0.04.

(iv) The continuously compounded dividend rate on the stock is 0.02.

(v) A call option has premium 9.91.

(vi) A put option has premium 12.63.

Determine the time to expiry for the options.

(A) 3 months (B) 6 months (C) 9 months (D) 12 months (E) 15 months

11. You are given the following stochastic differential equations for two geometric Brownian motion pro-

cesses for the prices of nondividend paying stocks:

dS

1

(t ) =0.10S

1

(t ) dt +0.06S

1

(t ) dZ(t )

dS

2

(t ) =0.15S

2

(t ) dt +0.10S

2

(t ) dZ(t )

Determine the continuously compounded risk-free rate.

(A) 0.02 (B) 0.025 (C) 0.03 (D) 0.035 (E) 0.04

12. Which of statements (A)–(D) is not a weakness of the lognormal model for stock prices?

(A) Volatility is constant.

(B) Large stock movements do not occur.

(C) Projected stock prices are skewed to the right.

(D) Stock returns are not correlated over time.

(E) (A)–(D) are all weaknesses.

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502 PRACTICE EXAMS

13. For a put option on a stock:

(i) The premium is 2.56.

(ii) Delta is −0.62.

(iii) Gamma is 0.09.

(iv) Theta is −0.02 per day.

Calculate the delta-gamma-theta approximation for the put premium after 3 days if the stock price goes up

by 2.

(A) 1.20 (B) 1.32 (C) 1.44 (D) 1.56 (E) 1.62

14. S

t

is the price of a stock at time t , with t expressed in years. You are given:

(i) S

t

/S

0

is lognormally distributed.

(ii) The continuously compounded expected annual return on the stock is 5%.

(iii) The annual σ for the stock is 30%.

(iv) The stock pays no dividends.

Determine the probability that the stock will have a positive return over a period of three years.

(A) 0.49 (B) 0.51 (C) 0.54 (D) 0.59 (E) 0.61

15. All zero-coupon bonds have a 5% continuously compounded yield to maturity. To demonstrate an arbi-

trage, you buy one 5-year zero-coupon bond with maturity value 1000 and duration-hedge by buying N 2-year

zero-coupon bonds with maturity value 1000. You ﬁnance the position by borrowing at the short-term rate.

Determine the amount you borrow.

(A) −1168 (B) −524 (C) 0.389 (D) 524 (E) 1168

16. For an at-the-money European call option on a nondividend paying stock:

(i) The price of the stock follows the Black-Scholes framework

(ii) The option expires at time t .

(iii) The option’s delta is 0.5832.

Calculate delta for an at-the-money European call option on the stock expiring at time 2t .

(A) 0.62 (B) 0.66 (C) 0.70 (D) 0.74 (E) 0.82

17. Gap options on a stock have six months to expiry, strike price 50, and trigger 49. You are given:

(i) The stock price is 45.

(ii) The continuously compounded risk free rate is 0.08.

(iii) The continuously compounded dividend rate of the stock is 0.02.

The premium for a gap call option is 1.68.

Determine the premium for a gap put option.

(A) 4.20 (B) 5.17 (C) 6.02 (D) 6.96 (E) 7.95

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PRACTICE EXAM 1 503

18. The time-t price of a stock is S(t ). A claim on a stock pays C(t ) =

**S(t ). S(t ) follows geometric Brownian
**

motion with drift 0.10 and volatility 0.2.

The Itô process followed by C is of the form

dC(t ) =aC(t ) dt +bC(t ) dZ(t )

Determine a.

(A) 0.040 (B) 0.045 (C) 0.050 (D) 0.055 (E) 0.060

19. A 1-year American pound-denominated put option on euros allows the sale of €100 for £90. It is modeled

with a 2-period binomial tree based on forward prices. You are given

(i) The spot exchange rate is £0.8/€.

(ii) The continuously compounded risk-free rate in pounds is 0.06.

(iii) The continuously compounded risk-free rate in euros is 0.04.

(iv) The relative volatility of pounds and euros is 0.1.

Calculate the price of the put option.

(A) 8.92 (B) 9.36 (C) 9.42 (D) 9.70 (E) 10.00

20. For a 1-year call option on a nondividend paying stock:

(i) The price of the stock follows the Black-Scholes framework.

(ii) The current stock price is 40.

(iii) The strike price is 45.

(iv) The continuously compounded risk-free rate is 0.05.

It has been observed that if the stock price increases 0.50, the price of the option increases 0.25.

Determine the implied volatility of the stock.

(A) 0.32 (B) 0.37 (C) 0.44 (D) 0.50 (E) 0.58

21. The Itô process X(t ) satisﬁes the stochastic differential equation

dX(t )

X(t )

=0.1dt +0.2dZ(t )

Determine Pr

¸

X(2)

3

>X(0)

3

¸

.

(A) 0.64 (B) 0.66 (C) 0.68 (D) 0.70 (E) 0.72

22. You are simulating one value of a lognormal random variable with parameters µ = 1, σ = 0.4 by drawing

12 uniform numbers on [0, 1]. The sum of the uniform numbers is 5.

Determine the generated lognormal random number.

(A) 1.7 (B) 1.8 (C) 1.9 (D) 2.0 (E) 2.1

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504 PRACTICE EXAMS

23. A nondividend paying stock satisﬁes the stochastic differential equation

dS(t )

S(t )

=0.15dt +0.3dZ(t )

You are given

(i) The price of the stock is 50.

(ii) The Sharpe ratio is 0.35.

Calculate the price of a European at-the-money call option on the stock with two years to expiry.

(A) 9.62 (B) 10.05 (C) 10.11 (D) 10.29 (E) 10.42

24. You are given:

(i) The price of a stock is 40.

(ii) The continuous dividend rate for the stock is 0.02.

(iii) Stock volatility is 0.3.

(iv) r =0.06.

A 3-month at-the-money European call option on the stock is priced with a 1-period binomial tree. The tree

is constructed so that the risk-neutral probability of an up move is 0.5 and the ratio between the prices on the

higher and lower nodes is e

2σ

h

, where h is the amount of time between nodes in the tree.

Determine the resulting price of the option.

(A) 3.11 (B) 3.16 (C) 3.19 (D) 3.21 (E) 3.28

25. For a portfolio of call options on a stock:

Number of Call premium

shares of stock per share Delta

100 11.4719 0.6262

100 11.5016 0.6517

200 10.1147 0.9852

Calculate delta for the portfolio.

(A) 0.745 (B) 0.812 (C) 0.934 (D) 297.9 (E) 324.8

Solutions to the above questions begin on page 599.

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Appendix A. Solutions for the Practice Exams

Answer Key for Practice Exam1

1 A 6 B 11 B 16 A 21 E

2 E 7 D 12 C 17 B 22 B

3 B 8 A 13 C 18 B 23 D

4 B 9 D 14 B 19 E 24 B

5 D 10 E 15 A 20 B 25 E

Practice Exam 1

1. [Section 2.4] Options are convex, meaning that as the strike price increases, the rate of increase in the

put premium does not decrease. The rate of increase from 30 to 35 is (6.40−2.40)/(35−30) =0.80, so the rate of

increase from 35 to 38 must be at least (38 −35)(0.80) = 2.40, making the price at least 6.40 +2.40 = 8.80. Thus

(A) is correct.

2. [Subsection 1.2.1] By put-call parity,

P =C +Ke

−r t

−Se

−δt

=4.10+28e

−0.025

−30 =1.4087

For 100 shares, the cost is 100(1.4087) = 140.87 . (E)

3. [Section 13.1] The monthly arithmetic average of the prices is

39+37+43

3

=39.6667

The monthly geometric average of the prices is

3

(39)(37)(43) =39.5893

The payments on the options are:

• The arithmetic average price call options with strike 36 pay 39.6667−36 =3.6667.

• The geometric average strike call options pay 43−39.5893 =3.4107.

• The arithmetic average price put options with strike 41 pay 41−39.6667 =1.3333.

The total payment on the options is 100(3.6667) +200(3.4107) +300(1.3333) = 1448.8 . (B)

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599

600 PRACTICE EXAM 1, ANSWERS TO QUESTIONS 4–7

0.852314

0.836106

0.923301

0.904837

0.941765

0.980199

Year 0 Year 1 Year 2

Figure A.1: Zero-coupon bond prices in the solution for question 5

4. [Section 9.3] By Black’s formula,

d

1

=

ln(260/256) +0.5(0.25

2

)(0.5)

0.25

0.5

=0.1761

d

2

=0.1761−0.25

0.5 =−0.0007

N(d

1

) =N(0.18) =0.5714

N(d

2

) =N(0) =0.5

C =260e

−0.02

(0.5714) −256e

−0.02

(0.5) = 20.16 (B)

5. [Section 18.1] The prices of bonds at year 2 are e

−0.1

=0.904837, e

−0.06

=0.941765, and e

−0.02

=0.980199

at the 3 nodes. Pulling back, the price of a 2-year bond at the upper node of year 1 is

0.5e

−0.08

(0.904837+0.941765) =0.852314

and the price of a 2-year bond at the lower node of year 1 is

0.5e

−0.04

(0.941765+0.980199) =0.923301

The price of a 3-year bond initially is

0.5e

−0.06

(0.852314+0.923301) =0.836106

The yield is −(ln0.836106)/3 = 0.059667 . (D) The binomial tree of bond prices is shown in Figure A.1.

6. [Lesson 16] This is arithmetic Brownian motion with µ = 0.5, σ = 0.9. For time t = 2, µt = (0.5)(2) = 1,

σ

t =0.9

**2. The movement is 12−10 =2.
**

Pr(X(2) >12) =1−N

2−1

0.9

2

**=1−N(0.79) =1−0.7852 = 0.2148 (B)
**

7. [Section 12.4] By the Boyle-Emanuel formula, with period

1

24

of a year, the variance of annual returns is

Var(R

1/24,1

) =

1

2

¸

(40

2

)(0.20

2

)(0.02)

¸

2

/24 = 0.0341 (D)

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PRACTICE EXAM 1, ANSWERS TO QUESTIONS 8–10 601

8. [Lesson 9] For one share, Black-Scholes formula gives:

d

1

=

ln(42/40) + [0.05−0+0.5(0.22

2

)](0.5)

0.22

0.5

=0.5521

d

2

=0.5521−0.22

0.5 =0.3966

N(−d

2

) =N(−0.40) =0.3446

N(−d

1

) =N(−0.55) =0.2912

P =40e

−0.05(0.5)

(0.3446) −42(0.2912) =1.2133

The cost of 100 puts is 100(1.2133) = 121.33 . (A)

Note that this question has nothing to do with delta hedging. The purchaser is merely interested in guaran-

teeing that he receives at least 40 for each share, and does not wish to give up upside potential. A delta hedger

gives up upside potential in return for keeping loss close to zero.

9. [Lesson 8] First calculate the logarithms of ratios of consecutive prices

t S

t

ln(S

t

/S

t −1

)

0 50.02

1 51.11 0.02156

2 50.09 −0.02016

3 48.25 −0.03743

4 52.06 0.07600

5 54.18 0.03991

Then calculate the sample standard deviation.

0.02156−0.02016−0.03743+0.07600+0.03991

5

=0.01598

0.02156

2

+0.02016

2

+0.03743

2

+0.07600

2

+0.03991

2

5

=0.001928

5

4

(0.001928−0.01598

2

) =0.002091

0.002091 =0.04573

Then annualize by multiplying by

52

0.04573

52 = 0.3298 (D)

10. [Subsection 1.2.1] By put-call parity

12.63−9.91 =90e

−0.04t

−85e

−0.02t

90e

−0.04t

−85e

−0.02t

−2.72 =0

Let x =e

−0.02t

and solve the quadratic for x.

x =

85+

85

2

+4(90)(2.72)

2(90)

=

175.577

180

=0.975428

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602 PRACTICE EXAM 1, ANSWERS TO QUESTIONS 11–16

The other solution to the quadratic leads to x <0, which is impossible for x =e

−0.02t

. Now we solve for t .

e

−0.02t

=0.975428

0.02t =−ln0.975428 =0.024879

t =50(0.024879) = 1.244 (E)

11. [Section 17.3] The Sharpe ratios must be equal, so

0.10−r

0.06

=

0.15−r

0.10

0.01−0.1r =0.009−0.06r

0.04r =0.001

r = 0.025 (B)

12. [Subsection 6.2.1] (C) is not a weakness, since one would expect that the multiplicative change in stock

price, rather than the additive change, is symmetric.

13. [Section 12.2] Theta is expressed per day of decrease, so we just have to multiply it as given by 3. Thus

the change in price is

∆ε+0.5Γε

2

+θh =−0.62(2) +0.5(0.09)(2

2

) −0.02(3) =−1.12

The new price is 2.56−1.12 = 1.44 . (C)

14. [Section 7.2] We are given that the average return α = 0.05, so the parameter of the associated normal

distribution is µ = 0.05 −0.5(0.3

2

) = 0.005. For a three year period, m = µt = 0.015 and v = σ

t = 0.3

3 =

0.5196. For a positive return, we need the normal variable with these parameters to be greater than 0. The

probability that an (0.015, 0.5196

2

) variable is greater than 0 is N(0.015/0.5196) =N(0.03) = 0.512 . (B)

15. [Subsection 20.1] The price of a 5-year bond with maturity value 1 is e

−5(0.05)

= 0.778801. The price of a

2-year bond with maturity value 1 is e

−2(0.05)

= 0.904837. Letting P(0, T) be the price of a T-year zero-coupon

bond, the duration-hedge ratio is

N =−

5P(0, 5)

2P(0, 2)

=−

5(0.778801)

2(0.904837)

=−2.15177

Thus you buy a 5-year bond for 1000 and sell 2.15177 2-year bonds for 1000 at a cost of

778.80−2.15177(904.83) = −1168 (A)

16. [Section 10.1] Delta is e

−δt

N(d

1

), or N(d

1

) for a nondividend paying stock. Since the option is at-the-

money,

d

1

=

(r +0.5σ

2

)t

σ

t

=

r +0.5σ

2

σ

t

So doubling time multiplies d

1

by

2.

N(d

1

) =0.5832

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PRACTICE EXAM 1, ANSWERS TO QUESTIONS 17–19 603

d

1

=N

−1

(0.5832) =0.21

d

1

2 = (0.21)(1.4142) =0.2970

N(0.2970) =N(0.30) =0.6179 (A)

17. [Section14.2] For gap options, put-call parity applies with the strike price. If you buy a call and sell a put,

if S

T

>K

2

(the trigger price) you collect S

t

and pay K

1

, and if S

t

<K

2

you pay K

1

and collect S

t

which is the same

as collecting S

t

and paying K

1

, so

C −P =Se

−δt

−K

1

e

−r t

In this problem,

P =C +K

1

e

−r t

−Se

−δt

=1.68+50e

−0.04

−45e

−0.01

= 5.167 (B)

18. [Section 17.1] The process for S is

dS = (0.12−0.02)S dt +0.2S dZ

Using Itô’s lemma,

dC =C

S

dS +

1

2

C

SS

(dS)

2

+C

t

dt

=

0.10S

2

S

dt −

1

2

0.2

2

S

2

(2)(2)S

3/2

dt +

0.2S

2

S

dZ

=

0.05

S −

0.04

8

S

dt +0.1

S dZ

= (0.05−0.005)C dt +0.1C dZ

The constant multiple of the drift term is therefore 0.05−0.005 = 0.045 . (B)

An alternative and easier method is to log the process and then exponentiate it back. lnC =0.5lnS, and

dlnS(t ) =

¸

0.12−0.02−0.5(0.2

2

)

¸

dt +0.2dZ(t ) =0.08dt +0.2dZ(t )

dlnC(t ) =0.04dt +0.1dZ(t )

dC(t )

C(t )

=

¸

0.04+0.5(0.1)

2

¸

dt +0.1dZ(t ) =0.045dt +0.1dZ(t )

19. [Section 4.3] The 6-month forward rate of euros in pounds is e

(0.06−0.04)(0.5)

= e

0.01

= 1.01005. Up and

down movements, and the risk-neutral probability of an up movement, are

u =e

0.01+0.1

0.5

=1.08406

d =e

0.01−0.1

0.5

=0.94110

p

∗

=

1.01005−0.94110

1.08406−0.94110

=0.4823

1−p

∗

=1−0.4823 =0.5177

The binomial tree is shown in Figure A.2. At the upper node of the second column, the put value is calculated as

P

u

=e

−0.03

(0.5177)(0.08384) =0.04212

At the lower node of the second column, the put value is calculated as

P

tentative

d

=e

−0.03

¸

(0.4823)(0.08384) + (0.5177)(0.19147)

¸

=0.13543

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604 PRACTICE EXAM 1, ANSWERS TO QUESTIONS 20–22

0.86725

0.04212

0.8

0.1

0.75288

0.14712

0.94014

0

0.81616

0.08384

0.70853

0.19147

Figure A.2: Exchange rates and option values for put option of question 19

but the exercise value 0.9−0.75288 =0.14712 is higher so it is optimal to exercise. At the initial node, the calcu-

lated value of the option is

P

tentative

=e

−0.03

¸

(0.4823)(0.04212) + (0.5177)(0.14712)

¸

=0.09363

Since 0.9−0.8 =0.1 >0.09363, it is optimal to exercise the option immediately, so its value is 0.10 (which means

that such an option would never exist), and the price of an option for €100 is 100(0.10) = 10 . (E)

20. [Section 11.2.1] ∆ is observed to be 0.25/0.50 =0.5. In Black-Scholes formula, ∆ =e

−δt

N(d

1

) =N(d

1

) in

our case. Since N(d

1

) =0.5, d

1

=0. Then

ln(S/K) +r +0.5σ

2

σ

=0

ln(40/45) +0.05+0.5σ

2

=0

0.5σ

2

=−ln(40/45) −0.05 =0.11778−0.05 =0.06778

σ

2

=

0.06778

0.5

=0.13556

σ=

0.13556 = 0.3682 (B)

21. [Section 7.2] The fraction X(2)/X(0) follows a lognormal distribution with parameters m = 2

¸

0.1 −

0.5(0.2

2

)

¸

= 0.16 and v = 0.2

**2. Cubing does not affect inequalities, so the requested probability is the same
**

as Pr

¸

lnX(2) −lnX(0) >0

¸

, which is

1−N

−0.16

0.2

2

=N(0.57) = 0.7157 (E)

22. [Section 15.2] The sum of the uniform numbers has mean 6, variance 1, so we subtract 6 to standardize

it.

5−6 =−1

We then multiply by σ and add µ to obtain a (µ, σ

2

) random variable.

(−1)(0.4) +1 =0.6

MFE/3F Study Manual—7th edition 2nd printing

Copyright ©2010 ASM

PRACTICE EXAM 1, ANSWERS TO QUESTIONS 23–25 605

Then we exponentiate.

e

0.6

= 1.822 (B)

23. [Section 17.3] We back out the risk-free rate from the Sharpe ratio, as deﬁned in equation (17.3):

0.35 =

0.15−r

0.3

r =0.15−0.3(0.35) =0.045

The given Itô process is a geometric Brownian motion. A stock following a geometric Brownian motion is

in the Black-Scholes framework, so we use the Black-Scholes formula for the price of the option. Note that

K =S =50 since the option is at-the-money.

d

1

=

¸

0.045+0.5(0.3

2

)

¸

(2)

0.3

2

=0.4243

d

2

=0.4243−0.3

2 =0

N(d

1

) =N(0.42) =0.6628

N(d

2

) =N(0) =0.5

C(50, 50, 2) =50(0.6628) −50e

−0.045(2)

(0.5) = 10.29 (D)

24. [Lesson 3] The risk-neutral probability is

0.5 =p

∗

=

e

(r −δ)h

−d

u −d

=

e

(0.06−0.02)(0.25)

−d

u −d

=

e

0.01

−d

u −d

but u =de

2σ

h

=de

2(0.3)(1/2)

=de

0.3

, so

e

0.01

−d =0.5

¸

e

0.3

d −d

¸

e

0.01

=d

¸

0.5(e

0.3

−1) +1

¸

=1.17493d

d =

e

0.01

1.17493

=0.85967

u =0.85967e

0.3

=1.16043

The option only pays at the upper node. The price of the option is

C =e

−r h

p

∗

(Su −K) =e

−0.06(0.25)

(0.5)

¸

40(1.16043) −40

¸

= 3.1609 (B)

25. [Subsection 10.1.7] Delta for a portfolio of options on a single stock is the sum of the individual deltas of

the options.

100(0.6262) +100(0.6517) +200(0.9852) = 324.8 (E)

MFE/3F Study Manual—7th edition 2nd printing

Copyright ©2010 ASM

Determine the price of the option. You are given the following binomial tree for continuously compounded interest rates: Year 0 Year 1 Year 2 0. Calculate the continuously compounded interest rate on a default-free 3-year zero-coupon bond. Estimate the annual variance of the portfolio if it is rehedged every half-month. (ii) The volatility of the futures contract is 0.2.06 0. A 6-month European call option on the futures contract with strike price 256 is priced using Black’s formula. X (t ).017 (C) 0.034 (E) 0. .16 (C) 20.32 For a delta-hedged portfolio.08 0.04.26 (D) 0. (A) 19. (A) 0.21 (C) 0.35 (D) 20.10 0.25.5. Determine Pr X (2) > 12 .06 6. you are given (i) The stock price is 40.0593 (B) 0.0598 0. (A) 0. An asset’s price at time t .16 7. (B) 0. (iii) The option’s gamma is 0. (ii) The stock’s volatility is 0.0597 (E) 0.054 MFE/3F Study Manual—7th edition 2nd printing Copyright ©2010 ASM Questions continue on the next page .5 dt + 0. The price of a 6-month futures contract on widgets is 260. (A) 0.9 dZ (t ) You are given that X (0) = 10.74 5.500 PRACTICE EXAMS 4. .02.84 (B) 20.001 (B) 0.02 The probability of an up move is 0. satisﬁes the stochastic differential equation dX (t ) = 0. You are given: (i) The continuously compounded risk-free rate is 0.57 (E) 20.027 (D) 0.04 0. .0594 (C) 0.0596 (D) 0.29 (E) 0.

10S 1 (t ) dt + 0.04 Which of statements (A)–(D) is not a weakness of the lognormal model for stock prices? Volatility is constant. For European options on a stock having the same expiry and strike price. (A)–(D) are all weaknesses.PRACTICE EXAM 1 501 8. (A) 0. The strike price is 90. estimate the annual volatility of the stock.02 12.34 10.18 Using the method in the McDonald textbook that does not assume expected return is zero. The stock’s volatility is 22%. you are given: (i) (ii) (iii) (iv) (v) (vi) The stock price is 85.04.10S 2 (t ) dZ (t ) Determine the continuously compounded risk-free rate.91. Determine the cost of the put options.15S 2 (t ) dt + 0. Projected stock prices are skewed to the right. The stock pays no dividends. (A) 3 months (B) 6 months (C) 9 months (D) 12 months (E) 15 months 11.035 (E) 0. The continuously compounded risk-free rate is 5%.09 48. (A) 121 (B) 123 (C) 125 (D) 127 (E) 129 9. Large stock movements do not occur. You would like to hedge your downside exposure by buying 6-month European put options with a strike price of 40.06 54. The continuously compounded dividend rate on the stock is 0.29 (D) 0. Stock returns are not correlated over time. . MFE/3F Study Manual—7th edition 2nd printing Copyright ©2010 ASM Questions continue on the next page .33 (E) 0.11 (B) 0. The continuously compounded risk free rate is 0. .02 51. You are given the following weekly stock prices for six consecutive weeks: 50. You own 100 shares of a stock whose current price is 42.03 (D) 0. A put option has premium 12. (A) 0.02. (A) (B) (C) (D) (E) (B) 0.12 (C) 0.11 50.25 52. . A call option has premium 9.63.025 (C) 0. Determine the time to expiry for the options. You are given the following stochastic differential equations for two geometric Brownian motion processes for the prices of nondividend paying stocks: dS 1 (t ) = 0. You are given: (i) (ii) (iii) (iv) The Black-Scholes framework is assumed.06S 1 (t ) dZ (t ) dS 2 (t ) = 0.

32 (C) 1. and trigger 49. You ﬁnance the position by borrowing at the short-term rate.17 (C) 6.61 15. You are given: (i) (ii) (iii) (iv) S t /S 0 is lognormally distributed. Gamma is 0.02 (D) 6.70 (D) 0. You are given: (i) The stock price is 45. (ii) The continuously compounded risk free rate is 0.62 (B) 0. (A) −1168 (B) −524 (C) 0. Calculate delta for an at-the-money European call option on the stock expiring at time 2t .82 17.51 (C) 0.54 (D) 0. (iii) The option’s delta is 0.02 per day. (A) 0. Determine the probability that the stock will have a positive return over a period of three years.09.68. (A) 0. S t is the price of a stock at time t . Calculate the delta-gamma-theta approximation for the put premium after 3 days if the stock price goes up by 2. (A) 1. . For a put option on a stock: (i) (ii) (iii) (iv) The premium is 2. .66 (C) 0. with t expressed in years.56 (E) 1. The premium for a gap call option is 1. (A) 4.5832.44 (D) 1. .20 (B) 1. Theta is −0. Delta is −0.502 PRACTICE EXAMS 13. All zero-coupon bonds have a 5% continuously compounded yield to maturity. The annual σ for the stock is 30%.62 14.02. (iii) The continuously compounded dividend rate of the stock is 0.59 (E) 0.389 (D) 524 (E) 1168 16.95 MFE/3F Study Manual—7th edition 2nd printing Copyright ©2010 ASM Questions continue on the next page .08. The stock pays no dividends.62.20 (B) 5. The continuously compounded expected annual return on the stock is 5%. Determine the premium for a gap put option. strike price 50. you buy one 5-year zero-coupon bond with maturity value 1000 and duration-hedge by buying N 2-year zero-coupon bonds with maturity value 1000. To demonstrate an arbitrage. Gap options on a stock have six months to expiry.96 (E) 7.56. Determine the amount you borrow.74 (E) 0.49 (B) 0. For an at-the-money European call option on a nondividend paying stock: (i) The price of the stock follows the Black-Scholes framework (ii) The option expires at time t .

The strike price is 45. Calculate the price of the put option.0 (E) 2. The continuously compounded risk-free rate in pounds is 0.10 and volatility 0.58 The Itô process X (t ) satisﬁes the stochastic differential equation dX (t ) = 0.92 20.37 (C) 0.040 (B) 0.50 (E) 0.2 dZ (t ) X (t ) Determine Pr X (2)3 > X (0)3 .8 (C) 1.66 (C) 0. . (i) (ii) (iii) (iv) (B) 9.7 (B) 1. The time-t price of a stock is S(t ).70 (E) 10.060 100 for £90. (A) 8.04.1.8/ .06.9 (D) 2. You are given (i) (ii) (iii) (iv) The spot exchange rate is £0.50.05.2. σ = 0. The Itô process followed by C is of the form dC (t ) = a C (t ) dt + bC (t ) dZ (t ) Determine a .36 (C) 9. It has been observed that if the stock price increases 0.1 dt + 0. The current stock price is 40. Determine the generated lognormal random number. A 1-year American pound-denominated put option on euros allows the sale of with a 2-period binomial tree based on forward prices. A claim on a stock pays C (t ) = motion with drift 0.72 22. The relative volatility of pounds and euros is 0. (A) 0. (A) 0.00 For a 1-year call option on a nondividend paying stock: The price of the stock follows the Black-Scholes framework.4 by drawing 12 uniform numbers on [0.42 (D) 9.PRACTICE EXAM 1 503 18. The continuously compounded risk-free rate is 0.050 S(t ). .25.64 (B) 0. You are simulating one value of a lognormal random variable with parameters µ = 1.055 (E) 0.44 (D) 0. (A) 1. S(t ) follows geometric Brownian (D) 0. the price of the option increases 0.68 (D) 0. 1]. . The continuously compounded risk-free rate in euros is 0.045 (C) 0. It is modeled 19. Determine the implied volatility of the stock. (B) 0.1 MFE/3F Study Manual—7th edition 2nd printing Copyright ©2010 ASM Questions continue on the next page .70 (E) 0.32 21. The sum of the uniform numbers is 5. (A) 0.

28 25. (B) 10. Stock volatility is 0. (A) 3.1147 Delta 0. where h is the amount of time between nodes in the tree.11 (B) 3.05 (C) 10. For a portfolio of call options on a stock: Number of shares of stock 100 100 200 Calculate delta for the portfolio.11 (D) 10.19 (D) 3. The continuous dividend rate for the stock is 0.745 (B) 0. r = 0. Determine the resulting price of the option.934 (D) 297. (ii) The Sharpe ratio is 0.812 (C) 0.504 PRACTICE EXAMS 23.15 dt + 0.06.62 24.02.29 (E) 10. (A) 0.16 (C) 3.6517 0.21 (E) 3.42 A 3-month at-the-money European call option on the stock is priced with a 1-period binomial tree.5 and the ratio between the prices on the higher and lower nodes is e 2σ h .3. The tree is constructed so that the risk-neutral probability of an up move is 0.8 Call premium per share 11. You are given: (i) (ii) (iii) (iv) The price of a stock is 40.5016 10.4719 11. (A) 9.6262 0. MFE/3F Study Manual—7th edition 2nd printing Copyright ©2010 ASM . Calculate the price of a European at-the-money call option on the stock with two years to expiry. A nondividend paying stock satisﬁes the stochastic differential equation dS(t ) = 0.9 (E) 324.3 dZ (t ) S(t ) You are given (i) The price of the stock is 50.9852 Solutions to the above questions begin on page 599.35.

(B) • The arithmetic average price put options with strike 41 pay 41 − 39.5893 = 3.6667) + 200(3.80) = 2.3333) = 1448. 2. P = C + K e −r t − Se −δt For 100 shares. Solutions for the Practice Exams Answer Key for Practice Exam 1 1 2 3 4 5 A E B B D 6 7 8 9 10 B D A D E 11 12 13 14 15 B C C B A 16 17 18 19 20 A B B E B 21 22 23 24 25 E B D B E Practice Exam 1 1. so the rate of increase from 35 to 38 must be at least (38 − 35)(0.2.Appendix A. MFE/3F Study Manual—7th edition 2nd printing Copyright ©2010 ASM 599 .8 . meaning that as the strike price increases. • The arithmetic average price call options with strike 36 pay 39.40.10 + 28e −0.4107. The total payment on the options is 100(3. [Section 13.40 + 2. making the price at least 6.025 − 30 = 1.4] Options are convex. Thus (A) is correct.40 = 8.4107) + 300(1. [Section 2.4087) = 140.40)/(35 − 30) = 0.4087 (39)(37)(43) = 39. The rate of increase from 30 to 35 is (6.3333. (E) 3. the rate of increase in the put premium does not decrease.40 − 2.1] The monthly arithmetic average of the prices is 39 + 37 + 43 = 39. [Subsection 1.87 .80. the cost is 100(1.6667.6667 = 1.80.5893 The payments on the options are: • The geometric average strike call options pay 43 − 39.6667 − 36 = 3.1] By put-call parity.6667 3 The monthly geometric average of the prices is 3 = 4.

2148 1 24 (B) 7.1761 5.600 PRACTICE EXAM 1.5)(2) = 1.25 0.980199) = 0.923301 0.4] By the Boyle-Emanuel formula.923301 The price of a 3-year bond initially is 0. Pulling back.5714) − 256e −0.02) 2 /24 = 0. 0.059667 . σ = 0.852314 0.836106 The yield is −(ln 0.941765) = 0.16 (B) d1 = ln(260/256) + 0.202 )(0. [Lesson 16] This is arithmetic Brownian motion with µ = 0.79) = 1 − 0.3] By Black’s formula. the variance of annual returns is (D) (402 )(0. e −0. and e −0.7852 = 0.980199 0.852314 + 0.06 = 0.9 2 2−1 = 1 − N (0.0007 N (d 1 ) = N (0.5.25 0.9 2.252 )(0. σ t = 0. [Section 9.941765 + 0.18) = 0.06 (0.5e −0.08 (0.923301) = 0. with period Var(R 1/24.980199 at the 3 nodes.9.904837 + 0. ANSWERS TO QUESTIONS 4–7 Year 0 Year 1 Year 2 0. µt = (0.1761 − 0.5e −0.5714 N (d 2 ) = N (0) = 0.1: Zero-coupon bond prices in the solution for question 5 4.941765. The movement is 12 − 10 = 2.5 d 2 = 0.941765 Figure A.02 (0.02 = 0.904837 0.1 = 0.5e −0.1.836106 0. [Section 12.5(0. Pr(X (2) > 12) = 1 − N 0.02 (0.852314 and the price of a 2-year bond at the lower node of year 1 is 0.1] The prices of bonds at year 2 are e −0.5) = 0. the price of a 2-year bond at the upper node of year 1 is 0. (D) The binomial tree of bond prices is shown in Figure A.5 = −0. [Section 18.836106)/3 = 0. For time t = 2.0341 MFE/3F Study Manual—7th edition 2nd printing Copyright ©2010 ASM .04 (0.1 ) = 1 2 of a year.5) = 20.5 C = 260e −0.904837. 6.

5) (0.3966 N (−d 2 ) = N (−0.039912 0.02156 = 0.3446) − 42(0.02156 − 0.222 )](0.72) 2(90) = 175.3446 N (−d 1 ) = N (−0.22 0.PRACTICE EXAM 1. and does not wish to give up upside potential.577 = 0. [Subsection 1.975428 180 MFE/3F Study Manual—7th edition 2nd printing Copyright ©2010 ASM .076002 + 0.02016 − 0.22 0.2133) = 121.5 d 2 = 0.5(0.020162 + 0.72 = 0 Let x = e −0.015982 ) = 0.09 48. Black-Scholes formula gives: d1 = 0.2.04t − 85e −0.5) = 0.5 = 0. The purchaser is merely interested in guaranteeing that he receives at least 40 for each share. [Lesson 9] For one share.02t and solve the quadratic for x .03743 0.05(0.11 50.02016 −0.04573 52 = 0.3298 (D) 10.04t − 85e −0.33 .07600 0.06 54.01598 5 2 + 0.55) = 0.5521 Then calculate the sample standard deviation.02t 90e −0.91 = 90e −0.03743 + 0.001928 5 5 (0.1] By put-call parity 12.002091 4 0.18 ln(S t /S t −1 ) 0. [Lesson 8] First calculate the logarithms of ratios of consecutive prices t 0 1 2 3 4 5 St 50.02 51. x= 85 + 852 + 4(90)(2.05 − 0 + 0.63 − 9.02t − 2.037432 + 0.07600 + 0.04573 Then annualize by multiplying by 52 0.5521 − 0.2912 P = 40e −0. (A) Note that this question has nothing to do with delta hedging. A delta hedger gives up upside potential in return for keeping loss close to zero.2133 The cost of 100 puts is 100(1.03991 ln(42/40) + [0.03991 = 0.001928 − 0.02156 −0.2912) = 1. 0.25 52. ANSWERS TO QUESTIONS 8–10 601 8.002091 = 0.40) = 0. 9.

5832 MFE/3F Study Manual—7th edition 2nd printing Copyright ©2010 ASM .02t = − ln 0.05) = 0.602 PRACTICE EXAM 1. For a three year period. since one would expect that the multiplicative change in stock price.1r = 0.5σ2 d1 = = t σ σ t So doubling time multiplies d 1 by 2.02t .975428 = 0.2. 13.44 . we need the normal variable with these parameters to be greater than 0. (C) 14.015. e −0.024879) = 1.3 3 = 0.778801) =− = −2. is symmetric.09)(22 ) − 0.2] We are given that the average return α = 0.5Γε2 + θ h = −0.06 0.1] The price of a 5-year bond with maturity value 1 is e −5(0. The price of a 2-year bond with maturity value 1 is e −2(0. or N (d 1 ) for a nondividend paying stock. ANSWERS TO QUESTIONS 11–16 The other solution to the quadratic leads to x < 0. The probability that an (0. which is impossible for x = e −0.778801.02t = 0.15177 2P(0.05 − 0.06r 0. T ) be the price of a T -year zero-coupon bond.5σ2 )t r + 0. (B) 15.32 ) = 0.5196. (r + 0.12 = 1.5(0. 5) 5(0.5(0.62(2) + 0. Thus the change in price is ∆ε + 0. Letting P(0. so we just have to multiply it as given by 3.015/0. N (d 1 ) = 0.05) = 0.975428 0.15 − r = 0.15177 2-year bonds for 1000 at a cost of 778.10 − r 0.025 (B) 12. 2) 2(0.3] The Sharpe ratios must be equal.51962 ) variable is greater than 0 is N (0.02(3) = −1. [Section 10. rather than the additive change. [Subsection 6.83) = −1168 (A) 16. the duration-hedge ratio is N =− 5P(0.04r = 0. [Section 17.015 and v = σ t = 0. [Section 12.244 (E) 11. For a positive return.009 − 0.005. Now we solve for t . so the parameter of the associated normal distribution is µ = 0.01 − 0.512 . [Subsection 20.05. [Section 7. so 0.904837.03) = 0.2] Theta is expressed per day of decrease. m = µt = 0.56 − 1.5196) = N (0.15177(904.024879 t = 50(0. Since the option is at-themoney.80 − 2. 0.10 0.904837) Thus you buy a 5-year bond for 1000 and sell 2.001 r = 0.1] Delta is e −δt N (d 1 ).12 The new price is 2.1] (C) is not a weakness.

045 .PRACTICE EXAM 1.21 d 1 2 = (0.5(0. if S T > K 2 (the trigger price) you collect S t and pay K 1 .1C dZ The constant multiple of the drift term is therefore 0.005)C dt + 0. Up and down movements.5177)(0.21)(1.5) = e 0.94110 = 0.1)2 dt + 0. P = C + K 1 e −r t − Se −δt = 1.19147) = 0.5177 MFE/3F Study Manual—7th edition 2nd printing Copyright ©2010 ASM .02 − 0.2S dt + dZ 2 (2)(2)S 3/2 2 S 2 S 0.08 dt + 0.01 = 5.04 S dt + 0.04 dt + 0.05 − 0.4823)(0.5 The binomial tree is shown in Figure A.167 18.08384) + (0.01005 − 0. and the risk-neutral probability of an up movement.68 + 50e −0.13543 1.1 0.01+0.30) = 0. [Section 17.2970) = N (0.04 − 45e −0.02)S dt + 0.2] For gap options. the put value is calculated as tentative Pd = e −0.01 = 1.5832) = 0.2 dZ (t ) = 0.1 d =e p∗ = 0. put-call parity applies with the strike price.22S 2 0. so C − P = Se −δt − K 1 e −r t In this problem.5(0.22 ) dt + 0.12 − 0.03 (0. the put value is calculated as Pu = e −0. [Section 14.3] The 6-month forward rate of euros in pounds is e (0.94110 0.5177)(0.6179 (A) 17.5 lnS.4823 1. ANSWERS TO QUESTIONS 17–19 603 d 1 = N −1 (0.04212 At the lower node of the second column.005 = 0.08384) = 0.4142) = 0. d lnC (t ) = 0. and d lnS(t ) = 0.12 − 0.1 dZ (t ) = 0.4823 = 0.01−0. (B) An alternative and easier method is to log the process and then exponentiate it back.5 (B) Using Itô’s lemma. At the upper node of the second column. and if S t < K 2 you pay K 1 and collect S t which is the same as collecting S t and paying K 1 .08406 − 0.06−0.1 dZ (t ) = 1.1 S dZ = 0.03 (0. are u = e 0.2970 N (0. [Section 4.1] The process for S is dS = (0.94110 ∗ 1 − p = 1 − 0.045 dt + 0. If you buy a call and sell a put.2.08406 = 0.10S dt − = (0.04 + 0.05 S − 8 = 0. lnC = 0.1 dZ (t ) C (t ) 19.04)(0.2 dZ (t ) dC (t ) = 0.01005.05 − 0.2S dZ dC = C S dS + 1 C SS (dS)2 + C t dt 2 1 0.

(−1)(0.5177)(0.1 0.14712 0.05 = 0. so the requested probability is the same as Pr ln X (2) − ln X (0) > 0 .1] ∆ is observed to be 0.9 − 0.08384 Figure A.5(0.8 = 0.2 2 = N (0.09363.05 = 0.94014 0 0.06778 = 0.04212) + (0.75288 = 0.2: Exchange rates and option values for put option of question 19 but the exercise value 0.06778 σ2 = 0. and the price of an option for 100 is 100(0.14712 is higher so it is optimal to exercise.9 − 0. it is optimal to exercise the option immediately. σ2 ) random variable.25/0.5σ2 =0 σ ln(40/45) + 0. 5 − 6 = −1 We then multiply by σ and add µ to obtain a (µ.57) = 0.1 > 0.10 (which means that such an option would never exist).4823)(0.16 21.86725 0. [Section 7.04212 0.5σ2 = − ln(40/45) − 0.11778 − 0.2 2.22 ) = 0.2.14712) = 0.75288 0.604 PRACTICE EXAM 1.1 − 0.03 (0.16 and v = 0.6 MFE/3F Study Manual—7th edition 2nd printing Copyright ©2010 ASM .50 = 0. ∆ = e −δt N (d 1 ) = N (d 1 ) in our case.2] The fraction X (2)/X (0) follows a lognormal distribution with parameters m = 2 0. (E) 20.70853 0.81616 0. Since N (d 1 ) = 0.05 + 0. ANSWERS TO QUESTIONS 20–22 0. variance 1.8 0.4) + 1 = 0. so its value is 0. At the initial node. Then ln(S/K ) + r + 0.13556 = 0.19147 0.09363 Since 0. the calculated value of the option is P tentative = e −0. d 1 = 0.5σ2 = 0 0.2] The sum of the uniform numbers has mean 6. which is 1−N −0. Cubing does not affect inequalities. [Section 11. In Black-Scholes formula. so we subtract 6 to standardize it.13556 0.5.10) = 10 .5.3682 (B) 0.5 σ= 0. [Section 15.7157 (E) 22.

32 ) (2) = 0.7] Delta for a portfolio of options on a single stock is the sum of the individual deltas of the options.42) = 0.29 24.822 (B) 23.35 = 0. ANSWERS TO QUESTIONS 23–25 605 Then we exponentiate.4243 − 0.1609 (B) 25.3] We back out the risk-free rate from the Sharpe ratio.3 − 1) + 1 = 1.5(e 0.17493 u = 0.25) (0. as deﬁned in equation (17.3 2 d 2 = 0.1.01 − d = 0.3 2 = 0 C (50.5) = 10.25) − d e 0.06−0.3 = 1.6517) + 200(0. 50. e 0.5 e 0.01 − d = = u −d u −d u −d e 0. 100(0.06(0.85967e 0.15 − 0. [Subsection 10.9852) = 324.01 = 0.17493d e 0. [Lesson 3] The risk-neutral probability is 0. 2) = 50(0.045 + 0.85967 1. so we use the Black-Scholes formula for the price of the option.045(2) (0. A stock following a geometric Brownian motion is in the Black-Scholes framework.6262) + 100(0.4243 N (d 1 ) = N (0.3 . [Section 17.6628) − 50e −0.5 = p ∗ = but u = d e 2σ h (D) = d e 2(0.6 = 1.3(0.3 r = 0. The price of the option is C = e −r h p ∗ (Su − K ) = e −0.15 − r 0.6628 N (d 2 ) = N (0) = 0.3)(1/2) = d e 0.5 0.01 = d 0.16043 The option only pays at the upper node. d1 = 0.35) = 0.8 (E) MFE/3F Study Manual—7th edition 2nd printing Copyright ©2010 ASM . Note that K = S = 50 since the option is at-the-money.5(0.02)(0.5) 40(1.045 The given Itô process is a geometric Brownian motion.3 d − d d= e 0. so e (r −δ)h − d e (0.16043) − 40 = 3.3): 0.PRACTICE EXAM 1.

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