Raj. Iyer & Jos L.

Peydr

Solutions CFP Tutorial #4

Question 1 a)If gamma=0.4, the optimal decision for the firm is to wait until t=2 and then to convert (oblige the debt holders to have equity instead of debt) in all states of nature except when the asset value is 1176. Therefore the final payoffs for the holder (buyer) will be 350, 235.2 and 117.6 and the value at t=0 will be 205.44 Lets explain it a bit better: From problem no 2 from tutorial 3, we already have the asset tree. Now to price these bonds we have to see when the firm will force conversion and then calculate the payoffs to the bondholders. If the firm forces conversion at the upper node at t=2, bond holders receive= 0.4* 1176= 470.4, thus the payoff is higher for the bond holders if the firm forces conversion, therefore the firm will not force conversion. Therefore the payoff to bond holders at uu=350 At ud at t=2, If the firm forces conversion, the payoff to bond holders is 0.4*588=235.2 As against 350 if they were not forced to convert. Now the firm will force conversion as the payoff to bond holders is lower if it forced conversion. Therefore the payoff to bond holders at ud=232.5 Similarly at node dd, we will see that the firm forces conversion as 0.4*294=117.6 is lower than 294 (294 is the payoff received by bond holders if conversion is not forced). Therefore the payoff to bond holders at dd=117.6. Now at t=1 at node u , the value of the bond is [0.6*350+0.4*235.2]/ 1.12= 271.5 Now at t=1 at node d, the value of the bond is [0.6*235.2 + 0.4*117.6]/1.12=168 Again at each of the above nodes the firm has the choice to force conversion, let us see what happens at node u at t=1. If the firm forces conversion at u at t=1, bond holders receive 0.4*840=336 which is greater than 271.5, therefore the firm will not force conversion at t=1 in the upper node. Now at t=1 at the lower node, the bond holders receive 0.4*420=168 therefore the firm is indifferent between forcing conversion or not. Now discounting the payoffs of the bond holders to t=0, we get the value of this bond [0.6*271.5 + 0.4*168]/1.12=205.44 Now to check if the firm forces conversion immediately at t=0, we see that 0.4*600=240 which is higher than 205.44. Thus the firm will not force conversion at t=0. Thus the value of this bond is 205.44. b) and c) If gamma is either 0.65 or 0.71 the optimal decision for the firm is to wait until t=2 and then to convert (oblige the debt holders to have equity instead of debt) only when the asset value is 294, the value of the security will be 258.75 (if gamma=0.65) or 261 (if gamma=261). d) The company issues this security in order not to go bankrupt, so it avoids bankruptcy costs. Question 2 a) If the stock goes down at t=1 the option will become worthless at t=2 since 80<90. Therefore, the value of the option will be 144, 96, 0 and 0 (in the states up/up, up/down, down/up and down/down). The value of the option will be 120 and 0 at t=1 (states up and down respectively). Hence, the value at t=0 is 81.81 b) If the price of the stock is 85, then there is an opportunity to arbitrage. The strategy is to sell high (sell the exotic) and buy low (the replicating portfolio that consist of the stock and a bank account). Today you get 85-81.81>0.

Strategy: Buy at t=0 3 stocks and borrow 218.18. At t=1 in the up state just buy 1 stock and in the down state no position. You will see that the payoffs at t=1 and t=1 will be 0, and since there is a positive payoff at t=0, you just made money (a free lunch!). Since you go long in the stock in order to arbitrage, the restrictions in short selling are not binding. Question 3 The fair forward price is simply todays (spot) price compounded forward at the risk free rate for the relevant amount of time: 50 x (1.12)0.5 = 52.915. Recall that this number is obtained through a replicating portfolio argument: to get same effect as entering into the long forward position, the investor could instead buy the stock today for 50 using borrowed money. In six months time, he or she would repay the borrowing of 52.915 and be left holding the stock.

Question 5 a. The initial fair forward price is the spot price compounded forward at the risk-free rate: 40 x 1.080.5 = 41.57. The initial value of the position though is zero. b. Three months later the value of the initial position can be positive or negative or, by coincidence, zero. The short forward position will pay off X- ST , or specifically in this case, 41.57 ST . To generate (or replicate) the payoff I will get in three mo nths time, today I need to lend the present value (discounted at the riskfree rate) of 41.57 and I need to short the stock. In three months time I will get 41.57 back from my lending and have to buy back the stock to cover my short position. The present value of a cash flow of 41.57 in three months time is 41.57/ 1.080.25 = 40.78 . If I short the stock today, I will collect 38. Therefore, I will need an extra 40.78 38 = 2.78 of my own money to invest in the replicating portfolio and this therefore has to be the value of the original short forward position. Note that, given that taking a short position corresponds to taking a view that the price of the underlying will fall, in this case the short forward position has a positive value when prices go down.

Solution from Urs Peyer Question 4 a)

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