END EXAM

Q 1: For each of the following statements, choose the right answer(s). (25 marks)
A. The process of protecting oneself against future price changes by shifting some or all
of the risk to someone else is called:
a. speculating
b. investing
c. hedging
d. gambling

B. When an asset is selling at a strike price below its market price, it is said to be
a. in a long position.
b. selling at its exercise price.
c. in the money.
d. out of the money.

C. Suppose an investor buys an option for a $1000 premium on a $100,000 August

T-bill futures contract with a strike price of 120. On the expiration date, the T-
bill futures contract has a price of 115. (Recall that arbitrage will result in the
spot price equaling the futures contract price.) What is the individual likely to
do?
a. He will buy the asset and make a profit of $5,000.
b. He will not buy the asset and thus suffer no loss.
c. He will buy the option but suffer a loss of $5,000.
d. He will not buy the option but he will suffer a loss of $1,000.

D. When two borrowers engage in a currency swap, they agree to:

a. trade one currency for another, thus avoiding the foreign exchange market.
b. make payments on each other's borrowings in a different currency.
c. pay to each other any depreciation or appreciation of the currency.
d. exchange fixed-rate interest payments for variable-rate interest payments.

E. Consider the buying of put option, the probability that a buyer would have
negative payoff increases with the
a. increase in stock price
b. decrease in stock price
c. increase in maturity duration
d. decrease in maturity duration
Q 2:
A. How can options, futures, and forward contracts be used to devise simple hedging
strategies? (6 marks)

- An option gives the holder the right but not the obligation to buy or sell an asset at a
specific price on a specific date.
- Forward contracts are binding agreements to buy or sell an asset at a specific price on a
specific date.
- A futures contract is simply a standardized forward agreement.

B. What is the difference between entering into a long forward contract when the
forward price is $50 and taking a long position in a call option with a strike price
of $50? (4 marks)

A long forward is an obligation to buy at the forward price at a fixed date and a long position
is a right to buy at the strike price over a determine period of time.

C. Suppose you observed that high-level managers make superior returns on

investments in their company’s stock.
a. Would this be a violation of weak-form market efficiency? (2 marks)

A high-level manager might well have private information about the firm. Her ability to trade
profitably on that information is not surprising. This ability does not violate weak form
efficiency: The abnormal profits are not derived from an analysis of past price and trading
data. If they were, this would indicate that there is valuable information that can be gleaned
from such analysis. But this ability does violate strong-form efficiency. Apparently, there is
some private information that is not already reflected in stock prices.

b. Would it be a violation of strong-form market efficiency? (2 marks)

The information sets that pertain to the weak, semistrong, and strong form of the EMH can be
described by the following illustration:

The weak-form information set includes only the history of prices and volumes. The
semistrong-form set includes the weak form set plus all other publicly available information.
In turn, the strong-form set includes the semistrong set plus insiders’ information. It is illegal
to act on this incremental information (insiders’ private information). The direction of valid
implication is:

Strong-form EMH  Semistrong-form EMH  Weak-form EMH

The reverse direction implication is not valid. For example, stock prices may reflect all past
price data (weak-form efficiency) but may not reflect relevant fundamental data (semistrong-
form inefficiency).
Q 3: Consider the three stocks in the following table. Pt represents price at time t, and Qt
represents shares outstanding at time t. Stock C splits two-for-one in the period.

a. Calculate the rate of return on a price-weighted index of the three stocks for the
first period (t = 0 to t = 1). (5 marks)

In order to calculate the price weighted index of three stocks for the first time period, we need
to use the formula,
Average Value of the index at 𝑃
𝑃𝑟𝑖𝑐𝑒 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑖𝑛𝑑𝑒𝑥 𝑓𝑟𝑜𝑚 𝑡 𝑡𝑜 𝑡 = −1
Average Value of the index at 𝑃

90 + 50 + 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑃 = = 80
3
95 + 45 + 110
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑃 = = 83.33
3

Substituting these we get,

83.33
𝑃𝑟𝑖𝑐𝑒 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 𝑓𝑟𝑜𝑚 𝑡 𝑡𝑜 𝑡 = − 1 = 4.17%
80

Therefore, Price weighted index from t=0 to t1 is 4.17%.

b. What must happen to the divisor for the price-weighted index in year 2? (5
marks)

P1 = 95 + 45 + 110 = 250
P2 = 95 + 45 + 55 =195

New divisor for the period 2 is given by the following formula,

𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃
𝑁𝑒𝑤 𝑑𝑖𝑣𝑖𝑠𝑜𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃
Total value of P2 = 95+45+55 = 195
Average value of P1 = (95+45+110)/ 3 = 83.33

Substituting these we get,

195
𝑁𝑒𝑤 𝑑𝑖𝑣𝑖𝑠𝑜𝑟 = = 2.340
83.33

Therefore, new divisor = 2.340

c. Calculate the rate of return on the price-weighted index for the second period (t
= 1 to t = 2). (5 marks)
The return is zero in this case. Since the index remains unchanged as the return in this case
seperately for each stock is zero.
Q 3: A call with a strike price of $60 costs $6. A put with the same strike price and
expiration date costs $4.
a. Construct a table that shows the profit from a straddle. (5 marks)
PAYOFF TO A STRADDLE
ST  X ST > X
PAYOFF OF CALL 0 ST - X
+ PAYOFF OF PUT + (X - ST) +0
TOTAL X - ST ST - X

b. Draw the profit graph for this strategy at the expiration date (15 marks)

50 60 70

c. For what range of stock prices would the straddle lead to a loss?(5 marks)

When the asset price greater than $60, the call option provides a payoff of ST – 60 and the put
option provides no payoff. Taking into account the $10 cost of the options, the total profit is
ST – 70.
When the asset price less than $60, the put option provides a payoff of 60T − S and the call
option provides no payoff. The options cost $10 and so the total profit is 50T − S.
The trader makes a profit (ignoring the time value of money) if the stock price is less than $50
or greater than $70.

Q 4: A margin account is used to buy 200 shares on margin at $35 per share. $2000 is
borrowed from the broker to complete the purchase.
Determine the actual margin:

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 − 𝐿𝑜𝑎𝑛 𝑓𝑟𝑜𝑚 𝑏𝑟𝑜𝑘𝑒𝑟

𝑀𝑎𝑟𝑔𝑖𝑛 = × 100
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘

a. When the purchase is made. (5 marks)

The value of the purchase is 200 × 35 = $7000.

The initial margin is: 𝐴𝑐𝑡𝑢𝑎𝑙 𝑚𝑎𝑟𝑔𝑖𝑛 = × 100 = 71.429%

b. If the price of the stock rises to $45 per share. (5 marks)

The value of the purchase is 200 × 45 = $9000.

The initial margin is: 𝐴𝑐𝑡𝑢𝑎𝑙 𝑚𝑎𝑟𝑔𝑖𝑛 = × 100 = 77.778%

c. If the price of the stock falls to $30 per share. (5 marks)

The value of the purchase is 200 × 30 = $6000.

The initial margin is: 𝐴𝑐𝑡𝑢𝑎𝑙 𝑚𝑎𝑟𝑔𝑖𝑛 = × 100 = 66.667%
Q 5: The following table contains data about options on IBM stocks.

a. What will be the proceeds and net profits to an investor who purchases the
October 2011 expiration IBM calls with exercise price $165 if the stock price at
option expiration is $155? (5 marks)

Proceed = Not exercise the option = 0

Net profit = Proceed - Premium = 0 – 8.7 = -8.7

b. What if the stock price at expiration is $175? (5 marks)

Proceed = Stock price - Strike price = 175 – 165 = 10

Net profit = Proceed - Premium =10 – 8.7 = 1.3

c. Now answer part (a) and (b) for an investor who purchases the October
expiration IBM put option with exercise price $165. (6 marks)

Proceed = Stock price - Strike price = 175 – 165 = 10

Net profit = Proceed - Premium = 10 – 7 = 3

Proceed = Not exercise the option = 0

Net profit = Proceed - Premium = 0 – 7 = -7

Q 6: The spot price for smoked Salmon is $5,000 per ton and its six-month futures price
is $4,800. The monthly interest rate is 0.0025 (0.25%).
a. What is the average monthly net convenience yield on smoked salmon for the next
six months? (5 marks)

𝑌𝑖𝑒𝑙𝑑 = (1 + 𝑅𝑎𝑡𝑒) −
×
𝑌𝑖𝑒𝑙𝑑 = (1 + 0.0025) −
𝑌𝑖𝑒𝑙𝑑 = 8.09%
b. If you are a manager of Bread & Circus and need 10 tons of smoked salmon in six
months. How can you avoid the risk in the price of smoked salmon over the next
six months using futures? (5 marks)

c. Suppose that your net convenience yield for smoked salmon is 1.2%. How does this
change your hedging strategy? (5 marks)

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑌𝑖𝑒𝑙𝑑 = [𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒 × (1 + 𝑅𝑎𝑡𝑒 − 𝑌𝑖𝑒𝑙𝑑) ]

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑌𝑖𝑒𝑙𝑑 = [5,000 × (1 + 0.0025 − 1.2) × ]
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑌𝑖𝑒𝑙𝑑 = 𝑥