Practice questions

These are practice questions for the exam, so ideally you should try to do them
without looking at the answers

The actual exam will have fewer questions than this. There are more here, so you can
better prepare

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 Short-answer questions
(1) Explain briefly the role of the “initial margin” and the “maintenance margin” in the
“mark-to-market” procedure in the futures market.

(2) On 10/12/2012, the December Euro FX Futures are traded at the futures price
F = 1.2938 USD/1 EUR. The spot exchange rate between the Euro and the Dollar is
S = 1.2957 USD/1 EUR. So, F < S. Does that suggest that the market expects the
Euro to depreciate against the dollar in the next two months?

(3) Explain what is a currency carry trade.

(4) How can you replicate a standard European call option with strike price K using
binary options?

(5) The Delta of a call option will increase as the volatility of the stock increases. True or
False? Why?

(6) Compare the following two positions. There are three strike prices, K 1 = 10, K 2 = 20
and K 3 = 30. Position 1 holds a butterfly position (using all three options) and
borrows the present value of 10 dollars (borrow 10 × B(t; T ) dollars today, repay 10
dollars tomorrow). Position 2 holds a short straddle (sell the 20 call, sell the 20 put).
Draw the payoff diagrams for the two positions. In each case, what are you betting
on? Which position is cheaper today and why?
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 Questions on forwards and swaps

1 Today is September 1st. A company plans to borrow in December 8 mln USD for
three months at LIBOR
I What position should the company take in Eurodollar futures contracts to hedge its
interest rate risk? What happens when LIBOR rates increase or decrease?

I What position should the company take if it wants to hedge the interest rate risk using
FRAs? Why?

2 Today is t = 0 and the annualized LIBOR rates for the 6, 18, and 30 month
maturities are 2.8%, 3.2%, and 3.4%, quoted as simple interest rates. Calculate the
continuously compounded forward rates f0,6mth,18mth and f0,18mth,30mth , and the FRA
rates rFRA,6mth,18mth and rFRA,18mth,30mth

3 Today is t = 0 and the LIBOR’s are as before. Some time ago a bank agreed to
receive 1-year LIBOR and pay 3% at the end of each year. The notional principal is
$100 million. Today this swap has a remaining life of 2.5 years. The 1-year LIBOR
rate at the last payment date was 2.9%, (again simple interest rate). Find the current
value of the swap.

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 Question 4

European puts and calls with one year to maturity are available on ABC common stock at
the following prices:

Strike price Call price Put price

30 - 5
40 10 -
50 - 10

The dashes indicate that the corresponding options are not available. The stock pays no
dividends, and its current price is $38 per share. The current price of a zero coupon bond
paying one dollar one year from now is $0.90.
(1) Calculate the three missing prices in the table.

(2) Explain how you could make an arbitrage profit trading at the quoted prices.

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 Question 5
Alex, a manager at Fast Food, Inc.(FFI) received 1,000 shares of company stock as part of
his compensation package. The stock currently sells at $40 at share. Alex would like to
defer selling the stock until the next tax year. In January, however, he will need to sell all
his holdings to provide for a down payment on his new house.
Alex is worried about the price risk involved in keeping his shares. At current prices, he
would receive $40,000 for the stock. If the value of his stock holdings falls below $35,000,
his ability to come up with the necessary down payment would be jeopardized. On the
other hand, if the stock value rises to $45,000, he would be able to maintain a small cash
reserve even after making the down payment. Alex considers three investment strategies:
(1) Strategy A is to write January call options on FFI with strike price $45. These calls
are currently selling for $3 each.

(2) Strategy B is to buy January put options on FFI with strike price $35. These options
also sell for $3 each.

(3) Strategy C is to sell the January calls with strike price $45 and buy the January puts
with strike price $35.
Evaluate each of these strategies with respect to Alex’s investment goals. What are the
advantages and disadvantages of each? Which strategy would you recommend?
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 Question 6

A chooser option gives its owner the right to specify at the time of exercise whether the
option is a put or a call. Your firm is considering a three-period American chooser option
with a time-dependent strike price.
Each option covers 100 shares of ABC stock. The current price of the stock is $80 per
share. Over each period, the stock price will either increase by 25% or decrease by 20%.
The strike price of the option grows at 5% per period. The initial strike price is $8,000.
The stock does not pay dividends, and the simple interest rate is 2.5% per period.
(1) Given the information above, what is the value of the chooser option?

(2) Under what circumstances should the option be exercised before the expiration date?

(3) If the seller of the option wishes to hedge its position using stock shares, how many
shares should it hold initially?

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Answers

HKUST, FINA5290, G. Panayotov

 Short-answer questions
(1) See L2 slide 26
(2) See L4 slide 15
(3) See L4 slide 16.
(4) We long an asset-or-nothing call with strike K and short K shares of cash-or-nothing
call with strike K . The binary options we use should have the same maturity as the
standard European call.
ln( S )+(r + 1 σ 2 )(T −t)
(5) False. ∆ = N(d1 ), where d1 = K σ√T2−t . This formula shows that d1 is not
monotonic in σ. Particularly, when the option is deeply in the money, higher σ reduces
the option’s ∆. Alternatively, you can look at the graphs in Lecture 11 slides 21-22, in
particular in the tails, and try to make some conclusions about the slopes (that is, the
deltas) for different volatilities
(6) The payoff diagrams of both positions resemble tents. The maximum payoff of both
positions is 0 (when the strike is 20). (If you depicted a regular butterfly with positive
payoff, you forgot to include the borrowing.) The difference is that the butterfly
position has wings that do not go below -10, while the short straddle has wings that
extend much further. From the payoff diagrams, both positions are bets that the
stock price will not move far from 20. In the case that the stock price does not move
far from 20, the proceeds from each position today will outweigh the non-positive
payoff at maturity. From the payoff diagrams, position 2 will be cheaper today
because it does not bound the negative payoffs at -10.
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 Questions on forwards and swaps 1

(see L5 slide 10) It should sell (i.e., short) Eurodollar futures contracts. If rates
increase, the futures price goes down and the company gains on the futures. This
compensates the company’s loss from the higher borrowing rates. If rates decrease,
the futures price goes up and the company loses on the futures. On the other hand, it
gets a lower borrowing rates, so the gains and losses again offset each other.

(see L5 slide 7) It should buy (i.e., go long) FRAs. According to the payoff formula
for FRAs, the company gains when LIBOR rates increase, which compensates its loss
from the higher borrowing rates. And vice versa when rates decrease.

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 Questions on forwards and swaps 2
First convert the simple LIBOR rates to continuously compounded interest rates.

r0,6mth = ln (1 + 0.5 × rLIBOR,0,6mth ) /0.5 = ln (1 + 0.5 × 2.8%) /0.5 = 2.78%

r0,18mth = ln (1 + 1.5 × rLIBOR,0,18mth ) /1.5 = ln (1 + 1.5 × 3.2%) /1.5 = 3.13%
r0,30mth = ln (1 + 2.5 × rLIBOR,0,30mth ) /2.5 = ln (1 + 2.5 × 3.4%) /2.5 = 3.26%

cont. comp.
∗T
We used above the formula 1 + r simple ∗ T = e r (see also L2 slide 7)

Now we use the formula for the forward rate from L5 slide 4:

f0,6mth,18mth = r0,18mth × 1.5 − r0,6mth × 0.5 = 3.13% × 1.5 − 2.78% × 0.5 = 3.305%
f0,18mth,30mth = r0,30mth × 2.5 − r0,18mth × 1.5 = 3.26% × 2.5 − 3.13% × 1.5 = 3.455%

The FRA rates are from L5 slide 8 (make back simple from cont. comp):
FRA
r0,6mth,18mth = e f0,6mth,18mth − 1 = 3.36%
FRA
r0,18mth,30mth = e f0,18mth,30mth − 1 = 3.52%

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 Questions on forwards and swaps 3
First will do for $1, and will use L for LIBOR, F for FRA. From L6 slides 9-11, the value of
a swap is the expected present value of the remaining cashflows (note that the offsetting
swap mentioned on those slides in L6 has a value of zero). So, need to replicate the
remaining cashflows.
Positions 6 months 18 months 30 months
Long swap L
r−6mth,6mth − 3% L
r6mth,18mth − 3% L
r18mth,30mth − 3%
F L
r6mth,18mth −r6mth,18mth
Short 6-18mth FRA today L
1+r6mth,18mth
F L
r6mth,18mth −r6mth,18mth F L
Invest in bonds − L r6mth,18mth − r6mth,18mth
1+r6mth,18mth
F L
r18mth,30mth −r18mth,30mth
Short 18-30mth FRA today L
1+r18mth,30mth
F L
r18mth,30mth −r18mth,30mth F L
Invest in bonds − L r18mth,30mth − r18mth,30mth
1+r18mth,30mth
Total L
r−6mth,6mth − 3% F
r6mth,18mth − 3% F
r18mth,30mth − 3%
(Total in numbers) 2.9% − 3% 3.36% − 3% 3.52% − 3%
Now calculate the present value of these cashflows (for a notional value of $1)
2.9% − 3% 3.36% − 3% 3.52% − 3%
L
+ L
+ L
= 0.0072 (so 0.72 mln for 100 mln notional)
1 + 0.5 × r0,6mth 1 + 1.5 × r0,18mth 1 + 2.5 × r0,30mth

So, all we did was to substitute the unknown future rates r L with what the market expects
for them today (the FRA rates r F ). And we did that at zero cost today!!

HKUST, FINA5290, G. Panayotov

 Question 4

(1) Each of the missing options could be created synthetically.

I The call with strike $30 could be created by buying the stock, buying the put with
strike $30, and borrowing the present value of $30. The net investment required would
be $[5 + 38 - 30(.90)] = $16.
I The net investment required to create the call with strike $50 is $[10 + 38- 50(.90)] =
$3.
I The put with strike $40 could be created synthetically by shorting the stock, buying the
call with strike $40, and lending the present value of $40. The net investment required
here would be $[10 - 38 + 40(.90)] = $8.
I Here are the prices for all of the options, both actual and synthetic:

Strike price Call price Put price

30 16 5
40 10 8
50 3 10

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 Question 4 (cont’d)
(2) Cannot make arbitrage profit by trading puts and calls with the same strike – we used
put-call parity, so enforced no arbitrage. Need to use calls/puts with different strikes.
For both the call prices and the put prices the middle strike option is too expensive
relative to the two end strike options (think butterflies).
So, can buy synthetic calls with strike prices of $30 and $50 and sell two calls with a
strike price of $40. The overall portfolio would thus be long one put with a strike price
of $30, long one put with a strike price of $50, short two calls with a strike price of
$40, long two shares of stock, and borrowing of $(30+50)(.90) = $72. This strategy
would produce an immediate cash inflow of $(-5-10 + 20 - 76 + 72) = $1.
S < 30 30 ≤ S < 40 40 ≤ S < 50 S < 50
Long 1 put with K = 30 30 − S 0 0 0
Long 1 put with K = 50 50 − S 50 − S 50 − S 0
Short 2 calls with K = 40 0 0 −2(S − 40) −2(S − 40)
Long 2 shares 2S 2S 2S 2S
Borrow 72 −80 −80 −80 −80
Total payoff 0 S − 30 50 − S 0
In no circumstances would you have a loss later, and if the final stock price is between
$30 and $50 you would have an additional profit. Or, we could short two of the
synthetic middle strike puts and buy the end strike puts. However, this will lead to
exactly the same overall position that we just considered, as it must because of the
relationship between the actual and synthetic options.
HKUST, FINA5290, G. Panayotov
 Question 5

(1) By writing call options (in fact ”covered calls”, given the long position in the stock),
strategy A takes in premium income of $3,000. If the price of the stock in January is
less than or equal to $45, Alex will have his stock plus the premium income.

But also, the most he can have is $45,000 + $3,000 because the stock will be called
away from him if its price exceeds $45. (We ignore interest earned on the premium
income from writing the options in this very short period of time.) The payoff as a
function of the stock price in January, ST , is

Stock price Portfolio value

ST ≤ $45 (1, 000)ST + 3, 000
ST > $45 45, 000 + 3, 000 = $48, 000

This strategy offers some extra premium income (by selling the upside) but leaves
substantial downside risk. At an extreme, if the stock price fell to zero, Jones would
be left with only $3,000. The strategy also puts a cap on the final value at $48,000,
but this is more than sufficient to purchase the house.

HKUST, FINA5290, G. Panayotov

 Question 5 (cont’d)
(2) By buying put options with a $35 strike price, strategy B pays $3,000 in premiums to
insure a minimium level for the final portfolio value. This minimium value is
(35)(1, 000) − 3, 000 = $32, 000. This strategy allows for upside gain, but exposes
Alex to the possibility of a moderate loss equal to the cost of the puts. The payoff is
Stock price Portfolio value
ST ≤ $35 35, 000 − 3, 000 = $32, 000
ST > $35 (1, 000)ST − 3, 000

(3) The cost of strategy C is zero. The value of the portfolio in January will be:
Stock price Portfolio value
ST ≤ $35 $35, 000
$35 < ST < $45 (1, 000)ST
ST ≥ $45 $45,000

If the stock price is less than or equal to $35, this strategy preserves the $35,000 in
principal. If the stock price exceeds $45, the value of the portfolio can rise to a cap of
$45,000. In between, the proceeds equal 1,000 times the stock price
Given Alex’s objective, the best strategy would be C since it satisfies the two requirements
of preserving the $35,000 in principal while offering a chance of getting $45,000. Strategy
A should be ruled out since it leaves Alex exposed to the risk of substantial loss of
principal.
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 Question 6
(1) The stock price tree over the next three periods will be

The risk-neutral probability is p = (1.025 − 0.8)/(1.25 − 0.8) = 0.5.

After one period, the strike price will be 8000 (1.05) = 8400. After two periods, it will
be 8820, and after three periods it will be 9261.
At maturity the owner of the option will choose for it to be a call (put) if the stock
price at that time is higher (lower) than the strike price at the time.
Now the solution is as we did before, working backwards from the expiration date, and
checking at each point for optimal early exercise.
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 Question 6 (1, cont’d)
So, the values of the chooser option at maturity (0 periods to maturity) are:
V (15625, 0) = 6364, V (10000, 0) = 739, V (6400, 0) = 2861, V (4096, 0) = 5165.
The option is designated as a call if the final value of the stock is $15625 or $10000 and
as a put if the final value of the stock is $6400 or $4096.
Applying the risk-neutral valuation equation gives the values in the previous periods as
V (12500, 1) = max{12500 − 8820, (0.5 × 6364 + 0.5 × 739)/1.025}
= max{3680, 3464.88} = 3680
V (8000, 1) = max{8820 − 8000, (0.5 × 739 + 0.5 × 2861)/1.025}
= max{820, 1756.10} = 1756.10
V (5120, 1) = max{8820 − 5120, (0.5 × 2861 + 0.5 × 5165)/1.025}
= max{3700, 3915.12} = 3915.12
V (10000, 2) = max{10000 − 8400, (0.5 × 3680 + 0.5 × 1756.10)/1.025}
= max{1600, 2651.76} = 2651.76
V (6400, 2) = max{8400 − 6400, (0.5 × 1756.10 + 0.5 × 3915.12)/1.025}
= max{2000, 2766.45} = 2766.45
V (8000, 3) = max{8000 = 8000, (0.5 × 2651.76 + 0.5 × 2766.45)/1.025}
= max{0, 2643.03} = 2643.03

The current value of the chooser option is $2,643.03.

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 Question 6 (cont’d)

(2) The option should be exercised immediately if the value of the stock reaches $12,500
with one period remaining to maturity.

(3) The current delta of the option is

(V (10000, 2) − V (6400, 2))/(10000 − 6400) = −0.031858

To hedge the sale of the option, the issuing firm should short stock worth
$8, 000 × 0.031858, or 3.1858 shares.

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