HKUST FINA3203 L3/L4 Spring 2022

School of Business Yicheng Zhu

Midterm Exam
Tuesday, March 22, 2022

1 (20 points) Short Questions

(Please briefly explain your answers.)
(i) (5 points) The spot exchange rate between Euros and USD is 1.19 USD per EUR. The
annualized continuously-compounded risk-free interest rates in Euro zone and U.S are
both 0.5%. The three-month forward exchange rate is 1.196 USD per EUR. What is
the implied annualized continuously-compounded convenience yield for USD?
(ii) (5 points) The Hong Kong Monetary Authority promised that the exchange rate be-
tween HKD and USD is fixed at 7.8 HKD per USD. The annualized continuously com-
pounded interest rates US is 1%. What must the interest rate (annualized, continuously-
compounded) be in Hong Kong if HKMA allows for free exchange between the two
currencies?
(iii) (5 points) Explain why investors who want to get exposure to realized volatility
prefers to trade volatility swap instead of strategies involving other assets.
(iv) (5 points) Consider two forward contracts on the same non-dividend-paying financial
asset underlying but different maturities, 6 month and 1 year, respectively. If the
forward prices are the same for the contracts, what is the implication in terms of the
forward interest rate?

2 (25 points) Commodity Forwards

The spot price of Brent Crude oil is currently 50 USD per barrel. The cost of storing one
barrel of oil for one year is $3, paid when storage starts. The annually-compounded risk-free
rate is 2% per annum. The forward price of Brent Crude oil with 1-year maturity is 55 USD
per barrel.
(i) (8 points) What should be the no-arbitrage price of 1-year forward? Is the market
forward price higher or lower than the price implied by absence of arbitrage?
(ii) (17 points) Design a trading strategy in order to take advantage of the arbitrage op-
portunity. Lay out in detail what assets you need in your portfolio and the cash flow
of your strategy. What is your arbitrage profit? Profit realized either now or 1 year
later should suffice.

1
3 (35 points) Swaps of Stocks
The spot price of stock ABC is traded at $50 per share. Stock ABC pays a constant dividend
yield of 5% per annum, continuously-compounded.
The 1, 2, 3 year zero-coupon bonds with face value $1000 trade at $990.05, $975.31 and
$961.75, respectively.

(i) (6 points) What are the annualized continuously-compounded risk-free rates for 1 year,
2 year and 3 year deposits?

(ii) (6 points) What are the 1-year, 2-year and 3-year forward prices for one share of ABC?

(iii) (8 points) What is the swap price for ABC for a swap contract with maturity 3 years
and one settlement after 1 year, 2 years and 3 years, respectively?

(iv) (15 points) Suppose after 1 year, after the first settlement, the spot price of stock
ABC is $52, and 1 and 2 year zero coupon bonds with face value $1000 cost $990.05
and $975.31, respectively. How much can an investor with a long position of the swap
in (iii) get right after the first settlement if he or she tries to close the contract in the
market?

4 (20 points) Pricing Forward Contracts

Consider an asset whose spot price at t is unavailable (i.e., St is unknown). The asset does
not yield any dividends. Financial analysts estimate that the value of the asset after a year
(i.e., at t + 1) can take two values: with 20% probability, the asset value is 50; and with
80% probability, the asset value is 40. Based on the capital asset pricing model (CAPM),
financial analysts also estimate that the expected return of the asset is 5% (annualized and
annually-compounded). The annually-compounded risk-free rate is 2% per annum.

(i) (5 points) What is Et [St+1 ], the time-t expectation of the payoff of the asset at t + 1?

(ii) (5 points) What is the present value of the asset at t?

(iii) (10 points) Suppose there is a forward market for the asset. What is the theoretical
forward price at time t for maturity t + 1?