UNIVERSITY OF ZIMBABWE

DEPARTMENT OF MATHEMATICS
HMTHCS316: INTRODUCTION TO FINANCIAL MATHEMATICS — 2024 ASSIGNMENT 1/PN

1. State and explain the 4 types of option positions with the aid of payoff diagrams.
2. What do you understand by the term ’hedging’ ?
3. What is the difference between a long forward position and a long call position?
4. Explain the difference between a future and a forward contract.
5. A trader enters into a short cotton futures contract when the futures price is 50 cents
per pound. The contract is for the delivery of 50,000 pounds. How much does the
trader gain or lose if the cotton price at the end of the contract is (a) 48.20 cents per
pound; (b) 51.30 cents per pound?
6. A forward has been priced in such a way that K > S0 erT , where K is the strike price
and S0 is the price today of an asset and T is is the maturity date. Explain using some
arbitrage arguments why the buyer of the asset should not enter this contract.
7. Suppose that a European call option to buy a share for $100.00 costs $5.00 and is held
until maturity. Under what circumstances will the holder of the option make a profit?
Under what circumstances will the option be exercised? Draw a diagram illustrating
how the profit from a long position in the option depends on the stock price at maturity
of the option.
8. Suppose that a European put option to sell a share for $60 costs $8 and is held until
maturity. Under what circumstances will the seller of the option (the party with the
short position) make a profit? Under what circumstances will the option be exercised?
Draw a diagram illustrating how the profit from a short position in the option depends
on the stock price at maturity of the option.
9. A trader buys a call option with a strike price of $45 and a put option with a strike
price of $40. Both options have the same maturity. The call costs $3 and the put
costs$4. Draw a diagram showing the variation of the trader’s profit with the asset
price.

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10. An investor sells a European call on a share for $4. The stock price is $47 and the strike
price is $50. Under what circumstances does the investor make a profit? Under what
circumstances will the option be exercised? Draw a diagram showing the variation of
the investor’s profit with the stock price at the maturity of the option.
11. Suppose that a June put option on a stock with a strike price of $60 costs $4 and is
held until June. Under what circumstances will the holder of the option make a gain?
Under what circumstances will the option be exercised? Draw a diagram showing how
the profit on a short position in the option depends on the stock price at the maturity
of the option.
12. An investor buys a European put on a share for $3. The stock price is $42 and the strike
price is $40. Under what circumstances does the investor make a profit? Under what
circumstances will the option be exercised? Draw a diagram showing the variation of
the investor’s profit with the stock price at the maturity of the option.
13. A stock is currently $100. It is known that at the end of three months it will be either
$110 or $90. The risk-free interest rate is 5% per annum. What is the value of a
three-month European call option with a strike price of $95?
14. Suppose that the Pula-Rand spot and forward exchange rates are as follows:
Spot 1.6080
90-day forward 1.6056
180-day forward 1.6018
What opportunities are open for an arbitrageur in the following situations?
i A 180-day European call option to buy P1 for R1.57 costs 2 cents.
ii A 90-day European put option to sell P1 for R1.64 costs 2 cents.
15. A principal of $130 is deposited in an 8% account and compounded continuously. At the
same time a principal of $150 is deposited in a 6% account and compounded annually.
How long does it take for the amounts in the two accounts to be equal?
16. Given the following returns and assuming that S(0) = $45, find the possible stock prices
in a three-step economy and sketch a tree of price movements:

Scenario K(1) K(2) K(3)

ω1 10% 5% -10%
ω2 5% 10% 10%
ω3 5% -10% 10%