Dr.

Dominic OKANE 2011-12

Advanced Derivatives
Examined Coursework
Master Level 2
M.Sc. In Financial Markets
ANNE SCOLAIRE / ACADEMIC YEAR 2014-2015

Lecturer: Dominic OKane

1 December 2014

Dr. Dominic OKANE 2011-12

Instructions READ CAREFULLY

This coursework contributes 30% of your final exam result

It must be done in groups of 3-5 (no more)
You must do all questions which are equally weighted
The answers must be sent in by 11:59pm on Sunday 21st December to me at
dominic.okane@edhec-risk.com

You must send me:

1.
A word document in pdf format with your answers set out clearly
2.
Excel spreadsheet containing all of your work. I will only look at this if I need to clarify
something (which I should not need to do). All of your answers must be in the pdf
document.
Note:
Points will be deducted for bad presentation, i.e. non-labelled inputs, unclear graphs, untidy
spreadsheets
There is a 100% penalty for copying and 10% for each day of late submission

Dr. Dominic OKANE 2011-12

Question 1
Implement a Black Scholes hedging simulation in Excel.
You should use N time steps and define dt=T/N where T is the time to option expiry
Simulate the following option: European Call Option.
Initial Stock Price = $100 Strike = $100 Volatility = 20% T= 1 yr r = 5% N=20
Do the following:
a)

Plot the evolution of the stock price, the option price, the option delta, the value of the stock
held and the value of the cash held, and the value of the replicating portfolio over the lifetime of
the option for a path in which the option finishes in the money (the final stock price is more
than 10% above the strike)

b)

Repeat (a) for an option which finishes out of the money (the final stock price is more than 10%
below the strike)

c)

Repeat (a) for an option which finishes at or close to the money (the final stock price is within 5%
of the strike).

d)

Discuss the differences between hedging portfolios in (a), (b) and (c)

Dr. Dominic OKANE 2011-12

Question 2
Implement a Black Scholes hedging simulation in Excel.
You should use N time steps and define dt=T/N where T is the time to option expiry
Simulate the following option: Digital Call.
Initial Stock Price = $100 Strike = $100 Volatility = 20% T= 1 yr r = 5% N=20
Do the following:
a)

Plot the evolution of the stock price, the option price, the option delta, the value of the stock
held and the value of the cash held, and the value of the replicating portfolio over the lifetime of
the option for a path in which the option finishes in the money (the final stock price is more
than 10% above the strike)

b)

Repeat (a) for an option which finishes out of the money (the final stock price is more than 10%
below the strike)

c)

Repeat (a) for an option which finishes at or close to the money (the final stock price is within 5%
of the strike).

d)

Discuss the differences between hedging portfolios in (a), (b) and (c) and how the delta depends
on the stock price.

e)

How does the situation differ from the hedging of a vanilla call option. Discuss.

Dr. Dominic OKANE 2011-12

Question 3
In Excel VBA build a Monte Carlo simulation to price a call option using Black-Scholes. Make sure
you declare variables and their types. Use the Rnd(-20) to allow the seed to be used to control
the random sequence

a)

Copy a listing of the code into your report.

b)

For an option which has the following characteristics: S(0) = $100 K = $100 Volatility = 20% T= 1
yr r = 5% calculate the price of the option for the following values of NumTrials:
100,200,500,1000,2000,5000,10000 and plot these on a graph. Compare this to the Black
Scholes price.

c)

By bumping the initial stock price from $100 to $100+dS, calculate the delta of the call option
over the values of NumTrials = 100,200,500,1000,2000,5000,10000 using different seeds for
each pricing for dS=0.10, 1 and 10.

d)

Also calculate the option delta using the Black-Scholes analytical model .

e)

Plot the error in delta by calculating the difference between the results of (c) and (d) as a
function of NumTrials for each value of dS. Explain why the error changes when dS changes.

f)

Add the line Rnd(-20) to the Monte Carlo function and repeat (c) - (e)

g)

Explain the difference in the deltas between (e) and (f)

Dr. Dominic OKANE 2011-12

Question 4
Suppose that we have managed to fit the volatility smile of the market prices of equity options with
a time to expiry of 1 year and a risk-free rate of 5% using the function

( x) 0.025x2 0.225x 0.60

where x is the moneyness of the strike and the initial stock price S0 is 100.
Recall that

x K / S0

In the following - assume that the dividend yield is 0%, that the initial stock price is $100
Our aim is to calculate the probability distribution of the final stock price implied by this volatility
smile and to use this to price other derivatives so that their prices are consistent with the smile

Question continues on the next page

Dr. Dominic OKANE 2011-12

Question 4 (continued)
a.

Build a spreadsheet to calculate the market implied probability density g(S) from the volatility
function on the previous page

b.

Using this probability density function, calculate the price of 1-year European digital call options
with strikes at 60, 80, 100, 120, 140. Explain clearly how this was done.

c.

Price the same digital call options as in (b) using Black-Scholes the pricing formula was given in
the lecture notes using the appropriate volatility for that strike.

d.

Explain why the results of (b) do not agree with (c). Which prices do you think are most consistent
with the market ? Why ?

e.

Calculate the price of a 1-year down and in put option where the barrier is tested only on the
option expiry date (it is not path dependent). The barrier is at 60 and the strike price is 100.
Explain clearly how this was done.

Dr. Dominic OKANE 2011-12

Question 5
a.

Write a VBA function which uses Monte-Carlo to price a 6-month Arithmetic Average Asian call
option. Include your code in your report pdf.

b.

Using this code, value an Arithmetic Average option with a current stock price of $100, a strike
price of $100, risk free rate of 5% and dividend yield of 0% where the stock price volatility is 30%.
Assume that averaging is done weekly. Use 10,000 trials.

c.

Adapt your code to value a Geometric Average option with the same characteristics as the
Arithmetic Average option. Include your code.

d.

Using the method of control variates, attempt to improve upon the quality of the estimation of the
Arithmetic option price knowing the you can price a Geometric Average option in Black-Scholes if
you make the following adjustments

Avg / 3

q Avg

1
r q 2 / 6
2

Explain carefully the steps in (d) and show how your pricing estimate changes.

Dr. Dominic OKANE 2011-12

Question 6
a.

Assuming a flat volatility at 30%, calculate the strike variance of a 1-year variance swap on a stock
which has a current price of $100 and a risk free rate of 5% using the formula from the course
notes which states that

2Strike

2
rT (erT 1) erT
T

S (0) P( K )

C(K )
dK
dK

2
2
K
0 K

S (0)

[Note: For the integration set the minimum strike to $0 and the maximum strike to $200 and use
steps of dK=$1. Use the analytical form of the Black-Scholes model for P(K) and C(K) (not the
Monte Carlo. You will have to implement this in VBA.]
b.

Repeat the calculations in (a) but this time assume that the volatility is strike dependent and takes
the following functional form

( x) 0.2 x 2 0.4 x 0.50

c.

x K / S0

Explain the difference between the results in (a) and (b)

Dr. Dominic OKANE 2011-12

Question 7
The hazard rate (t) is the probability that a credit defaults in the interval [t,t+dt] conditional on it
surviving to time t. If (t)= is constant then we can show that the survival probability Q(T) is given
by

Q(T ) exp T

(a) Build a spreadsheet that calculates in a column the term structure of Q(T) for T=0 to T=5.0 years in 3
month steps where is one of the inputs
(b) Next to this column add a column which calculates -dQ(T) which is approximately Q(T-0.25) - Q(T)
(c) Add a column that calculates the Libor discount factor Z(T) = exp(-rT) where r is an input cell

(d) Using this spreadsheet, calculate the RPV01 of a 5-year CDS contract (using Actual 365 and quarterly
payments)
(e) Using this spreadsheet, calculate the Protection Leg PV of this 5-year CDS contract make the
recovery rate R another spreadsheet input. You can integrate using quarterly time steps.
(f) Set r=5% and R=40%, calculate the breakeven spread for this CDS contract for =0.01, 0.02, 0.03,
0.04, 0.05, 0.06, 0.07, 0.08, 0.09, 0.10 and plot the breakeven spread as a function of
(g) On the same graph plot also the function S= (1-R)
(h) Repeat (f) and (g) where R=20%

10